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Out of finance options? Try mezzanine debt Add to ...

The owners of many small and medium-sized businesses (SMBs) are finding it increasingly difficult to acquire the formal financing, loans or investors needed to maintain and build their businesses.

There are many alternative sources of financing available, such as term loans, equity financing and various government programs. But if these types of traditional financing are not available it might be time to look at something known as mezzanine debt.

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This type of term loan is an excellent way to get more debt financing together with reasonable operating flexibility than would otherwise be possible. It is sometimes, and perhaps more aptly, referred to as participating debt, junior debt, subordinated debt or even quasi-equity.

You may be familiar with a U.S. term for similar type financing — junk bonds.

What is mezzanine debt?

Lenders who offer mezzanine debt are willing to accept a higher level of risk. They are often notably more flexible than traditional lenders and may even provide a lower rate of interest in return for a share in the success of the business. The target rate of return to the lender is the normal term-debt interest rate plus some factor of return that reflects the additional risk, or some benefit to be received by the borrower.

This type of loan is usually secured with fixed assets but may also be related to working capital through the collateralization of current assets. Lenders will customize the loan transaction to minimize the risk of a borrower's default. In doing this, the lender might offer to:

• Take a position subordinate to the traditional term lender.

• Advance more funds than would be available under traditional lending criteria.

• Reduce or defer interest.

• Make payments interest-only with no principal repayment, or provide long terms such as eight to 10 years, often as a function of cash flow.

Less equity required

Mezzanine debt does not eliminate the need for equity but it does reduce the amount required, and accordingly, it also reduces business risk. A common criterion for mezzanine debt is an established, reliable and predictable cash flow instead of the traditional solid security base. Usually security is secondary, and subordinated to the primary or senior debt.

This is the type of term loan an owner should seek when planning for such things as:

• A leveraged buyout.

• Ownership succession.

• A major plant expansion.

• An acquisition.

• A rapid, but temporary, growth phase.

While these are typical reasons for using mezzanine debt, the financial community has welcomed the principle of bonus returns and adopted the structure of mezzanine debt for many other situations. For example, it is periodically used to carry out a turnaround or a restructuring.

Sharing in the future success of your business

While these lenders play a more passive role than an investor and may convert much of the yield to a pre-tax cost, they do participate in your business's future success. Depending on the nature of the transaction, the lender may structure the loan repayment to share in your future prosperity in a number of different ways. For example, the lender may require a bonus return comprised of one or more of the following:

• A percentage of net cash flow, pre-tax income, or gross revenue.

• A fixed fee, either one-time or paid periodically.

• Nominal-cost common shares.

• Warrants or options to purchase common shares or the right to convert debts into common shares.

Where to find mezzanine debt lenders

Unlike the United States where a public market for junk bonds developed in the 1970s and 1980s, Canada has primarily a private-placement market for mezzanine debt. Pension funds are the primary source because of their substantial accumulated treasury funds, inherent lack of a cost base for these funds and, of course, their long-term perspective. Some insurance companies are candidates for the same reasons, but they have traditionally preferred mortgages. Trust companies and banks are beginning to take a more active interest as the competition and sophistication of corporate financing increase.

Understanding the lender's perspective

The lender's financial return is comprised of:

• Return of principal.

• Interest spread (mark-up) on loaned funds.

• Participation revenue or continuing fees.

• Upfront fees.

In assessing your application, the lender will estimate the timing of each element and develop a financial model to compute its internal rate of return (IRR). Whether the deal is acceptable depends on the lender's forecast of an acceptable return in relation to the risk.

Given the above, the lender's most important yardsticks for an attractive mezzanine debt deal include the following:

• A proven management team.

• Shareholder commitment.

• An established historical cash flow.

• Stability within the industry.

• Minimal capital expenditures.

• A clear market niche.

• The existence of competitive barriers, including trademarks or patents.

The typical lender will complete a comprehensive business evaluation. Some aspects will be objectively based on factual data while others will be subjectively based on intuition. A comprehensive and credible business plan will both assist the lender and facilitate interpretation of the opportunity.

Benefits of mezzanine debt

The state of the economy is an important factor in determining the attractiveness of mezzanine debt: it is attractive in an expanding economy where cash flows increase as business grows and early retirement of the debt is feasible; in a recession, however, mezzanine debt presents more risk for both the lender and borrower.

The key benefits of this type of funding are the limited term and defined costs, but don't underestimate other ways mezzanine debt can benefit the company:

• Often a mezzanine lender will want a seat on the board of directors. Such participation in your business can add important expertise, objectivity and networking contacts.

• Shareholders retain a higher proportion of ownership.

• It is less expensive than equity financing.

• The “return” to the lender is usually paid out of pre-tax earnings thereby reducing taxes payable.

• A leveraged (LBO) or management buyout (MBO) can be completed with higher leverage than would otherwise be possible.

Special to the Globe and Mail

Excerpts from The Financing Toolkit for Small & Medium Businesses by Gary A. Fitchett, CA, provided by the Canadian Institute of Chartered Accountants. For more information go to www.knotia.ca/store, or www.cica.ca/financing.

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