In last month’s blog, we covered the two most common sources of financing for small business acquisitions: traditional term loans and SBA loans. This month we hit on the more complex but very flexible mezzanine financing, as well as seller financing and equity investors. A good transaction likely incorporates several different sources of funds, so it’s important to know when to choose equity over debt, or which kind of debt is best for your situation, whether you’re buying a business for the first time, or looking to grow your established business through acquisition.
Mezzanine Financing (JUNIOR/SUBORDINATED DEBT)
Mezzanine financing is a hybrid between debt and equity, often offering a combination of subordinated debt and preferred equity to businesses in the lower middle market ($5-$100M in revenue and $1-$10M of EBITDA). You can customize terms based on the needs of your business, you do not need to provide collateral, but you’ll pay significantly higher interest rates (12-30%), closer to equity returns, because it is considered riskier. While your senior lender gets regular monthly payments on interest and principal, you might pay your mezz lender interest-only (or NO) monthly payments with a balloon payment on principal at maturity. Lower monthly debt payments will increase your profit margins, improve cash flow for paying down other bank loans, and provide better returns to investors. Since minimal collateral and due diligence is required, the underwriting process is quick, making mezzanine financing convenient if you need a loan on short notice for something like a time-sensitive acquisition opportunity.
Source(s): Non-bank/mezzanine lenders, private investors, insurance companies, mutual funds, pension funds, hedge funds.
Typical Terms: 12% to 30% APR (Annual Percentage Rate). Regular interest-only payments (sometimes no initial payments at all) for 3 to 7 years (commonly 5-6) with a balloon payment. Often interest accrues only for the first 3 years but a warrant in place outlines that debts not paid back within the term convert to ownership or equity interest in the company (an “equity kicker”). Typically, subordinated debt with equity kicker, but can be convertible debt, preferred equity or subordinated debt without an equity co-investment. Lenders are flexible with structure based on business dynamics.
Loan Amount: $500,000 to $100M+.
Requirements: Minimum of $5M in sales and $1-2M+ of EBITDA (lenders usually look at EBITDA). Proven business model with consistent and reliable cash flow and positive growth projections. Because debt is unsecured, mezzanine financing is typically only available to profitable companies.
PROs: Increased cash flow due to minimal monthly debt payments. Nominal collateral/personal guarantees. Shorter and less competitive underwriting process.
CONs: Very high interest rates. Can result in equity participation (typically no more than 5% to 15%).
Good for: Profitable, mid-size, mid-stage (3- to 5-year old) companies with consistent cash flow but limited assets who can’t qualify for traditional bank loans and need funds quickly. Companies with an expert financial controller tracking cash flow closely can do very well with mezzanine debt.
If you don’t want to involve another third-party in your acquisition, you can use another form of debt – seller financing - to complete the transaction, essentially turning the seller into another bank. Seller financing usually represents a small fraction of the total purchase price, but can fill a valuation gap between the seller’s expectations/desires and what you, the buyer, bring to the table through other funding sources. In a seller-financed transaction, you still pay the seller the majority of cash at closing, in addition to regular future payments based on agreed-upon terms of the seller note.
Requirements: Seller must be comfortable receiving payments after closing.
Typical Terms: 6% to 15% APR. Monthly interest/principal payments for 5 to 7 years. Specific terms negotiated during due diligence.
Loan Amount: Typically, 10-30% of the purchase price. (Smaller deals have more seller financing. Bigger deals have less.)
PROs: Easily negotiated during diligence without third party delays. Usually a win-win for buyer and seller.
- Buyer: Cheaper than other forms of financing like equity or mezz debt. Interest payments on seller note (10%) are lower than return buyer will earn on equity (25%). Delays cash outlay to seller.
- Seller: Interest payments usually provide higher returns (10%+) than what they’ll earn with other investments. Can increase total valuation. Can increase cash at closing to the seller by eliminating the need for escrow.
- Buyer: Can increase total purchase price.
- Seller: Delays receipt of cash. Potential for default on payments.
- A buyer who wants to be a top bidder using a cheaper capital source than equity, and benefit from tax-deductible interest expenses post-closing.
- A seller who wants to maximize total purchase price and is willing to collect cash over the long-term and benefit from regular monthly payments (fixed income) after closing.
If you don’t want to take on more debt, another option is to raise money from investors in exchange for equity. Equity is typically more expensive than debt as your ownership shares get diluted and shareholders share claim the company’s future earnings. Their investment in your company is a risk because they do not have claims on assets like debt holders do in the case of future financial difficulties. Because of this risk, they expect high returns (over 25%). Know that in a majority transfer, bringing in outside investors can mean relinquishing full control of decision-making.
In some instances, this is desired by business owners who feel they have maxed growth at its current level and require outside investors and leadership to grow the business into the next tier. An example would be a company that performs about $10MM year after year but doesn’t have the infrastructure, capital or leadership team to grow the company into a $25MM or $50MM business and can use professional help to drive significant growth. While you do have to give up a stake in the business, having a skilled investor to support this growth, could mean your smaller share actually turns into a more valuable asset when the company triples in size.
Source(s): Owner, other shareholders or new investors.
Requirements: Ability to win investors with convincing business plan.
Typical Terms: Investors get a slice of ownership and profits for the life of the business or until they sell their shares.
Investment Size: Whatever 1) it takes to fund the deal or 2) you are willing to share.
PROs: No interest payments or personal guarantees.
CONs: Shared ownership/control. Diluted equity.
Good for: Individual first-time buyers and new, cyclical or seasonal businesses with unstable, unpredictable cash flows that have trouble qualifying for traditional bank loans and need to minimize monthly debt payments in order to maximize and reinvest cash flow for immediate growth.
You fund and close on your dream acquisition. Business is booming, and you plan to keep your shareholders and debtholders happy for years to come with high returns on their investments.
With multiple financing sources in place, however, it’s good to be aware of their payback order in the unlikely event your newly-acquired company faces bankruptcy or liquidation in the future. Your senior lenders have first claim to all the company’s assets since their loans are secured – this is what allows them to lend at the lowest cost (because they are taking less risk). On the other end of the spectrum, your equity investors get paid only after all other lenders, including anything owed to the seller in the seller note. In this way, the least expensive (and least risky) debt gets paid back first, while the most expensive (and most risky) debt is paid last, if at all.
- Senior debt (conventional bank term loans or SBA lenders)
- Subordinated (junior) debt, including mezzanine
- Seller note
- Equity investors
So…which type of financing is best for me?
As you can tell, financing a deal can be quite complex. You must assess what options makes sense for you, your business and the company you’re acquiring. Factors to consider include the size and stage of your business, your risk profile, your industry and the future goals of the consolidated companies. The good news is, by leveraging your business correctly using a combination of the sources described above, you can create greater returns for yourself and your investors.