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Learning Center Experience
By Rachel Byers, PhD, CPA, Accounting Faculty, Kaplan University Published January 2016
Do you own a profitable business that is in need of capital
for growth? Have you reached the maximum amount of collateralized debt that
banks are willing to lend your company but don’t want to relinquish substantial
equity? If so, mezzanine financing may be
In a cash strapped economy, businesses have to get creative
with structuring financing deals. Mezzanine debt is an option for financing
that falls between senior, collateralized debt and private equity funding. Because
mezzanine debt is unsecured, subordinated debt (debt that ranks after other
debt in liquidation/bankruptcy), lenders require high returns on their
investment. Who might be interested in this type of capital structure?
Companies looking to fund a growth opportunity like an acquisition or a new
product, that’s who.
Consider a start-up company with very little invested by the
original owners that has grown substantially over the course of 2–5 years using
senior debt financing. The company has the opportunity for further growth and
to capitalize on other opportunities, utilizing economies of scale, but has
been turned down by banks because they are already highly leveraged. Private
equity firms have approached the company but want substantial equity, oftentimes
a controlling interest (greater than 50% equity). The owners are faced with the
decision to give up half of their company in order to fund the growth and
profit from expansion. That is, unless they secure a mezzanine deal.
Mezzanine debt takes many forms such as convertible debt
(debt that converts to equity), subordinated debt, or preferred equity
instruments. Typically, it will have a combination of cash interest payments,
payable in kind (PIK) interest (interest that accrues and is added to the
principal balance resulting in compounding interest accruals), and ownership
Continuing the example from the company described above,
assume the company had a present valuation of $2,500,000. The company projects
that its value will increase to $6,500,000 in 3 years if fully capitalized. In seeking $1 million in capital, the company offers the following terms:
Is this an attractive venture for an investor? Let’s run the
numbers and see.
Cash interest payments will result in a total of $150,000.
PIK interest accrues quarterly and is capitalized. For example, after the 1st
quarter, $12,500 (1/4 of 5% of $1M) would be added to the principal balance.
The 2nd quarter would accrue interest on that increased amount and would result
in an interest accrual of $12,656, and so forth. Total PIK interest payments
result in $175,264 at maturity. Assuming projections were met and the company
paid the investor the market value for the stock warrants ($200,000; $325,000
less exercise price of $125,000), the investment yields a total return on
investment (ROI) of 52.5%. Annual ROI would be 15.1%.
With returns like that, it is a win-win for all
involved. So, will you consider using mezzanine financing to grow your
business? Or, possibly, are you toying with the idea of investing in a mezzanine
Rachel Byers is a professor at Kaplan University. The views expressed in this article are solely those of the author and do not represent the view of Kaplan University.
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