Using Mezzanine
Financing in Minority Ownership Recapitalizations
An Effective Way to Transfer Ownership
By Samir Desai, Vice President, Key Principal
Partners
Tough decisions loom in the distance for entrepreneurs aged 50 and
older. As retirement nears, the pressures of maintaining their
businesses and planning for their future increase, and questions
of “what next?” abound. Characteristic of baby boomers, this
generation is hesitant to relinquish control of the companies
they’ve spent years nurturing, but they also no longer want to
hold an equity stake in those businesses. Mezzanine financing
provides an option for those entrepreneurs who want to free up
money and time while keeping a firm hand on the business. This
type of financing is especially useful for boomers looking for a
succession plan. While traditional regulations and restrictions
often limit the ability of business owners to exchange portions of
ownership for cash, minority ownership recapitalizations allow
boomer entrepreneurs to take some chips off the table. These funds
can be funneled into other retirement vehicles – ensuring that
their retirement fund is well diversified – or boomers can use the
cash immediately. In addition, the owner’s interest in the company
has not been completely removed, allowing him or her to enjoy
future company earnings and profits.
Ownership Transfer
Minority ownership recaps are also an effective way to transfer business ownership from one generation to the next. Business owners face
several challenges when transferring a company to their heirs.
The owners need to be provided with funds for retirement; they
usually want to avoid requiring heirs to have capital equal to the company’s value, and they desire to keep majority ownership and control of the company within the family. With minority recapitalizations, owners are able to reduce the amount of shares they hold in
the business without selling off
their stake.
Financial burdens for the business owners’ successors are then
avoided. Before considering a
minority ownership recap, however, boomer business owners should have a solid understanding of the uses, terms and providers of
mezzanine financing. As the name suggests, mezzanine capital fills the gap between what the senior bank
is willing to lend, the available equity and the total need for the transaction. In order to determine the maximum debt capacity of a company, issuers and investors will consider a ratio of total funded
debt-to-EBITDA of 4. Other
factors that are considered include the company’s industry, amount of recurring capital expenditures for the business and strength and depth of the management team.
Understanding Mezz Financing
Mezzanine or subordinated debt is inherently a debt product, with a governing loan agreement and norms that control the underlying security. The term of subordinated debt is longer than conventional bank financing, with maturities ranging from five to 10 years, with minimal amortization during the early periods and larger or bullet payments near or at the maturity date.
Equally as important as a knowledge of the uses and terms of mezzanine financing is an understanding of the types of mezzanine providers.
Not all mezzanine providers are
created equal. Most firms fall
into the category of “sponsored mezzanine.” Sponsored mezzanine firms utilize mezzanine financing to round out the capital structure of a company when it’s being purchased.
There are a few private equity
firms that focus on “sponsorless
mezzanine” in which the mezzanine provider invests directly into a
situation where the stakeholders
are not professional investor –
typically, a privately held or
family-held business.
When considering a sponsorless transaction, business owners should
interview the mezzanine provider on its investment philosophy and
conduct reference checks with existing and previous portfolio
companies (including those that have not performed well) to
understand how the provider reacts during adverse circumstances.
Mezzanine financing may not be the right fit for every boomer
business owner thinking about retirement, but a minority ownership
recapitalization can provide an ideal financing option for those
in certain circumstances, including when it is time to pass the
business on to a family member without the successor having to buy
the business outright.
Other situations that may be opportune for a mezzanine financing
transaction are when business owners want to raise capital to
expand the business or when owners of a privately held company
seek a liquidity event but do not want to give up economic or
operational control. Whatever the situation, when executed
properly, and with the right provider, mezzanine financing can let
boomer business owners have their cake and eat it too.
This article originally appeared in The Deal.
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