Tag Archives | private equity

Mezzanine Financing

See Also:
External Sources of Cash
What Does A Lender Want To Know
Finding The Right Lender
Due Diligence on Lenders
Weighted Average Cost of Capital (WACC)

Mezzanine Financing

A mezzanine lender, provider of mezzanine financing, functions similar to a bank in terms of providing a source of capital for companies. They get their capital from private investors who look to make a profit off of the investments the mezzanine lenders make. Often times, the firm is structured as a limited partnership for tax purposes.

There comes a time in every company’s life cycle when the company and/or the entrepreneur need some more cash. Perhaps the company needs more working capital or some additional money to help fund an expansion. Or, maybe the entrepreneur feels that it’s time to reap the benefit of all those years of hard work. Whichever the case may be, the entrepreneur will be faced with many different financing options. An interesting and often over-looked option is that of bringing in a private equity partner in the form of mezzanine funding.


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Mezzanine Lenders

Mezzanine lenders are similar to banks … but they are not banks. The interest they charge is going to be higher than what commercial banks charge. Many entrepreneurs blench at the thought. But consider, other than maxing out your credit cards, what other alternatives do you have? Mezzanine lenders will charge you approximately what credit cards charge you. Their cost of capital ranges from the high teens to low twenties (18-23%). This may seem quite high, but if your enterprise is so risky that a bank will not touch it, then it is only fair that you reward someone for taking on this extra risk. Also, what bank would feel comfortable about an entrepreneur taking the bank’s money and pocketing it for personal gain? No bank would. Mezzanine lenders do.

Mezzanine lenders can also benefit the firm in other ways as well. They can help entrepreneurs upgrade their talent resources by finding professional management staff. They can help with finding better technology, placement with new customers or help you find sourcing alternatives. Remember, the best business partner is someone who brings more than just money to the table.

Financing typically comes in the form of either a loan and/or equity interest. Sometimes the debt is convertible into equity. Many people worry when they hear that their equity is compromised. This is actually not so. Mezzanine lenders are open to having their equity interest bought out. Think of it as a “pop” for taking on the risk.

Purpose of Mezzanine Financing / Mezzanine Capital

So, what is the purpose of mezzanine financing or mezzanine capital? First, let us consider a common business dilemma: 1) lack of working capital or 2) lack of funds for capital expansion. Entrepreneurs by nature are optimists and passionate people, especially when it comes to their companies. They want and need a financial partner that can grow with them. Typically, your first option of choice is your friendly, neighborhood commercial bank. There are several issues that one often encounters here:

1. Debt – Is your company too leveraged for the bank to accept?

2. Profitability – Is there enough profit to sustain the enterprise?

3. Cash Flow – Is your company generating enough cash to pay the bills?

4. Inventory – Are you turning it over fast enough?

5. Equity – Do you have enough skin in the game?

If your firm can pass the litmus test, then by all means you should go with your friendly, neighborhood commercial bank. They are typically your cheapest source of money.

Next, let us consider a more interesting question from the entrepreneur’s perspective. I’ve worked this long and hard. Don’t I deserve to be rewarded? Don’t I deserve to be a millionaire? If you don’t already have a million dollars in the bank, then the bank will probably be the first to tell you, “No.” So what’s a hard-working entrepreneur to do? Surprisingly, this issue is one that is faced by countless business owners as they face retirement or just want to “take some chips off the table” for security purposes.

The above cases represent typical situations where it makes sense to consider other financing options such as a Mezzanine Debt Financing.

Recapitalization Example

Below are some typical scenarios where you might want to consider working with a mezzanine lender:

1: Company needs capital infusion for either working capital or CAPEX.

2: Entrepreneur would like to buy out a partner.

3: Entrepreneur would like to “take some chips off the table” to provide security for his/her family.

4: Entrepreneur would like to pass along management to next generation.

5: Entrepreneur would like to share some equity with management staff and/or employees.

6: Entrepreneur would like help with selling the company to a strategic buyer at a good profit so s/he can retire.

Mezzanine Recapitalization: Conclusion

Entrepreneurs should consider mezzanine lenders a strategic financial resource. They many not always be your first choice, but they just might be your best choice. They have a higher cost of capital than banks. But, for the money, they provide a lot of strategic options to the entrepreneur that commercial banks could not be party to.

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External Sources of Cash

See Also:
Angel Investor
Categories of Banks
Commercial Paper
Common Stock
Convertible Debt Instrument
Venture Capital

External Sources of Cash

In another article, I told you about Sue and generating cash from sources within her business. I will not detail her entire story at this time, but will tell you that we were successful in obtaining external cash allowing her to grow the business with the piece of mind of a constant and predictable cash flow.

We need to make sure we are all talking about the same thing when we hear or see the phrase “external sources of cash”. So, today I am going to define external sources of cash, and in the future, I will share situations where the different types are best utilized.

There are two sources of external sources cash for businesses: lenders and equity investors. I will begin with the least costly.


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1st Source of External Cash: Lenders

Always remember that borrowing, no matter what the sources, will be less costly than equity. There are two classifications of lenders to discuss. However, within the classifications there are various sub categories. First and by far the least costly is traditional bank financing. What I am talking about here is when the bank takes all of the financial risk on your loan. Examples of these loans would be traditional lines of credit, loans for equipment, and building loans. Additionally, banks offer other products when they do not take all the risk and these products are more costly. Examples of these products are Small Business Administration (SBA) loans, equipment leasing, and factoring. Later in the series we will discuss the various differences in the lending philosophy of banks and different types of banks such as state vs. national, and community vs. multi state.

The second types of lenders are what I will call alternative lenders. Probably a term you may not be familiar with, but include such companies as asset based lenders, accounts receivable lenders, factoring companies and hard money lenders. These lenders take greater risk in their lending activities than banks. The reasons alternative lenders may be a better source than banks vary on a case by case basis. In future articles, each one of these will be discussed with examples and stories.

2nd Source of External Cash: Equity Investment

The second type of external cash for a business is equity investment. This by far is the most expensive cash or capital a business can acquire. You may be asking “why is this most expensive… I don’t have to pay it back”. Well, the answer is you are sharing part of your profits each year for the growth cash with your partner, and then upon the sale of the business, you share the return on equity with the partner.

Understanding the two different external sources of cash is critical because each or all may be needed in your business’s situation. For more tips on how to improve cash flow, click here to access our 25 Ways to Improve Cash Flow whitepaper.

External sources of cash

External sources of cash

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Carried Interests

See Also:
Hedge Funds
Venture Capital
Current Expenditures
How to Compensate Sales Staff
Indirect Labor

Carried Interests Definition

What are carried interests? The carried interests definition is a portion of an investment fund’s annual profit that is given to the fund manager at the end of the year. Carried interests are designed to incentivize to the fund manager to achieve outstanding performance for the fund. They are often set at around 20% of the fund’s profits.

You can also call carried interest carry, or profit interests. Use the amount to compensate fund managers and general partners at private equity firms and hedge funds. The carried interest may be the primary source of compensation for the fund managers; however, it does not include any of the fund manager’s own money that he may have invested in the fund.

There may be a hurdle rate of return stipulated, as well. For instance, the policy at a private equity fund may be that all of the investors must earn at least 7% return on their initial investment. In addition, the policy may consider everything above and beyond that pure profit and may use it to compute the fund manager’s carry.

Carried Interest Example

For example, a hedge fund has $100 million of invested capital from 10 investors. The hedge fund has told the investors to expect at lease a 5% return on their investment. In addition, the fund manager will earn a 20% carry on the profits above the 5% hurdle rate. Now, motivate the fund manager to maximize the fund’s performance. Furthermore, he will earn 20% of anything above $105 million.

At the end of the year, the fund is worth $125 million. The fund made a profit of $25 million, or 25%. Let’s see how much of this profit will go to the fund manager for his efforts.

Profit the Fund Manager Gets

Ten investors contributed $10 million each to make the full amount in the fund, $100 million. Each of the investors was told to expect at least a five percent return on their investments, or $500,000 each. For all ten investors, this adds up to $5 million. This means, according to the hurdle rate, the fund manager earns 20% on anything above $105 million.

The fund made $25 million. So subtract the $5 million for the hurdle rate. That leaves you with $20 million. Now, the fund manager earns 20% of the $20 million. This turns out to be $4 million. Then distribute the remaining $16 million among the investors or use it to cover other expenses or simply reinvest it in the fund.


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Recapitalizing Your Company Using Mezzanine Financing

Recapitalizing Your Company Using Mezzanine Financing

“There comes a time in every company’s life cycle when the company and/or the entrepreneur need some more cash. Perhaps the company needs more working capital or some additional money to help fund an expansion. Or, maybe the entrepreneur feels that it’s time to reap the benefit of all those years of hard work. Whichever the case may be, the entrepreneur will be faced with many different financing options. An interesting and often over-looked option is that of bringing in a private equity partner in the form of mezzanine funding. Furthermore, the only option may be recapitalizing your company using mezzanine financing.

Why can’t I just go to a bank?

Let us consider a common business dilemma: 1) lack of working capital or 2) lack of funds for capital expansion. Entrepreneurs by nature are optimists and passionate people, especially when it comes to their companies. They want and need a financial partner that can grow with them. Typically, your first option of choice is your friendly, neighborhood commercial bank. There are several issues that one often encounters here…”

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Recapitalizing Your Company Using Mezzanine Financing

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