Growth-oriented businesses often look to sources outside of internally generated company profits to fuel their growth. This entry provides a high level summary/review of various financing structures for such companies.
Summary - Common Forms of Financing Three common forms of financing include bank debt, mezzanine debt and private equity. Bank debt is generally senior in priority to other forms of financing. Mezzanine debt is subordinated debt. Sources of private equity include buy-out funds and venture capital funds, angel investors and other seed-round investors.
Senior Lending Typically, senior lenders are banks, asset-based lenders and leasing companies. Banks prefer to lend to companies with predictable cash flows and solid balance sheets. For example, a bank may be willing to lend a company two to three times its historic, annualized cash flow. Asset-based lenders may lend against a targeted percentage of accounts receivable, inventory, fixed assets and real estate.
Types of senior credit facilities include a revolving line of credit, term loans and capital lease financing. Factors that may enhance a company's credit-worthiness include the addition of personal guarantees, government -backed loan guarantees and seller financing (in the context of a business acquisition). Industrial revenue bonds, tax-exempt bonds and tax credit programs may assist in making senior financing available in a particular situation.
Mezzanine Financing Mezzanine financing combines features of debt financing and equity investments. Mezzanine lenders will seek a higher internal rate of return on a transaction to compensate them for the higher level of risk involved in the loan. A mezzanine lender may be willing to provide lending in a range equal to three to four times historic cash flow, less the amount of senior bank debt. Often, a mezzanine investment will be comprised of two components: a note and an equity warrant, known as an equity kicker. The promissory note may provide the lender with interest paid currently and a deferred payment of principal.
Some mezzanine lenders prefer a targeted internal rate of return mechanism to calculate the amount of interest payable instead of an equity kicker. A warrant, if exercised will provide the mezzanine lender with common equity of the borrower, providing the lender with an equity upside in the company if the company prospers. Mezzanine investment often include a standstill provision between the mezzanine lender and the senior lender in a subordination agreement. A mezzanine lender will often require a put option or a provision that allows the lender to force the sale of the company if the loan is not paid back after a certain period of time in order to provide an exit opportunity for the lender.
Private Equity Financing Buy-out funds typically acquire companies with a track record of proven success and with a demonstrated opportunity for future growth. They will often maximize the use of leverage to obtain their desired returns. Venture funds often invest in earlier stage businesses with strong developed technology, but that are not yet a fully matured business. Venture funds will want to see a clear and compelling path to an exit event, likely a sale of the company to a buyer or an initial public offering. Angel investors commonly provide seed funding for a start-up business. Angel investors subject their equity to significant risks and must project equally significant return on investment performance in order to compensate them for the risk exposure. Angel investors may desire to play a more active role with a company and may bring significant advisory skills to the company.
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