Magazine article CMA - the Management Accounting Magazine

Growing Your Business with Mezzanine Financing

Magazine article CMA - the Management Accounting Magazine

Growing Your Business with Mezzanine Financing

Article excerpt

For many Canadian small and medium sized businesses (SMEs), particularly those in high growth and export-oriented sectors, finding a source of capital to finance their development is a real challenge. New, innovative subordinated debt instruments widen the possibilities and may allow the entrepreneur and the management accountant to implement the firm's growth strategies.

Many of our country's most promising SMEs are held back because conventional lenders rely on collateral, such as bricks and mortar, rather than ideas, potential and track record. These businesses regularly find themselves in situations where they have insufficient tangible assets to offer, or their conventional lenders will not recognize the full potential of an expansion project. They often need financial instruments to complement existing operating lines of credit, term loans and internally generated funds to address what is generally perceived as being the riskier component of a loan package. One possible solution to this dilemma is for the business to obtain a mezzanine financing, or subordinated debt, vehicle.

Mezzanine financing, or sub-debt as it's often known, represents a bridge between senior debt instruments (those that have a first security position) and equity financing. In the U.S., the term "bridge financing" is commonly referred to in the same context. In reality, it is debt financing that is subordinated to senior creditors, some of whom will treat it as equity; hence the term, mezzanine financing.

Growing businesses require working capital to finance increases in inventory, R and D, accounts receivable and other such assets. Financing these needs can be difficult to transact due to the very nature of the assets; either they are not currently on the balance sheet or they are considered to be intangible. Moreover, development cycles are typically longer than is the case with traditional businesses. Examples of projects that are well-suited to sub-debt financing include the following:

* soft costs associated with upgrading/expanding of facilities;

* enabling management buy-outs;

* developing export markets;

* implementing marketing plans;

* financing the acquisition of intangible assets (such as intellectual properties).

Other needs for mezzanine financing are driven by the fact that there are unsatisfactory divestiture opportunities for venture capitalists, insufficient rates of return for investors or reluctance on the part of the existing shareholders to further dilute their holdings in the business.

Since lenders of subordinated debt instruments do not have the luxury of being able to rely on security as a secondary source of repayment, they must be confident in the primary source - the cashflow of the business. In order to become more comfortable with the business, there are some general characteristics these lenders seek in the businesses to whom they are lending. These features include the management, financial strength, and industry strength of the applicant.

Lenders look first for a strong, committed management team that possesses continuity. Some necessary components include a clear mission and vision for the organization and evidence of strategic planing. This should be complemented with a comprehensive MIS, so that management can track its performance against plan and efficiently manage the operation. Since most of the eligible businesses are knowledge-based, their strengths lie within their key employees. Thus, another important area is that of human resources management practices; they should reflect the most progressive practices in order to ensure that key people stay with the organization.

Financial strength is another key consideration for the lenders and most are looking for businesses that have been in existence for at least two or three years. This is measured by the historical earnings of the business in its abilities to meet its needs and obligations to date, otherwise known as its cash-flow coverage. …

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