September 18, 2006
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 those 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.
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.
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 investors — 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.