By Brian Boorstein
In the last article in our series on private equity, we presented a number of activities that you should undertake to position your company to access outside capital. We suggested that first you should determine if the time is right for your company to seek outside capital. Once you have resolved that question, you should then consider what the use of the capital would be. Finally, in advance of a capital raise, you should prepare the company, your management team and full financial statements to put your best foot forward.
The overall strength of your business, your business model and its promise, your record of development and growth to date, and the quality of your team and workplace all impact your ability to attract capital because they point to the company’s ability to increase revenue, earnings and cash flow. Since financing is most often sought to support the growth of a company, assuring strength in these areas is critical prior to seeking funding.
If you conclude that you will seek outside capital, the next decision is whether you should raise equity, mezzanine capital or senior debt for your business. Each represents different attributes and is commonly available at different points in a company’s life cycle.
In the private investment business, equity typically means that the company is raising financing by selling shares (or units in the case of a limited liability corporation) directly to an investor, who will acquire an ownership position in the company. The equity sold may be in the form of common stock or preferred stock, but in both cases no dividends or distributions are paid out to the equity holders until all of the obligations owed to debt holders are satisfied. As such, equity is the most junior class in the capital structure. Given its position below all other classes of capital, equity is the most risky security to own. It also happens to be the most expensive money you can raise. On the upside, though, owners of the equity could enjoy unbounded gains as the company grows in value.
As the name implies, mezzanine capital is positioned between senior debt and equity with respect to its price, liquidation preference and control rights. The term “mezzanine” broadly includes subordinated debt (ie, debt that is junior or subordinated in preference to senior or typical bank debt) or, despite the name, preferred stock. This hybrid security may, at times, look like debt, and at other times it may look like equity. Preferred stock that is categorized as mezzanine capital is most often found in private companies and is structured with more debt-like features, with fixed maturity dates, scheduled dividend payments and restrictive covenants.
Finally, senior debt is financing raised by companies that is secured by a first lien on specific or all of the assets of the business. Senior debt ranks before all other securities in terms of claims on assets in the event of a company sale or liquidation; has fixed terms of repayment (before any repayment of mezzanine capital and equity); and charges fixed or floating interest rates, at levels generally below those charged on mezzanine capital. As senior debt has the highest priority in the capital structure and must be repaid first, the overall cost of senior debt is generally lower than mezzanine capital and equity.
In assessing the appropriate capital for your company, you must weigh three critical factors: 1) ability to secure the type of capital, 2) the cost of the capital raised and 3) the probability of satisfying the payments on the capital. The first of these is discussed below. We will discuss the remaining two factors in a future article.
Ability to Secure Different Types of Capital
Much of a company’s ability to raise capital is tied to its history and business model. Your company competes in a certain industry, provides a service and/or manufactures products, and operates with various demands on and for working capital, capital expenditures and management talent. All of these factors culminate in the assets and the cash flow of a business and there is little that a business leader can do to change that current situation quickly. Moreover, the end result of the asset base and cash flow dynamics of your business set the stage for the type of securities and capital that you can raise.
To raise senior debt, the company needs to have a base of assets, which may include accounts receivables, inventory, machinery and equipment, real estate and, in some cases, intangible assets such as patents or proprietary software. Typically, senior debt comes in two forms: a revolving loan or a term loan. A revolving loan is generally provided by a lender based upon the level and quality of the company’s accounts receivables and inventory. With term loans, a lender will provide funds based on the company’s fixed assets, such as machinery, equipment and real estate.
The ability to attract mezzanine capital is typically more a function of the company’s cash flow than its assets. The company’s assets will be pledged first to a senior lender. Therefore, in the event that the company experiences financial distress, a mezzanine investor’s potential to recover its investment upon liquidation of the assets is more limited. Since liquidation of the assets alone may not be sufficient to repay the mezzanine principal in full, mezzanine investors expect to rely on the cash flow to support the company’s capability to provide the return of principal as well as a return on the investment.
Finally, the ability to attract equity requires the company to encompass a host of positive attributes, all of which point to the company’s ability to increase revenue, earnings and cash flow. A pure equity investor tries to determine whether the company can generate cash flow so that all debt obligations can be satisfied, and if it can reach a valuation level where sufficient gains can be realized on an investment. If your company has the business model, the management talent and the cash flow characteristics that point to the creation of greater value in the future, you should be able to attract equity capital into your company.