Making a Go / No Go Decision
Cost of Capital Analysis
You need to decide whether a prospective project will improve your company. The resource / risk factors you consider likely include labor, technology, and capital, with your capital considerations being the amount required, its availability, and its cost. A company’s least expensive sources of capital are excess cash on hand and bank debt; however, those options alone may not be sufficient. This memo focuses on “mezzanine” capital, and how three CEOs evaluated using that option to support projects that needed incremental outside financing.
Mezzanine debt fills the funding gap between a company’s senior debt (low risk, low cost) and its equity base (high risk, high return). As an alternative funding source, mezzanine debt costs more than bank debt because the lender’s junior position is exposed to greater cash flow and collateral risk. Your Return on Investment (ROI) analysis is whether the value created by a “Go” decision on your project exceeds the aggregate cost of capital, potentially including higher priced mezzanine debt. Of course, bringing in new equity presents another fundraising option; however, equity is generally the most expensive source of capital, and new equity may complicate your ownership structure.
Mezzanine capital is typically used to fund growth opportunities, such as acquisitions, new product lines, new distribution channels/ plant expansions, or stock buyouts precisely because the financial value these projects can generate a significant ROI. Mezzanine debt can also be justified for working capital or debt restructures, but it becomes more difficult to quantify the value created for making the Go/No Go decision.
The following three cases provide examples of where mezzanine debt was deemed an appropriate financing alternative.
Case I: Management Acquisition:
- The CEO of a manufacturing business owned 25% of the company while passive investors owned the remaining 75%
- The passive investors presented the opportunity to be bought out of their 75% share for $3,400,000 at the end of 2009.
- The CEO identified two primary goals for the buyout: 1) gaining 100% control over corporate decisions, and 2) increasing the value of his equity stake with the ability to build it further by growing the business (see chart below)
|($000’s)||FYE 12/31/09||FYE 12/31/10||FYE 12/31/11|
|Value – 5xEBITDA||4,945||4,245||7,960|
|CEO Ownership Value||1,236 (25%)||4,245 (100%)||7,960 (100%)|
- The CEO had established an excellent working relationship with the company’s bank; however, a collateral shortfall limited bank funding to $2,400,000 and prompted the need for $1,000,000 in mezzanine financing to be able to execute a Go decision.
- A mezzanine lender provided a $1,000,000, five-year term loan, priced at 8.00%, with a deferred fee of $45,000 due annually on the anniversary date of the closing. Financial covenants mirrored those of the senior bank.
- Rationale for the CEO’s Go Decision: 1) Gaining 100% control provided a highly desirable intangible benefit. 2) The expected increase in his equity value would readily exceed the mezzanine debt’s cost of capital – a roughly 3.0% interest premium and $90,000 – $225,000 in potential deferred fees.
- Go Decision Result: Two years after the buyout, the company’s senior bank agreed to refinance the mezzanine debt. While the CEO paid the mezzanine lender $170,000 in risk premiums, his equity value increased in excess of $6,700,000.
Case II: Equipment Purchase for a New High Margin Business:
- The subsidiary of a billion dollar global company wanted to stop providing its clients a small value added manufacturing process, so it approached one of its small vendors about performing the work.
- To facilitate the transaction, the subsidiary offered the production equipment to the vendor at a steeply discounted price of $300,000.
- The vendor’s management team felt they could realize a high gross margin performing the additional work without increasing existing fixed overhead – thus the project’s incremental gross margin contribution would flow directly to the bottom line
|Actual Core Business||Projected from New Venture||Projected Consolidated|
|Gross Profit Margin||12.5%||74.4%||17.7%|
- The vendor’s bank was unwilling to fund the equipment purchase because the company was already highly leveraged and cash flow was extremely tight.
- A mezzanine lender offered to provide a $300,000 five-year equipment loan at 11.25% interest plus a 3.0% common stock warrant.
- Basis for making a Go Decision: The projected $361,000 annual Gross Profit contribution generated by the equipment would quickly pay for itself, and future gross profits contributions would then be available to internally fund other expansion opportunities.
- Go-Decision Result: The project’s actual gross profit margin contribution only reached 60% of management’s expectations; however, over the course of the five year term of the loan, revenues from the new value added business generated an additional $1,080,000 in gross profits against a comparatively small $163,000 mezzanine capital premium (interest of $38,000 plus a one-time warrant payment of $125,000).
Case III: Support Working Capital & Development / Marketing Needs:
- A firm providing data management services to the retail industry faced a strategic decision to accelerate cross selling its services across an expanded retailer/distributor/manufacturer supply chain. The problem was requiring capital to invest in hiring new sales and marketing staff and to purchase additional data storage hardware.
- The firm’s bank relationship included a line of credit, term debt and lease facilities; however, the young company had not yet built a strong Equity base and the balance sheet needed more “patient” funding.
|($000’s)||FYE 12/31/08||FYE 12/31/09||FYE 12/31/10||FYE 12/31/11||FYE 12/31/12|
|Value – 5x EBITDA||1,525||80||450||5,180||5,600|
- A mezzanine lender offered to fund the growth opportunity with a $250,000 five-year balloon note: interest fixed at 12% and a 2% common stock warrant.
- Basis for making a Go-Decision: Management considered the alternative of waiting to fund the project internally; however, delaying growth risked conceding market leadership and share to more aggressive competitors.
- Go-Decision Result: Over the five year term, the company’s sales increased three-fold, and its EBITDA value increased by $4,000,000. Comparatively, the mezzanine financing premium cost only $195,000 (interest premium of $60,000 plus a warrant of $135,000).
Conclusion: Every project has to be considered on its own merits. If a project generates significant value, mezzanine debt represents a viable funding option when traditional sources are inadequate.