This guest post is written by Mike Gasparro of AxialMarket. You can also view the post on AxialMarket’s blog.

We recently sat down with several middle market mezzanine funds to discuss market views. We wanted to share perspectives on current market conditions and the impact on entrepreneurs. Consensus is, if you are looking to raise capital, but not happy with current equity valuations, mezzanine capital is likely worth considering.

If you need an intro or refresher on mezzanine finance, Peter [from AxialMarket] wrote a helpful post, “A Tutorial on Mezzanine Finance for Entrepreneurs“. In the current marketplace when equity valuations are down, mezzanine capital provides several potential advantages to business owners looking to raise capital:

1. You can use the capital for things that a typical commercial loan will not allow, such as growth capital, a dividend/special distribution, a recapitalization or buying out current shareholders.
2. The covenants/restrictions placed on the company are less stringent to those of the typical commercial loan.
3. Mezzanine capital is much less dilutive than private equity/venture capital since only a portion of the mezzanine investment has an equity component. At a time when valuations are below average, this can be a big deal for entrepreneurs who want to preserve their equity.

Generally speaking, mezzanine funds look for the following when considering an investment:  

• A Credible Debt And Exciting Equity Story: Mezzanine funds must be convinced that the company can meet its interest payment obligations (just like your commercial bank loan officer), but they ALSO want to be excited about the future growth prospects of your company (similar to an equity investor).
• Clear Use of Proceeds: Make it clear what you plan to do with the capital, and the impact it will have on your company’s P/L and cash flows over a 2-4 year period.
• EBITDA Greater Than $5 Million: There are mezzanine lenders that will focus on companies with lower EBITDA, but $5 million is the typical minimum size for most mezzanine capital providers.

Terms are constantly changing and are always going to be situation-specific; however, a general guide to current middle market terms (as of April 2010) are:

• Maximum Senior Debt to EBITDA of 2.0 to 2.75 – This measures the how many years of EBITDA (the proxy for cash flow) it will take the company to repay its senior debt. Senior debt includes all the outstanding amounts on revolving lines of credit plus any other short term and total long term debt which is secured by a first lien on the company’s assets. It does NOT include accounts payable or accrued expenses.
• Maximum Total Debt to EBITDA of 3.0 to 4.0 – Same concept as the previous ratio, except it measures how long it will take a company to repay all of its debt. Total debt includes all senior debt plus all subordinated and mezzanine debt. Note, this is also includes the new mezzanine debt that the fund is considering investing.
• Cash Interest 10% to 14%
• Paid-in-Kind Interest (“PIK”) 2% to 6% – PIK represents a portion of the interest payment that is not paid in cash. Annually or quarterly, this amount is added to the principal.
• Includes some warrants – Warrants give the fund the right, but not the obligation, to purchase shares of the company in the future at a pre-determined price.

As with every piece of capital, there are pros and cons to raising mezzanine capital. During times when valuations are down, mezzanine capital can be a compelling alternative to raising equity capital.