Finance alternatives for medium-sized companies

  • 2005-05-04
  • By Kalmer Kikas, vice president of Hanseatic Capital
RIGA - A bank loan, mezzanine financing and increase of share capital are the principal options for financing both business enlargement and acquisitions 's e.g., management buyout, management buy-in, etc. The natural question is when to use which sort of finance. When, for instance, should one use a bank loan?

If a company has had a strong cash flow on a steady basis and developed a relationship of trust with a bank, a loan would be the natural means for finance. As a rule, a bank loan and the leasing balance should not exceed the cash flow generated by operations (EBITDA) multiplied by three. Collateral is sufficient for a bank if the market value of the collateral exceeds the amount borrowed by at least 1.5 times. Banks usually lend money for the purpose of expansion, and in some cases also for the purpose of buying out, provided that the cash flow is acceptable.

When should mezzanine financing be used? A steady, long-term and strong cash flow is one of the fundamental prerequisites for using mezzanine finance, also referred to as a subordinated loan. The rule of thumb is that a subordinated loan can be used for increasing financing to up to five times the cash flow generated by operations (EBITDA). For example, if the annual EBITDA of a company is 1 million euros, and the amount of the bank loan is 3 million euros, the company can use an additional subordinated loan of no more than 2 million euros should it need extra financing. In other words, the company can engage "cheap owners' equity" to the amount of 2 million euros.

Current cash flow is important, as well. Not all companies can afford the use of "cheap owners' equity" or subordinated loans. The reason lies in the weak cash flow.

Companies typically need subordinated loans in three types of cases:

1. If there is no collateral and the bank does not wish to lend money beyond a certain amount;

2. If the owners do not wish to "dilute" their stake in the company. If the managers and owners are confident in the future prosperity of the company, the use of subordinated loans should be considered instead of increasing share capital. The reason is purely practical: subordinated loans would not "dilute" ownership interest;

3. Financing owners' equity is unavailable because the industry is unattractive and growth prospects are modest.

Subordinated loans are primarily used for buying out a company and 's in certain cases 's for financing the enlargement of business.

Finally, when should shareholders' equity be used? Share capital should be increased in the cases where the current cash flow is insufficient for raising a bank loan or subordinated loan. The owners' vision of the future must be positive. However, uncertainty is also greater in such cases since the cash flow generated so far does not enable the owners to plan the future cash flow with certainty. Usually the owners' equity is used as a financing source by starting companies that cannot afford raising a bank loan or subordinated loans.

How do different financing sources affect the cash flow in the short- and medium-terms?

Bank loan: the price of money is low, and principal payments also affect the cash flow. For example, if a company borrows 1 million euros with an interest rate of 5 percent for a term of 5 years and repays the loan on the basis of the annuity, approximately 225,000 euros is spent for servicing the loan on an annual basis.

Subordinated loan: The price of money is medium (greater impact on the income statement due to interest expenses); the cash flow is better (as a rule, the repayment of the principal is flexible at the end of the fifth year). With the same example where a company finances 1 million euros by means of a subordinated loan, approximately 120,000 euros is spent for servicing the loan on an annual basis 's i.e. almost half as much as in the case of a bank loan, plus repayment of the principal at the maturity.

Ownership equity: The price of money is high (that option has no current effect on the Income Statement, but has implications for the owners, since the participating interest is "diluted"); only possible dividend payments or redemption of shares affect the cash flow.

Optimal capital structure. The capital structure is usually formed in symbiosis of the needs of a company and the possibilities of financiers. Proper financial management of a company ensures a good and optimal result. On the other hand, a company may have either too big or too small owners' equity depending on the desires of owners. The outcomes depend on the risk tolerance (risk/reward rate), expectations and growth prospects of the owners.