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Business Growth Strategies

Can junior capital help you achieve your business goals?

10 Minute Read

Jonathan Zucker
Head of Capital Markets Group
Intrepid Investment Bankers

An East Coast based virtual meeting solutions company catering to blue-chip firms, particularly in the pharmaceuticals industry, had premium production capabilities that set it apart. As a result, its business was flourishing.

Then the pandemic struck. Fueled by the exploding demand for high-quality virtual meetings and productions, revenues really began to soar. Eager to cash in, shareholders decided they wanted to sell the business. But not quite just yet.

With the escalating demand for the company’s services, the shareholders saw an opportunity to grow the business even more by building two strategically located production studios. They didn’t want to sell until they had completed the expansion and further boosted the business’s value. However, first they had to figure out how to raise the needed growth capital for the project.

The answer was a junior capital financing.

Between senior debt and common equity

Junior capital is sometimes confused with mezzanine capital but is a broader term. Mezzanine capital is subordinated debt that resides between senior debt and equity on the balance sheet; junior capital fits in the same general niche but encompasses both subordinated debt and preferred or structured equity.

Companies sometimes incorporate junior capital into their financing mix when they need more capital than banks are willing to provide through traditional senior debt but they don’t want to sell common equity to dilute ownership.

A growth capital alternative

The virtual meetings company’s bank line of credit supported its basic working capital needs, but its bank didn’t believe the company had grown enough to justify providing the incremental capital needed for expansion. So, working with an investment banker, the company located a junior capital provider willing to help fund the building project.

Junior capital providers typically can do a deal very quickly, and that was the case here. The transaction closed within weeks, in the midst of the pandemic and without any in-person meetings.

Using about $10 million in junior capital, the company was able to double the size of its business almost overnight and positioned itself for a very attractive sale to a private equity fund.

Junior capital can support all kinds of growth objectives at a lower cost of capital than selling common equity. For example, a software company might need cash to hire the developers necessary to produce a new product; a consumer products company might need money for research and development; and a manufacturer might seek growth by investing in a new facility or equipment.

A way to provide partial shareholder liquidity

Another common use for junior capital is generating shareholder liquidity. Two ways of doing it are shareholder buyouts and dividend recapitalizations

In a buyout scenario, you might have three shareholders owning 33% of the company and two want to buy out the third. The two might take on subordinated debt to increase their ownership shares to 50% each and provide liquidity to the partner bowing out.

In a dividend recapitalization, an owner of a high-performing company could use junior capital to “take some chips off the table” while avoiding selling equity in the company and relinquishing any control.

In this second scenario, let’s say the company is generating $10 million in earnings a year and is valued at $80 million. The owner has never taken more out of the business than a modest salary and wants to tap into the company’s value to build some personal net worth. However, she wants to avoid selling stock in the company right now because she expects the business to continue on its strong growth path. So, instead, she has the company generate a $20 million dividend for her funded by subordinated debt.

It’s a way for the owner to hedge her bets. If the company fails at some point, she’s pocketed the $20 million in liquidity and taken care of her family. If the company continues to flourish, she can eventually retire the debt and sell the company.

Dividend recapitalizations have been very popular in recent years, because the low interest rate environment enables companies to issue dividends at a relatively low cost compared to that of selling company stock.

Other uses for junior capital

Some other popular uses of junior capital financing include:

To address bank covenant or credit risk challenges. Companies can use junior capital to replace a portion of senior debt with subordinated debt to reduce senior leverage; replace debt with equity to reduce total leverage; or give credit comfort that there is a deep-pocketed partner beneath the bank.

To complete an acquisition. Junior capital can be used to fill in a gap that exists beyond the bank’s leverage limits or maintain senior debt capacity for post-acquisition growth.

To gain credibility and strategic value on the path to eventual sale. Securing institutional capital creates a perception among future buyers of a certain level of sophistication. In addition, junior capital providers can accelerate value creation due to relationships and expertise.

Before you begin, get organized

Before you meet with an investment banker and seek out the right junior capital provider, get organized. These deals can move swiftly, so in order to ensure your transaction will close in a timely fashion, without hiccups, be prepared for the provider’s due diligence.

Is your legal documentation in order? Can you document all of your tax filings and that you have good financial controls? Are you able to generate a financial statement each month? Have you had an outside CPA produce an annual financial statement?

Questions to ask a junior capital provider

As you enter into discussions with providers, here are some questions you will want to ask them before doing a deal:

What happens if our company experiences financial difficulties?  You will be signing a legal contract that gives the junior capital provider certain rights if you don’t repay them on time, miss covenant targets or default. What you want to know is: If your company hits a bump in the road, will the provider work with you, or are you on a short leash?

What if our company performs well and we need more growth capital? How big is the fund? If the provider just did a $50 million deal with you and another growth opportunity presents itself, will you have access to additional capital?

What if we want to pay off the debt early? Most junior capital providers want you to be in the deal for five years or more. Know the penalty for paying the debt off early.

A flexible financing solution when the need arises

Some businesses, even as they’re growing, may never need junior capital financing. For instance, a company that’s profitable and generating plenty of cash flow may find all it needs from a financing perspective is a bank line of credit to support its working capital and inventory needs.

However, other businesses reach an inflection point where they need capital and no bank or other senior lender will step up to satisfy that need. At that point, junior capital is a flexible solution that can supplement a company’s existing bank facilities.

To learn more about how junior capital might fit nicely into your capital structure, contact a Union Bank commercial banker and ask to be introduced to an Intrepid investment banking specialist.

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