Today is Labor Day. That means our kids start school tomorrow. Last year, our youngest came home one day and announced they had just had career day in her fourth grade class. Evidently, when asked what I did for a living, Annabelle responded, “My Dad has a job … I think.”
I always get a good laugh when I think about that. I’m grateful that I can generate enough resources for our family while maintaining some flexibility to work from home and attend events of my kids. For her own sake, I hope my daughter never understands that mezzanine finance exists. However, her cute little comment does remind me of one problem in my business: too many business owners don’t understand their cost of capital.
I understand that my artistic skills are terrible, but this basic chart is an attempt to describe the possible sources of capital for a business. Most companies rely on equity (ownership of the business). Whether they are public or private, or whether owners manage the business or bring in professionals, company ownership is essentially the same. In the finance profession, we like to make this sound as complicated as it can possibly be, but at the end of the day shareholders own the business. They expect to be paid for owning the business.
The other potential source of capital for a business other than getting somebody to buy equity is to borrow money. Debt is cheaper, and more tax efficient. However, borrowing money increases the risk your businesses faces. Leverage increases the potential return for the equity holders, but increases the chance that they lose everything. Lenders don’t own the business. However, they want to be paid for lending money to the business. Relatively inexpensive loans are available from commercial banks through government guarantees like those of the Small Business Administration (SBA). Commercial banks will also lend fairly inexpensively to good companies that are larger. Big companies can borrow from a bunch of lenders in the public markets.
Sometimes there is a gap between the equity and the inexpensive debt available. Sometimes the bank won’t lend because they don’t want too or because there has been a problem. Sometimes companies don’t want to sell additional equity. Sometimes companies are just growing so fast the bank can’t keep up and the owners don’t want to sell. Capital is still needed, but equity and senior loans aren’t available. Larger companies can fill this need by issuing junk bonds. There are national players willing to fill this need for smaller companies at least a certain size. However, what about the smaller company?
I’m a mezzanine financier to lower middle market companies (the blue star on the graph).
For my daughter … Yes, I have a job that I love. That’s enough.