Summary: Small middle-market companies have fewer financial options than their larger counterparts. Large companies have choices comparable to those of small companies. However, they benefit from better pricing.
This article discusses cash flow financing options available to lower middle-market companies. It also includes options that are available to distressed companies. We cover the following:
- What is a middle-market company?
- Lower vs. upper middle-market companies
- Lower middle-market company financing options
- Options for distressed companies (“special assets”)
1. What is a middle-market company?
The middle market is a generic term for companies larger than a small business but smaller than a major enterprise. There are multiple definitions for this market. While these definitions don’t match perfectly, they have a substantial overlap.
The two most common definitions include:
- Revenues of $10 million to $1 billion
- EBITDA of $10 million to $750 million
*EBITDA = Earnings Before Interest, Taxes, Depreciation, and Amortization
2. Lower vs. upper middle-market companies
A problem with the term “middle-market” is that, because it covers such a large spectrum of companies, it has little useful value. Consider the following example:
Company A has an EBITDA of $15 million, while Company B has an EBITDA of $150 million. Both companies could be defined as middle-market companies.
However, Company B is an order of magnitude larger than Company A. Their differences are structural and go beyond EBITDA. Their management, operations, and financial reporting are likely very different.
These companies belong to two categories for all practical and financial purposes. This difference is important because larger companies typically have more financing options.
a) Lower middle-market
We define the lower market as companies with an EBIDTA of $5 to $15 million. These companies fall in a gray area with lenders.
Some lenders consider them to belong to the lower end of the middle market. Other lenders consider them in the upper end of the small business market.
This situation creates problems for them when looking for financing. These companies may regard themselves as too large for traditional small business financing. Unfortunately, they are also “too small” for most middle-market lenders.
Lower middle-market companies have some advantages over small businesses, though. They have access to cheaper financing, and more lenders are willing to work with them. However, they will still be limited in the types of financing they can access.
b) Upper middle-market
Larger middle-market companies enjoy more financing options and flexibility than their smaller counterparts. They can access different types of financing from several sources. Providers include banks, hedge funds, specialty lenders, private credit funds, and institutional investors.
Most upper middle-market companies can obtain financing products similar to large companies. These options include the following:
i) First lien financing
Term A and Term B financing, revolving lines of credit, etc.
Note: Term A loans are typically amortized evenly. Term B loans involve small amortization payments and a large balloon payment at the end of the term.
ii) Second lien financing
Terms loans subordinated to first lien financing and holding a second position.
iii) Mezzanine financing
High-yield debt that may be secured with a warrant. This type of debt usually has the lowest priority repayment.
iv) Equity financing
These include warrants and investments in preferred/common stock.
3. Lower middle-market company financing options
Five cash-flow financing alternatives can work with smaller middle-market companies. Your chosen option depends on your situation, size, line of business, and requirements.
a) Bank line of credit
A conventional line of credit is the most flexible solution for working capital issues. The company can draw funds when needed and repay them on a schedule.
Bank lines of credit typically have the most stringent qualification requirements. Additionally, they also have the strongest set of covenants.
b) SBA-backed loans
SBA-backed loans are a great alternative for lower middle-market companies that need less than $5 million dollars. These loans have simpler qualification requirements than bank financing and have competitive costs.
Note that these loans still go through a conventional underwriting process by the lender. Your company needs to provide accurate financials and other documentation.
c) Asset-based loans
Asset-based loans have simpler qualification requirements and are configured based on the assets your company needs to finance. They can be used to leverage property, machinery, equipment, inventory, and account receivables.
Assets like property, machinery, and equipment are typically financed with term loans. Your company gets funds when the loan is originated. Loan payments are amortized over several years until the loan is closed.
Accounts receivable and inventory are funded through a revolving line. These lines typically improve cash flow, which helps cover operational expenses.
d) Ledgered lines of credit
A ledgered line of credit, also called sales ledger financing, is a type of revolving line secured by your accounts receivable. It operates much like the receivables financing component of an asset-based loan and offers the same benefits.
Most ledgered lines operate using a borrowing certificate. The client fills out a borrowing certificate indicating the amount of eligible A/R, along with other details.
Your company’s availability will range from 85% to 90% of your eligible A/R. Companies typically request weekly funds to ensure sufficient liquidity to cover ongoing expenses (e.g., payroll).
e) Accounts receivable factoring
An accounts receivable factoring line enables you to finance your invoices and improve your cash flow. It provides similar benefits to a ledgered line, though it’s easier to obtain.
Factoring lines have simple qualification requirements, flexible covenants, and can be deployed quickly. They are a good option for companies that cannot obtain conventional financing.
4. Options for distressed companies
Lower middle-market companies in financial distress usually have a difficult time securing financing. The most common scenario is when a company is out of covenant with this loan. If the lender considers the issue serious, the client’s account is moved to the Special Assets group for handling.
The objective of the Special Assets team is to minimize the lender’s potential losses. Note that few companies transferred to the Special Assets team ever return to their original commercial banking group. Typically, they must exit the relationship and find a new lender.
a) Options
In our experience, small middle-market companies that must change lenders due to financial distress face limited options. They may find a lender. However, it’s doubtful they will get terms as good as those of the existing lender.
Most small middle-market companies in this situation need to focus on an asset-based solution. The most common options include asset-based financing and accounts receivable factoring.
i) Asset-based financing
In most cases, the most effective strategy is to replace existing financing with an asset-based loan. These lines can be structured to finance specific assets and offer the most flexibility.
Companies that work with commercial or government clients can also finance their accounts receivable. This strategy can provide a revolving line of financing to improve your cash position.
ii) Accounts receivable factoring
Companies that are unable to qualify for an asset-based loan and need to improve their cash flow should consider accounts receivable factoring. These lines can stabilize cash flow while your team handles the turnaround.
Factoring lines are more expensive than similarly sized asset-based loans. Consequently, the objective should be to migrate to cheaper financing as soon as it is practical.
b) Get professional help early on
Companies that have been moved to Special Assets should consider engaging professional help early on. An attorney or CPA experienced in turnarounds and distressed companies can help you increase your odds of a successful exit.
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