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By JONATHAN L. SCHWARTZ

Management teams seeking to acquire a company often ask me, “What capital structure is right for this business?” This is an important question, as the landscape is littered with bankrupt and liquidated companies that failed because their capital structures were inappropriate.

Most often, that’s because the capital structures were too heavily weighted to debt, created insurmountable performance hurdles for management, and did not take into consideration realistic projections for the company.

The capital structure used for an acquisition consists of three primary tiers: senior debt, mezzanine debt, and equity. The case of a loan on a million-dollar house is a good example of senior debt.

To buy the house, I would go to my senior lender and ask, “How much will you lend me to buy this house?” After telling him I can put $500,000 down on the house, he reviews my financial statements and says, “I will lend you 50 percent of the cost of the house and you will make payments of $5,000 per month.” In turn, I look at my monthly income of $10,000 and figure I can pay $5,000 to the bank while fulfilling my other debt obligations.

This senior debt is the primary tier of my capital structure. When the house appreciates 10 percent, I will see a 10 percent return on a million-dollar asset, but a 20 percent return on the $500,000 I have invested. I successfully doubled my return on the house from 10 percent to 20 percent. Therein lies the magic of leverage.

In terms of cost, senior debt is the most affordable form of capital for your business. There are two types of senior debt: a working capital line and term debt.

A working capital line is a senior revolving form of debt that is secured by your inventory and accounts receivables. In general, the advance rates, or the borrowing base available, will be 70 percent to 80 percent against receivables and around 50 percent to 60 percent for inventory.

Term debt is secured by the company’s hard assets property, plant, and equipment. Banks will lend against the hard assets based upon appraised value, liquidation value, or some range therein. Unlike the working capital line, term debt will require principal and interest payments that will be fully amortized over the life of the loan. Management can go to a bank, have the bank appraise the hard assets, and have a dollar amount lent to them against those assets.

After determining the maximum amount of senior capital available, you then need to decide if mezzanine capital is necessary. Mezzanine financing is sought to either fill the gap between equity and senior debt, or to simply increase leverage and boost the returns on your equity. The tradeoff is, you will pay a higher interest coupon than the senior debt and will give up some equity ownership to the mezzanine fund.

Using the example of our million-dollar house, let’s say I only have $300,000 available to put down. My senior lender does the same analysis as before and is still only willing to lend me the same $500,000. Where am I going to get the remaining $200,000? One alternative is to access the capital from mezzanine funds.

These funds provide debt capital secured not by the hard asset of the house, but by your annual earnings potential or cash flow, which for business is known as “EBITDA” earnings before interest, taxes, depreciation and amortization.

After going through their calculations, the mezzanine fund believes I have another $2,000 a month that is free and clear for principal and interest payments. The mezzanine fund will charge me a higher interest coupon than the senior lender and will want some of the upside, say 10 percent, if that house appreciates. If I can sleep at night with that type of debt structure, I sign off on everybody’s term sheets and am now the proud owner of the house.

In this example, my returns, assuming a 10 percent appreciation in the house, will be $100,000 less the 10 percent or $10,000 I have given to the mezzanine fund, which equals a $90,000 return on my $300,000 of equity. As you can see, even with the equity give-up to the mezzanine fund, I have boosted my return to 30 percent and ended up owning an asset I could not have owned otherwise.

Lastly, we come to equity. Management can put up its own hard-cash dollars for an acquisition or seek funding from equity funds or equity sponsor groups. The distinguishing feature between these two groups is the issue of control. An equity fund will invest with management for a minority stake in the company. On the other hand, equity sponsor groups are buyers of companies who seek majority control positions on behalf of the investors in their funds and allocate a percentage of ownership to management.

This is a time when businesses can take advantage of a vast array of credit products and financing sources to create the capital structure that best complements their business plans. When reviewing your capital structure, take a serious look at what you are willing to give up in order to obtain financing, and use your internal resources to structure the financing that will optimize your corporate objectives in the most cost-efficient manner.

Jonathan L. Schwartz is president of JLS Capital, a Beverly Hills-based investment banking firm specializing in raising private debt and equity capital for private middle-market companies. He can be reached at [email protected].

Entrepreneur’s Notebook is a regular column contributed by EC2, The Annenberg Incubator Project, a center for multimedia and electronic communications at the University of Southern California. Contact James Klein at (213) 743-1759 with feedback and topic suggestions.