A recapitalization is the process of exchanging one form of financing for another. For business owners wishing to take something off the table a recapitalization represents an alternative to the complete sale of a company. A recapitalization can provide the necessary capital for growth, achieve personal liquidity and diversify risk for owners wishing to sell less than 100% of their business. It gives a business owner the opportunity to sell a portion of their company while still maintaining a significant, or even a majority, ownership stake. In essence the owner is able to create liquidity and diversify risk today, while setting the stage for a second “payday” down the road. These transactions enable our clients to partially cash out of their investment in the business and capitalize on the enormous amount of sweat equity they have put into their business over the years.
The original owner can continue as a partner and/or manager of the company, while the new partner and capital provider shares the business owner’s culture and vision for the future. Unlike some strategic acquirers who purchase with a view towards eliminating overhead redundancies, private equity firms prefer a more passive or board level involvement and a collaborative relationship with the existing owner and management. As partners, private equity firms are often able to introduce opportunities to the company that were not previously available and can provide significant experience in order to assist the company in growing to its next level.
For owners wishing to partially cash–out the actual mechanics could be that the company issues stock to buy back debt, which had previously been provided by the owner for funding. In its simplest form the company may merely sell stock to a third-party investor.
Less common and understood is a leveraged recapitalization. If the owner desires to pass the business on to his/her children a leveraged recapitalization can be a very effective strategy to enable the owner to both take cash out of the business while at the same time making it affordable for children to obtain ownership. With a leveraged recapitalization, instead of issuing stock, the company may take on additional debt. The amount of debt available to the company depends upon both the assets available to collateralize the loan as well as the cash flow available to service it.
ADVANTAGES
Conventional Recapitalization
- Can provide the capital for growth and achieve personal liquidity and risk diversification for the shareholders through a partial sale of the company’s equity to a passive institutional investor, while simultaneously refinancing (or “recapitalizing”) the company’s capital structure.
- Represents an alternative to a complete sale, thereby enabling the shareholders to capitalize on future growth potential while utilizing third party investment capital.
Leveraged Recapitalization
- Enables retention of 100 percent of the company ownership.
- Financing source is typically a conventional commercial bank which can act faster than a third-party equity investor.
- Risk of a breach of confidentiality is much lower.
DISADVANTAGES
Conventional Recapitalization
- There can be adverse tax consequences if preferred stocks are distributed through recapitalization. The company’s cash might get drained by preferred stock dividends.
- If a business has been classified as an S corporation, it becomes difficult to do a recapitalization because such corporations cannot have more than one class of stock.
Leveraged Recapitalization
- Personal guarantees will likely be required by the bank as security for the additional debt obtained. So, even though the business owner has taken cash out of the business, risk still remains with the personal guarantees.
- There will be increased financial reporting required by mezzanine and senior debt providers.
- Additional debt on a business will increase the stress on cash flows, since lenders will require sufficient cash to cover the debt servicing requirements. This can affect a company’s ability to grow.
“In essence the owner is able to create liquidity and risk diversification today,
while setting the stage for a second “payday” down the road.”
SUMMARY – MORE THAN SIMPLY SELLING YOUR BUSINESS
Liquidity
Business owners can realize significant personal and family liquidity by selling part of the business to a financial partner and extracting 70% – 80% or more of their company’s current value.
Diversification
Avoids the risks of having personal and family wealth tied to a single business enterprise and allows for prudent wealth diversification .
Upside
Entrepreneurs can participate in a “second bite of the apple” in 3 to 5 years by maintaining a meaningful ownership stake and aggressively growing the business, using the capital from the financial partner, thereby creating an opportunity for significant additional wealth.
Management
Owners and existing management maintain operational control of the business. With new financial partners owners can focus on accelerating growth without exposing themselves to additional financial risk.
Partner
A well-capitalized partner with deep pockets and extensive business connections sets the stage for strong growth organically and/or through acquisitions.
* Note:
LockeBridge advises its clients on all exit options. Recapitalizations is just one of numerous potenial exit strategies. It is critically important that the business owner(s) meet with the banker to discuss options which compliment their each shareholder’s personal objectives.
