11 Mar 10 Reasons to Perform a Majority or Minority Recapitalization
Corporate recapitalizations can be a beneficial tool used by business owners seeking capital. The structure, source and uses of the funds can be as unique and varied as the businesses themselves. Recapitalizations are typically funded using both debt and equity. Today’s liquid private markets include options for both majority and minority recapitalization. Businesses in various stages of growth have successfully used recapitalizations to achieve personal and business growth goals. What follows is a brief description of a few of the reasons business owners perform recapitalizations, including the benefits and risks associated with this unique financing arrangement.
Take some chips off the table
Perhaps the most undiversified group, from an investment perspective, is the middle-market business owner. Founders make large, but risk-mitigating bets on the businesses they build. They often achieve outsized returns in doing so, but such returns come with a higher dose of systemic risk.
Some debt financing companies, including those that work on equity majority, dividend and leveraged recapitalizations will do so with the expectations that a portion of the money will be for owners looking for diversification. Depending on the investor in the deal, issuers can receive favorable turns, terms and valuations on the debt including debt without the need for a personal guarantees.
Moving from systemic to systematic risk using a majority recapitalization can be a wise move. It works for owners both old and young. In fact, those that intend on a complete sell-side transaction in a few years can greatly benefit from such a restructure several years prior, especially if it includes the right estate planning, but I’m getting ahead of myself.
A recapitalization can be used as a simple financial tool for raising inorganic growth capital. Debt or private equity infusions can be a great way to source capital for the next wave of growth through mergers and acquisitions. Some of the most successful business owners have built their wealth through bolt-on or tuck-in acquisition opportunities.
Organic growth capital
Fast-growing companies are often burdened with capital constraints. Even companies that kick-out large amounts of cash flow can be hampered in their growth if the cash flow cannot track with the increased demand for working capital the business requires. These are good problems to have, especially for high-profit companies, but they are problems nonetheless.
A leveraged-based recapitalization of the business can help. A capital infusion here can be used to buy more inventory, hire more sales & support staff and/or beef-up systems and processes in an effort to create a better platform for sustained growth.
Estate planning + tax basis reset
Recapitalizations can take many forms. They are not always about levering the company with a large debt burden, but a recap could include ESOP or a stock exchange from common to preferred. This is frequently used when businesses owners are looking to transfer assets to children or grandchildren. If done properly, this form of recapitalization allows a reset of the tax basis, effectively freezing the majority owner’s stake in the business. Alternative options include various trusts, donor-advised options and gifting to family members and charity that are more favorable with an initial recapitalization and then a later sale.
Due to the opportunity to reset valuations at a lower, more tax-favorable rate, many lenders were peddling this as a service to entrepreneurs and business owners from 2008 to 2010 when valuations were extremely depressed. During that time, many owners took advantage of the opportunity to reset their tax basis by first having a professional business valuation followed by a corporate restructuring or recapitalization.
The full landscape and structure of recapitalizing using trusts, uni-trusts, and donor advised funds is well beyond the scope of a short blog post. However, the estate planning and tax sheltering options available cannot be understated, neither can the need to prepare for a business sale many years in advance. Also, macro trends do matter and year or two of depressed earnings can actually be a boon for longer-term tax savings.
Prepare for a later sale
Recapitalization financing can be used as a financing bridge shortly before a business is sold. The length of time between when a business is recapitalized and when a full sell-side engagement takes place depends on a number of factors, including the stability of the business, the cleanliness of the financials and other operational books, the age of the owner, growth factors (including those mentioned above) and the macroeconomic trends.
Recapitalization financing can certainly be used prior to an eventual sale, but the lenders’ warning bells will chime if an owner is looking to obtain recapitalization financing only a year or two before an eventual exit and that financing does not include a significant plan for growth. Any financier is going to want to see his/her investment in the company either grow or be protected by growth. It is best to recapitalize with an eye on growth and a time horizon that is at least three years or more.
In some cases, a recap is—in and of itself—an exit strategy for an owner. Depending on the existing structure, the percentage of the debt and the relationship between buyer and seller, a recapitalization may include a business owner selling a minority or majority stake. The selling owner often intends to hold the remaining ownership shares indefinitely and subsequently walk into the sunset as a silent partner.
An ESOP, for instance, is nothing more than a fancily-structured recapitalization, used as an exit strategy for a retiring owner.
Retire old debt
There are several instances where a recapitalization makes sense simply for cost-of-capital maintenance and improvement. A decrease in interest rates or an improvement in the financial solvency of a company could impact its ability to source capital more cheaply.
Just like a homeowner refinancing his/her mortgage, a business owner may find a recapitalization as a prime method for saving some coin, even with origination and early termination fees factored-in.
Leveraged, management buyouts remain one of the most prolific reasons for performing a majority recapitalization. Internal management—with a legitimate intent to acquire a majority stake from founders and other shareholders—may source capital from various sources to help fund the buyout.
The terms on this type of financing may be structured a bit differently and include some personal guarantees, but the ability to use both leverage and outside private equity in recapitalizing for the purpose of senior management acquiring the business
It is unlikely obtaining a tax shield on debt would be the primary reason for a business owner to recapitalize the company, but it certainly remains a key benefit. Tax incentives can help with the cash flow bite taken when a leveraged recapitalization is placed on a business.
A tax shield is simply this: because the business is taxed after interest expense is incurred, there is a reduction in the tax liability the company will incur on an on-going basis. Again, it remains a secondary benefit, but a benefit nonetheless.
Maintain Culture & Control
True entrepreneurs are hard-driving, workaholics. They often have a difficult time completely unplugging from work and especially from the company they found and grew. By recapitalizing, a founder/owner will still maintain operational and cultural control of the business whilst taking some risk off the table. In addition, the optimistic owner may have bright prospects for the future of the business. Retaining some ownership and control over operations, while being able to share in at least some of the upside potential as the business grows is a win-win for most entrepreneurs. The second bite of the apple after yet another season of prolonged company growth is a real possibility for most quickly-growing companies.
No two company recaps look the same. In fact, many recapitalizations will include a varied mix of the features and benefits outlined above. For instance, an owner who may be 8 to 10 years away from retiring with a business that produces $4mm a year in adjusted EBITDA. She believes she can take her business to over $8mm in EBITDA with the assistance of a few key hires, some systems improvements, increases in inventory and perhaps a couple of small acquisitions. The owner would also like to take some chips off the table as well. In sourcing recapitalization financing from various lenders a detailed sources & uses document outlines the various intended uses of the recapitalization financing.
As always, financing of this type is best obtained through a rigorous search, screen and vet process, typically achieved by a knowledgeable investment banker. Understanding both the benefits and risks associated with this type of transaction can be extremely helpful in achieving the best possible outcomes.