Many business owners/operators really enjoy running and growing their companies. Yet, they realize that too much of their net worth is tied up in the business they have devoted significant effort to making a success. Consequently, they seek ways to achieve liquidity, addressing various objectives such as estate planning, asset diversification, and philanthropy. In such cases, a liquidity event becomes necessary. But is the recapitalization of your company the answer? It can be a suitable solution.
Selling a control stake in the company often serves as the means to accomplish this objective. Additionally, if the sellers want to “take chips off the table,” they can participate with the new control partners through a continued ownership interest, usually retaining ownership with the new investors on terms equal to or similar to their new investment.
To successfully execute such a transaction, several key considerations and areas need to be addressed, ensuring the satisfaction of all parties involved. So, how is such a transaction accomplished, and what are the important factors to be considered?
The Basics of a Recapitalization (“Recap”)
Recapitalization of your company involves investors placing a total valuation on the business and buying a control position, while current owners/managers retain a minority position and continue to operate the business. A simple example is as follows:
Company EBITDA: $2,000,000
Valuation multiple: 5X
Total valuation: $10,000,000
Percentage acquired: 70%
Paid to sellers at close: $7,000,000
Source of funds:
Investors’ equity: $3,500,000
Senior debt $3,500,000
This simple example assumes that the target company of the recap is debt free and does not have excessive cash. Company valuations are typically on a “cash free/debt free” assumption. In the event it’s not, the value is adjusted.
In the above example, of the $7 million paid to the sellers, half of that comes from new borrowings of the target company.
The growth in modern Private Equity funds can be traced to the 1970s and the leveraged buyout craze. It was during this period when institutional fund managers (pensions, college endowments, trusts, insurance companies and wealthy individuals or families) evolved their investment strategies to allocate a portion of their investment portfolios to illiquid, long-term investments seeking a premium return to publicly traded stocks and bonds. Major pools of capital were raised by managers such as Kohlberg, Kravis & Roberts and Forstmann, Little & Co., which made front page news with major management-led acquisitions. The returns on these investments was increased by utilizing heavy levels of debt to leverage the transactions, which led to the creation of the “junk bond” market, driven by Drexel Burnham bankers.
Private Equity (“PE”) evolved into a major investment strategy for institutional funds, despite occasional setbacks in the 1980s and 90s. Nowadays, there are thousands of funds globally, ranging from millions to billions in size. These funds operate under terms established with investors, specifying minimum and maximum investments, debt limits, and investment timeframes. Additionally, they don’t directly manage portfolio companies, but instead, provide guidance as directors and advisors. Moreover, many PE funds target the “middle market,” typically focusing on companies with revenues between $10 million and $250 million.
Although corporate investors can structure transactions as recaps, the preponderance of these transactions is funded by institutional buyers and Private Equity funds.
What Are Other Important Areas to Consider About a Recap?
Investors typically want management continuity, at least for a specified term. Employment agreements for key executives are common.
The control ownership position assures the investors that key strategic decisions will be made with their consent. These include any needed additional capital raises, acquisitions, employee changes if needed, and the ultimate disposition of the investment.
Readily Available Additional Capital:
Investors usually retain some level of “dry powder,” uncommitted funds available to make additional investments in a portfolio company.
When investors identify a market, they are optimistic about, they sometimes deem an investment to be a Platform Company. This means they want to invest additional funds in that market behind the management of the Platform Company. This is usually through an acquisition strategy.
Percentage of Equity Acquired:
There is wide latitude in the minority ownership left with the selling shareholders, but investors want their new partners to have enough to be meaningful, so that they will be motivated by a sizable gain in their ongoing holdings (or feel significant pain if unsuccessful).
Board of Directors:
Usually, the Board to whom management reports will be small, comprised of investors, industry experts they recruit, and minority owners/senior management. Five to seven member Boards are quite common.
In portfolio companies, it is common to have a “carried interest” arrangement for key individuals. This equity participation, such as options, junior or phantom stock, doesn’t involve cash investment but rewards them based on the company’s equity value growth. To discourage key personnel from leaving, vesting provisions are implemented, acting as “golden handcuffs.” Typically, around 10% of the equity value is allocated for these interests.
Investment Horizon and Liquidity Event:
When participating in an investor-led recapitalization, it is ensured that a subsequent liquidity event takes place within a defined timeframe. The duration is determined by the investment agreement between the fund manager and investors, as well as the manager’s compensation structure. In some cases, it may be advantageous for a fund manager to exit an investment relatively quickly, as they retain control over the decision. Generally, the maximum investment period falls within the range of five to seven years.
Who Will Buy the Company:
Throughout history, portfolio companies have primarily been sold to strategic buyers—larger companies seeking industry expansion. However, in larger transactions, some opt for an Initial Public Offering (IPO) to achieve liquidity and establish a market for the company’s stock. As the private investment market has matured, an increasing number of liquidity events now involve sales to other private investor groups. In other words, private investor groups have emerged as a viable alternative for liquidity, providing an avenue for companies to transition ownership while maintaining privacy and control.
Private investors may approach you directly and put an offer in front of you. But that may not happen and may not be the best thing for the sellers. Private investment organizations are usually very top heavy, with a few well-paid senior partners and minimal staff of analysts and staff. For that reason, they often do not perform much of their own search work.
Our methodology is to identify the investors that match your company’s needs and create an appetite for your company, ultimately resulting in competition for the deal. Subsequently, we will narrow down the search to a few investors who are best suited for the transaction. Once this is done, we can proceed to negotiate the best deal for the seller. This negotiation encompasses various aspects, including financial terms, operational factors, and constructive collaboration between the investors and your company. By employing this approach, we ensure a thorough and comprehensive process that maximizes the benefits for all parties involved.