Many entrepreneurs have a significant amount of their net worth tied up in their business. During the good times, when growth seems endless and businesses prosper, it’s easy for owners to feel bullet-proof. But while nobody ever wants an economic downturn, one positive side to a bump in the road is that it forces business owners to realize that they are anything but bullet-proof, and recognize the importance of succession planning and diversifying their net worth. So how can business owners do that? Here are a few key ways to take some chips off the table without being forced to sell.
Alternatives for Taking Chips Off the Table
One way that business owners can diversify is with a strategy called a leveraged recapitalization (recap). This allows owners to take cash out of the business and transfer the risk of investment into other asset classes. In a recap, an outside financing source provides capital to a company to facilitate a distribution of cash to the business owners. The financing for the recap could come from one of the following sources:
Let’s explore the concepts and advantage/disadvantages of each based on a simple example of a company that has $5 million of EBITDA, a debt-free balance sheet and an owner who wants to pull some cash out of the company.
Debt Recapitalization
In a debt recapitalization, an owner simply goes to the bank and asks for a loan in the company. Based on the net tangible assets, future free cash flows and ability to meet future financial covenants, the bank would provide a certain amount of debt that could be distributed to the owner through various mechanisms, such as a dividend. The amount of debt provided (in the form of either senior or mezzanine financing) would depend on the qualitative and quantitative characteristics of the business.
Advantages:
- A business owner will retain 100 percent ownership of the company.
- The process is relatively quick – typically three to four months – because owners need only negotiate with the bank.
- This type of financing can be done confidentially, with minimal disruption to the operations of the business.
Disadvantages:
- Personal guarantees will very likely be required by the bank as secondary 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. Owners need to assess whether they can stomach this extra debt.
- There will be increased reporting required by mezzanine and senior debt providers.
- Additional debt on a business will increase the stress cash flow, since lenders will require sufficient cash to cover the debt servicing requirements. This can affect a company’s ability to grow.
- Comparatively less cash is available for payout to a business owner under a debt recap because debt is the only source of capital.
Equity Recapitalization
Under an equity recap scenario, the owner would sell a portion of his/her share and debt would be introduced into the company to facilitate the transaction. This is the type of transaction most commonly executed by private equity groups. Under an equity recap, owners can sell anywhere from 10 percent to 90 percent of their business, with the more common range falling between 25 percent and 75 percent.
Advantages:
- A financial institution will not require personal guarantees from business owners because the private equity partners or other equity investor is providing sufficient capital to alleviate guarantee requirements.
- The business owner gains a financial partner with access to additional capital.
- The combination of debt financing and equity investment would result in more cash to distribute compared to debt recap financing.
Disadvantages:
- The business owner is no longer the sole steward of the business.
- If additional capital is needed for future growth, the business owner will need to match the investment of the private equity group to avoid diluting its ownership position.
A Recap Isn’t Right for Every Business
A recapitalization can definitely help middle market business owners diversify their net worth, but it isn’t for everyone. The best candidates are companies that employ a team of managers (rather than a single owner) with stable (or growing) cash flows. It also helps if there are some tangible assets within the business that can be used as collateral.
It is also important for owners to recognize that equity recaps are not the only way. A debt recap provides an alternative for owners who are not yet willing to sell their company and give up control.