"The most important single central fact about a free market is that no exchange takes place unless both parties benefit." - Milton Friedman

Many experienced business owners searching for a succession plan have wrestled with the notion of selling their companies, even as they continue to see significant growth ahead of them. Fortunately, there's an alternative financial technique known as a private equity recapitalization (recap), where business owners can sell a portion of their business to private equity (PE) partners and still have the opportunity for growth.

PE firms can be savvy business partners that bring more than just capital to the table. They also provide industry, operational and organizational expertise, all of which can be used to increase the value of a business. That's a good thing because if the company's value increases, a recap also allows owners to profit for a second time when the business is sold again in the future. Let's take a look at how private equity recapitalization works.

How a PE Recap Works

Let’s work through a simple fictional example:

Bob founded ABC co., a manufacturing company, 20 years ago. ABC co. has weathered many storms throughout the years, but a recent downturn has made it clear to Bob that too large a percentage of his net worth is tied up in the company. Bob sees the opportunity for continued growth in the company, but also has a need to take some chips off the table and reduce his involvement in daily operations. Unfortunately, ABC co. does not have a competent secondary management team to run the business' day-to-day operations.

After some research on possible options and discussions with other entrepreneurs who have successfully recapitalized their businesses, Bob decides to pursue a PE recap. The company finds a partner that wishes to invest in the company and begins the search for a management team to lead the company into the future.

The business is debt free and the negotiated enterprise value (EV) of ABC co. is agreed upon by both parties to be $20 million. The acquisition will be financed with 40% equity and 60% debt. After the transaction, ABC co. will carry $12 million in debt. Bob will also continue to own 30% equity of the company.

The value of the equity after the recap will be as follows:

Total enterprise value of ABC co. $20,000,000
Less: Debt on recapitalization ($12,000,000)
New equity value of ABC co. $8,000,000
Total enterprise value of ABC co. $20,000,000
Less: Buy-in for 30% of the equity value ($2,400,000)
Pre-tax proceeds to Bob $17,600,000

After five to seven years, the private equity firm will execute on a liquidity event for the business either through the sale to another larger private equity, a sale to a strategic buyer or through an IPO.

Bob's equity value in the second sale, if they were able to double the enterprise value of the business over that timeline, would look like this:

Second sale of business - Assume that EV doubles $40,000,000
Less: Debt outstanding on second sale (estimate) ($5,000,000)
Equity value of ABC co. $35,000,000
Bob's 30% equity value on second sale
$10,500,000

So, Bob walks away with $28.1 million versus $20 million that he would have earned on the initial sale of 100% of his business. You can do the math if the enterprise value was to triple over this time period, which is not an unreasonable assumption given the mandate of most private equity to aggressively grow portfolio companies.

In addition to profiting from the growth, Bob has been able to systematically remove himself from the business as a deeper management team has been built to fully take over operations. Also, the PE firm has continued to assist with executing the strategy, providing board representation and positioning the business for a premium valuation on the second exit.

The Risks of a Recap

Obviously, we went through a very simplistic example with lots of fictional assumptions, but it illustrates the upside for this type of transaction. As with most things, there are also downsides to consider:
  1. Bob is no longer the boss. The PE will set up an advisory board and empower the new management team to drive the business going forward. Most business owners find it difficult to relinquish control.
  2. After the transaction, the company will carry a significant amount of debt. Most business owners are cautious about high debt levels.
  3. The value of the company on the second exit is not guaranteed, nor is the timeline known. Many variables could derail these plans.
  4. There is a risk of choosing the wrong PE partner. Business owners will need to verify the track record of the PE to determine the likelihood of success.

Know Your Options

Every situation is different. A private equity partner can be a great solution for a business in which the owner is optimistic about the future but still wants to diversify his/her personal net worth. But going down this road is as complicated, if not more complicated, than an outright sale, and it comes with its own set of risks, too. By knowing your options, you can put together the best possible deal when the time comes.