At some point in the lifecycle of a business, most owners wrestle with the decision of whether they should sell or remain working in their growing business. Most business owners probably don’t realize both objectives can be accomplished, namely, to sell the business and still have the opportunity to participate in its future growth. A financial technique known as private equity recapitalization (“recap”) exists, which allows business owners the opportunity to cash out of their businesses while staying involved in management and decision-making if they desire. Best of all, this technique also allows them to take a ‘second bite at the apple’ when the business is sold in the future. As such, this important tool provides business owners with growth and liquidity options.
Equity Recapitalizations Defined
A recapitalization is a transaction resulting in the reallocation of the debt and equity in the capital structure of a business. It represents an attractive option for owners considering an exit because it allows them to exchange some of their equity for cash while positioning the company for future growth. In an equity recapitalization, a private equity investor buys out most, but not all, of the owner’s interest in the business. This tactic allows the owner the opportunity to unlock some of the value tied up in the equity of the company and creates a liquidity event for what’s probably the largest portion of his/her net worth. Additionally, it allows the owner to remain involved in the operation and decision-making process of the company, or alternatively, to phase-out over time. Moreover, when the investor sells the business at some point in the future, the owner sells the remaining equity thus participating in the upside of a second liquidity event.
In addition to the benefits to the owner, recaps also provide management teams the chance to participate in the equity of the business when they don’t have the capital to do so. Since private equity investors usually require and actively seek the support of the management team, it’s likely they may offer top management the opportunity to participate in the equity of the business, either in the form of a buy-in and/or earn-in basis.
Overall, equity recapitalizations as a financial strategy offer numerous advantages including increased owner liquidity, continued ownership, risk minimization and enhanced growth opportunities, among others. Top management also benefits in this process as opportunities are created.
The Process of a Recapitalization
When a shareholder in a private company wants to liquidate his/her investment, the remaining shareholders are often first presented with the opportunity to purchase these shares. If the value of the ownership interest being sold exceeds the company’s available cash resources, another source of capital is required.
In this situation, it’s up to the remaining shareholders to determine whether they’d prefer to finance the buyout with debt or with equity.
In the event that the company’s capital structure and cash flow can support additional debt, the remaining shareholders are probably better off financing the buyout with debt, as this is usually the least expensive and easiest source of capital to arrange. However, if debt is not available to the company, the shareholders must find other source(s) of capital, often from an equity investor.
For the most part, private equity investors will seek to buy a controlling interest (at least 51%) in the company and the exact terms can vary. Business owners or equity investors should consult with a reputable business broker to arrange the specific details.
As baby boomers continue to retire in record numbers during the next five to 10 years, many business owners will consider alternatives to exiting their businesses a very viable option. They can modify the company’s capital structure in such a way that’s consistent with their plans and objectives, as well as those of the company. A private equity recapitalization makes it possible for business owners to achieve partial liquidity for their interest in the business, while continuing to participate in both the operations of the business and its upside potential. The management team also benefits as they can become shareholders in the company and, most importantly, the business will have the financial resources required to support its future growth.
Noel Calas is an associate intermediary and consultant at Bateson Business Brokerage in Longwood. He can be reached at 407-772-2340 or firstname.lastname@example.org.