Times have changed. Owners are operating their business in a volatile world. Competitive threats, financial and geopolitical events can quickly and significantly decrease their company’s operating cash flow and valuation. Because of their age, baby boomers have less time to recover from such events.
Let’s face it, most business owners have the majority of their wealth tied-up in their company. Very infrequently do I meet with an owner that doesn’t need money from the eventual sale of their business to fund a secure future/lifestyle.
Fortunately for some business owners, there is a liquidity option available to deal with their wealth concentration risk, which also provides some assurance of both capital and additional expertise to fund continued growth. It is called a private equity (“PE”) recapitalization transaction. In essence it allows an owner to sell their company twice.
In a recapitalization transaction, the owner sells a portion of the business in the first transaction and retains an equity ownership in the company. This allows the owner to take advantage of both the current and expected future value of the company. At a later date, usually 5-7 years from the original sale, the business is sold again and the owner can benefit from a second liquidity event at a higher valuation. In addition to providing capital to fund growth, private equity groups bring industry expertise, contacts, and financial, operational, organizational knowhow, which taken together can increase the value of a business.
An Example of How A Private Equity Recapitalization Works
Jack, now 62, started Best Co. (“BC”) 25 years ago. Managing BC, a business services company, has required 50-60 hours a week of Jack’s time. He has successfully managed the company through several recessions and challenging industry downturns. Although it took time, Best Co. has bounced back nicely from the 2008-9 recession. Jack still enjoys the business but is tired. He would like a reduced role and to develop a stronger management team. His wealth management advisor recently reminded him about the risk of having a large percentage of his net worth tied-up in Best Co. Jack spoke with an investment banker about liquidity options and learned how a PE Recap works.
First Transaction: BC’s annual revenue of $26 million is growing at 15% annually. Adjusted EBITDA is $4 million. The company has $2 million in bank debt. The negotiated enterprise value of BC is $24 million, representing a 6x valuation multiple. The private equity buyer forms a company called NEWCO to purchase the assets of BC and finances the acquisition with 40% equity and 60% debt. Jack will continue to own 25%. Transaction expenses were 4.5% of enterprise value.
Second Transaction: Five years later NEWCO’s revenue had grown to $50 million. Adjusted EBITDA was $9.0 million. The PE firm agreed to sell the assets of NEWCO to a strategic buyer at a 7x EBITDA multiple. Bank debt at the time of closing was $3 million. Jack’s equity stake at the time of the sale was 21.5%. It was diluted somewhat to provide equity incentives to the senior management team. Transaction expenses were 3.5% of enterprise value.
First Transaction’s Proceeds To Jack
Second Transaction’s Proceeds To Jack
By pursuing this equity recapitalization transaction, Jack realized $30.95 million in net pre-tax proceeds versus $20.9 million if he had sold 100% of the company at time of the first sale. That is an increase of $10 million. Another benefit of this type of transaction is it releases Jack from personal guarantees on bank debt and leases, etc.
Which Companies Are The Best Candidates For A Private Equity Recapitalization
In general, the best candidates for an equity recapitalization have most of the following characteristics: A history of consistent earnings; adjusted EBITDA of $2 million+; minimal bank debt; good growth prospects; low capital expenditure requirements; predictable recurring revenue; low customer concentration; EBITDA margins of 10%+; and where the owner is willing to back his/her belief in the potential of the company by buying 15% or more of NEWCO’s equity.
Recapitalization Risks & Concerns For The Owner
Pursuing an equity recapitalization transaction has its own set of risks, among them being:
- In order to attain a higher return on investment, PE firms will borrow money (use leverage) to finance the investment. Make sure your PE partner is not using excessive amounts of debt.
- There is no guaranty that the value of the company at the time of the second sale will meet the owner’s expectations.
- After the initial sale, the former owner will no longer be in control. The owner and the PE firm should agree to a thoughtful business plan before moving forward.
- It is likely the PE firm will make changes to existing management (i.e., the owner’s friends).
There is a chance of choosing the wrong PE partner. Owners and their advisors should thoroughly vet the reputation, track record and industry expertise of the PE firm by speaking with business owners who were acquired by the PE firm.
Twenty years ago, an equity recapitalization transaction was not a liquidity option for owners of qualified companies who wanted to participate in the expected growth of their company. Today, owners with companies that are attractive recap candidates have hundreds of private equity firms that might be interested in being their partner. Whether owners plan is to sell their company today or five years from now, the owner should understand what exit options are realistically available. A PE recapitalization transaction is one of the least understood but best options to mitigate an owner’s wealth concentration risk in their company.