For most owners of medium-sized companies, the business ties up the bulk of their financial net-worth. When nearing retirement, owners often become aware of the concentration of risk and lack of diversification of their financial assets. Also, many owners are now reaching a point in their life where they wish to reap the financial rewards of their work.
To date, the preferred method of creating liquidity has been through a complete sale of the business. The M&A process is complicated, but well-understood and can often achieve an attractive valuation for the seller.
But what are your alternatives if you are not ready to give up control? Perhaps you continue to enjoy running your own company. Perhaps you are confident that your company will capture significant further financial upside over the next few years. In this case, a premature sale would likely mean that you would be leaving money on the table for the new owners.
The dividend recap is a structure where the company takes up additional debt capital to enable a significant one-time dividend to the owner. In essence, the process is based on utilizing the excess debt capacity of the business to allow some of the equity that has been built up in the past to be returned to the owner as cash.
The cash realized allows the owner to achieve a larger degree of wealth diversification away from the business, pass on cash to children and achieve other estate planning objectives. The recap transaction can be used by the owner as a first step in a longer process, with the objective of selling the company in the next three to seven years.
The most suitable companies for a significant dividend recap have modest levels of current outstanding debt (1x–2x EBITDA), a track record of stable positive cash flows and modest capital expenditures going forward.
The new financing structure is likely to include senior and junior term loans, as well as a revolving credit line. Depending on market conditions and company specifics, overall leverage may be increased to above 5.0x EBITDA, thus potentially allowing a special dividend of 3x-4x EBITDA to be distributed to the owner.
The continuing health of the debt market and the growing activity of non-bank lending institutions, coupled with relatively low interest rates, allow smaller companies to access debt finance at attractive terms. The economics of the financing in terms of loan pricing, covenants and amortization need to be evaluated carefully. Avoiding personal guarantees of the owner on the newly raised debt is a key requirement.
Going forward, transactional, legal and wealth management advice is crucial. Important legal considerations include the drafting of representations & warranties, covenants, as well as overseeing the information collected for debt finance providers. The higher leverage and reduced amount of equity increases the debt service obligations of the business and reduces financial headroom in case of a down-turn. For this reason, it may be prudent for the owner to obtain a solvency opinion from an independent provider to confirm that the recapitalization is being based on a prudent leverage structure. This can be useful in mitigating legal risks for the owner and board members in case of unexpected future financial problems at the company.
If you require any further information about starting a business, please contact Edward Grenville, Managing Shareholder, Inspire Business Law Group, PC (egrenville@inspirelawgroup.com; +415 279 0779; www.inspirelawgroup.com).
This article is provided for educational and informational purposes only and is not intended to be, and should not be construed as, legal advice.
Written by Benjamin Bartsch.