Owners of closely-held businesses can find themselves in situations where they need to release liquidity from their investment but their equity positions are not readily tradable. For these entrepreneurs, a complete sale of the company or a leveraged recapitalisation can be used to achieve their liquidity objectives. However, such alternatives need to be evaluated carefully and any chosen path to liquidity comes with high financial and emotional stakes.
A complete sale involves the sale of all the company’s shares to a strategic buyer or a financial buyer. Understanding these two types of potential buyers is important for a successful transaction.
- Strategic buyers – are interested in firms that are competitors or operate in adjacent sectors, where additional upside can be captured from the integration of the target company.
- Financial buyers – take a stand-alone view and are interested in targets that offer the highest potential return.
Strategic buyers may expect to generate synergies from a combination of the target with its own operations, theoretically allowing them to pay a valuation premium. Financial buyers employ leverage to enhance their equity returns and also contribute a wealth of experience in re-organizing and building businesses, two facts that often allow them to out-bid strategic buyers. A structured sale in an auction process directed at both groups of buyers is usually the best way forward.
As an alternative to a complete sale, many business owners have used leveraged recapitalisations to generate personal liquidity from their companies. In contrast to an outright sale, this type of transaction may or may not involve the sale of shares and never results in a complete exit. There are three major Leveraged recapitalisation structures that business owners should be aware of:
- Dividend recapitalisation – the excess debt capacity of the company is used to allow a large one-time dividend to shareholders, without dilution in ownership. The balance sheet is transformed through the take-up of additional debt.
- Minority recapitalisation – between 20-40% of the equity is sold to an investor, providing the shareholders with personal liquidity without giving up control of the firm. The company’s balance sheet usually remains unaffected.
- Majority recapitalisation – between 60-80% of the equity is sold with debt and equity being used to finance the transaction. The company’s balance sheet usually remains unaffected.
The key advantage of a dividend recap is that there is no dilution in ownership. This is ideal for business owners who want to diversify their personal net worth and continue growing their business. The pre-requisite for this is a balance sheet with relatively low levels of debt and strong, predictable cash flows. Favourable transaction terms will depend on securing a competitive debt package from finance providers. Although the proceeds raised from the dividend recap will normally be significantly less than proceeds from an outright sale, the owners preserve full ownership and control of the business.
A minority recap combines a balance sheet restructuring or liquidity event with a reduction of ownership stakes, whilst preserving overall control for the owners. The process is often complex and can combine the raising of senior and junior tranches of debt, as well as the issuance of preference shares. Owners wishing to sell large equity stakes need to appreciate that the pool of demand for minority equity investments in unquoted companies can be shallow. Owing to a lack of control and liquidity of a minority ownership position, private equity firms, strategic buyers and individuals are typically less likely to invest. As a result, the sellers are likely to suffer a valuation discount on their sale, compared to the disposal of a majority stake.
In the spectrum of available options, majority recaps fall between the minority recap and outright sale. At the high end (80% sale), the transaction is often structured as a 100% sale to a financial investor, followed by re-investment of a stake 20% into a joint holding company. Many private equity companies prefer such co-ownership structures because the former owner remains as a risk-sharing partner in the company going forward. The private equity firm’s objective of achieving a profitable exit in 5-7 years’ time provides the former owner with the crucial liquidity event. Compared to the minority recap, the owner should expect to achieve a full market valuation for both exit events. Sales of 50.1% to 60% stakes are less common. Whilst control passes to the new investor, care must be taken to structure shareholders agreements that provide the original owner with sufficient protections on his remaining investment. A clear business strategy going forward and a detailed agreement regarding a future exit (such as a planned public offering of stock) will be important to protect the value of the original owner’s remaining minority investment and secure his path to liquidity.
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.