Recaps For Small Businesses Good Or Bad?
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Recaps for Privately Held Businesses, Good Or Bad?
What’s a Recap and Why Should I Care?
Definition: A Recapitalization or Recap is a financing technique used typically by private equity investors to invest in privately-held businesses that allow the existing owner to restructure the debt and equity of their company to either obtain new capital for future business growth and/or to reduce their personal financial risk by taking some chips off the table.
Recaps are typically structured in such a manner as to repay any existing debt that has been personally guaranteed by the existing owner. This is one of the main benefits in that it reduces the owners’ personal financial risk from their personal guarantees on bank loans, capital leases, etc. If a “Black Swan” event occurs and the business flounders, the owner has at least taken substantial money off the table and avoided losing everything.
Recaps include a reduction in the owners’ percentage ownership of their business. This is frequently accomplished by the “Newco” formed to be the acquiring entity, purchasing 100% of the existing company (typically structured as a sale of assets – debt free) and the previous 100% owner of “Soldco” purchasing an agreed upon % ownership of “Newco” from the proceeds they receive at closing. Since the capitalization of “Newco” will typically include new debt (with no personal guarantees), the valuation of the equity in Newco to be purchased by the seller of “Soldco” can create some complex valuation and deal structuring issues/opportunities.
An example:
$10,000,000 – Value of 100% of Soldco on a debt free basis.
$3,000,000 – Amount of Soldco existing debt pre-closing – to be repaid at closing.
60%/40% — Desired Debt/Equity Capital Structure of Newco post closing
$6,000,000 Newco Debt, post closing (dependant upon sufficient cash flow)
$4,000,000 Newco Equity post closing
30% Agreed upon Ownership % of Newco to be bought by previous owner of Soldco
Therefore, if the value of Newco post closing is $10,000,000, less the new debt of $6,000,000, the previous owner of Soldco will be expected to purchase a 30% ownership of Newco by reinvesting $1,200,000 ($4,000,000 x 30% of Newco) of the proceeds received at closing ($10,000,000 price – $3,000,000 debt repay = $7,000,000), leaving the former owner of Soldco with $5,800,000 ($7,000,000 – $1,200,000) to pay for transaction costs and income taxes related to the sale of Soldco – and they still own 30% of Newco.
In this example, the previous owner has substantially reduced their investment risk and is still running the business under the Newco name which may be identical to the Soldco name but with “LLC” at the end instead of “Inc.” The personal guarantees on the debt have been eliminated and the investor group is available to assist in the future growth of Newco.
So, what are the drawbacks?
The investor group expects the 30% owner of Newco to remain the CEO of the business and participate on a full-time basis in growing the business. So if your goal was to retire in a year or so, a Recap is not the best deal structure to use. If your goal is to remain as CEO for 4-7 years more and then sell the company to a strategic buyer, you can sometimes get an even bigger payday.
The ownership interest in Newco will likely come with a restriction on your ability to resell or transfer shares in Newco to others such as family members through inheritance. If you desire to one day transfer your company to your children at or prior to your death, it will typically be blocked by a Recap. Investment groups typically do not want to be shareholders with your relatives.
Some business owners are emotionally attached to owning 51% or more of their business, particularly if the initial motivation for starting their business years ago was to be their own boss. Although investment groups that participate in Recaps have no desire to run the businesses in which they invest, the agreements with their institutional investors promise they will always have 51% or more ownership of their business investments in case they must make changes in the business to protect their investment.
It’s crucial to establish and maintain a close personal relationship with the people involved with the investment group. Choose wisely, and not necessarily the investment firm that offers you the highest valuation. They will be your partners after the Recap is complete and until the business is later sold. It can be a miserable existence when you and the investors dislike or mistrust each other or if you are constantly arguing about the future direction for the company.
Any time that you consider taking on investor partners, you want to evaluate the merits of a buy-out provision that’s typically available to all stockholders (called a shotgun provision). If you are unable to get along with the investment group, the shotgun provision provides either party the right to buy out the other at an agreed upon valuation metric and payment terms. It can be a double-edged sword since it allows the investor group to repurchase your ownership interest in Newco at a pre-agreed upon formula if you are financially unable to buy them out. Although in theory it allows you to buy them out, you must have the available funds to do so at the price and terms they propose or they can buy you out at the same price and terms.
Beyond the above aspects of a Recap, perhaps the greatest benefit is that it can bring in very savvy investors who are knowledgeable about your industry and can assist you in growing the business to a larger size more quickly. It also can provide both capital and expertise to implement a growth by acquisition strategy. Both of these can result in selling the company to a strategic buyer 4-7 years later at a much higher valuation, providing you a second bite of the apple.
Recaps are typically structured in such a manner as to repay any existing debt that has been personally guaranteed by the existing owner. This is one of the main benefits in that it reduces the owners’ personal financial risk from their personal guarantees on bank loans, capital leases, etc. If a “Black Swan” event occurs and the business flounders, the owner has at least taken substantial money off the table and avoided losing everything.
Recaps include a reduction in the owners’ percentage ownership of their business. This is frequently accomplished by the “Newco” formed to be the acquiring entity, purchasing 100% of the existing company (typically structured as a sale of assets – debt free) and the previous 100% owner of “Soldco” purchasing an agreed upon % ownership of “Newco” from the proceeds they receive at closing. Since the capitalization of “Newco” will typically include new debt (with no personal guarantees), the valuation of the equity in Newco to be purchased by the seller of “Soldco” can create some complex valuation and deal structuring issues/opportunities.
An example:
$10,000,000 – Value of 100% of Soldco on a debt free basis.
$3,000,000 – Amount of Soldco existing debt pre-closing – to be repaid at closing.
60%/40% — Desired Debt/Equity Capital Structure of Newco post closing
$6,000,000 Newco Debt, post closing (dependant upon sufficient cash flow)
$4,000,000 Newco Equity post closing
30% Agreed upon Ownership % of Newco to be bought by previous owner of Soldco
Therefore, if the value of Newco post closing is $10,000,000, less the new debt of $6,000,000, the previous owner of Soldco will be expected to purchase a 30% ownership of Newco by reinvesting $1,200,000 ($4,000,000 x 30% of Newco) of the proceeds received at closing ($10,000,000 price – $3,000,000 debt repay = $7,000,000), leaving the former owner of Soldco with $5,800,000 ($7,000,000 – $1,200,000) to pay for transaction costs and income taxes related to the sale of Soldco – and they still own 30% of Newco.
In this example, the previous owner has substantially reduced their investment risk and is still running the business under the Newco name which may be identical to the Soldco name but with “LLC” at the end instead of “Inc.” The personal guarantees on the debt have been eliminated and the investor group is available to assist in the future growth of Newco.
So, what are the drawbacks?
The investor group expects the 30% owner of Newco to remain the CEO of the business and participate on a full-time basis in growing the business. So if your goal was to retire in a year or so, a Recap is not the best deal structure to use. If your goal is to remain as CEO for 4-7 years more and then sell the company to a strategic buyer, you can sometimes get an even bigger payday.
The ownership interest in Newco will likely come with a restriction on your ability to resell or transfer shares in Newco to others such as family members through inheritance. If you desire to one day transfer your company to your children at or prior to your death, it will typically be blocked by a Recap. Investment groups typically do not want to be shareholders with your relatives.
Some business owners are emotionally attached to owning 51% or more of their business, particularly if the initial motivation for starting their business years ago was to be their own boss. Although investment groups that participate in Recaps have no desire to run the businesses in which they invest, the agreements with their institutional investors promise they will always have 51% or more ownership of their business investments in case they must make changes in the business to protect their investment.
It’s crucial to establish and maintain a close personal relationship with the people involved with the investment group. Choose wisely, and not necessarily the investment firm that offers you the highest valuation. They will be your partners after the Recap is complete and until the business is later sold. It can be a miserable existence when you and the investors dislike or mistrust each other or if you are constantly arguing about the future direction for the company.
Any time that you consider taking on investor partners, you want to evaluate the merits of a buy-out provision that’s typically available to all stockholders (called a shotgun provision). If you are unable to get along with the investment group, the shotgun provision provides either party the right to buy out the other at an agreed upon valuation metric and payment terms. It can be a double-edged sword since it allows the investor group to repurchase your ownership interest in Newco at a pre-agreed upon formula if you are financially unable to buy them out. Although in theory it allows you to buy them out, you must have the available funds to do so at the price and terms they propose or they can buy you out at the same price and terms.
Beyond the above aspects of a Recap, perhaps the greatest benefit is that it can bring in very savvy investors who are knowledgeable about your industry and can assist you in growing the business to a larger size more quickly. It also can provide both capital and expertise to implement a growth by acquisition strategy. Both of these can result in selling the company to a strategic buyer 4-7 years later at a much higher valuation, providing you a second bite of the apple.
Michael Shea is a Board Certified Intermediary and Shareholder of Transworld Business Advisors. With over 16 years of experience and literally hundreds of transacations consumated Mr. Shea is recognized as a leader in the M&A and Business Sales Arena. For more on him and Transworld visit https://www.yourfloridabusinessbroker.com
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