The Alternative to Selling:
Private Company Recapitalizations without
Relinquishing Majority Ownership
Samir Desai
One of the top issues faced by attorneys,
accountants and other advisors involved
in financial planning is how to help private business owners overcome the
lack of liquidity
of their company’s private shares. Most are surprised to
learn that their clients can liquefy a significant portion of shares
without giving up control of their company or going public. It
is a misconception that’s not surprising, considering that
the vast majority of financial investors do require a majority
ownership – and that nearly all articles and information
on the subject, written by those
investors, state that transferring majority ownership is the only
option.
However, a limited number of capital firms do offer ownership recapitalizations
that require only a minority stake in the company. To finance such
recaps, the firms use mezzanine securities, specifically subordinated
debt and preferred stock. Mezzanine securities are a hybrid between
senior debt and equity. Like senior debt, the securities are loans
that earn interest, and like equity, they are unsecured and long
term in duration. The overall cost of mezzanine securities is higher
than senior debt, but lower than equity.
In terms
of shareholder liquidity, mezzanine funds offer business owners
the chance to have their cake and eat it too – they
can take cash out of their business,
and yet maintain a majority ownership and management control.
Why Consider a Minority Ownership Recap?
Private business owners nearly always
face a lack of liquidity of their
company shares. Regulations and restrictions imposed by shareholder agreements
severely limit an
owner’s ability to exchange a portion of his ownership for
cash. And, although the owner may
take out nice salaries and benefits, the majority of his/her wealth
is tied up in the company and dependent
upon its continued success.
Therefore,
the primary reason to consider a minority ownership recap is for
wealth diversification purposes. Within the past few years,
even some of the most seemingly secure
companies have fallen upon severe financial distress. Changes in
technology, consumer practices,
or just a continuation of the world
market’s decline could
devastate a business owner’s financial security – if
that security is 100 percent invested
in his/her business.
A recap allows
an owner to “take chips off the table.” It
provides the peace-of-mind that their financial security is ensured,
but doesn’t require them to withdraw from the game or miss
future earnings.
Intergenerational Wealth Transfer
Minority ownership recaps are also
an effective way to transfer business
ownership from one generation to the next. Normally, the same issue of
liquidity of shares can
be an obstacle to a business owner’s desire to pass his/her
company on to the next generation. If 100 percent of a company’s
shares are held by the business owner, how does he/she “sell” the
business to the next generation without asking them to come up
with the funds individually? A minority ownership recap allows
the owner to withdraw a significant percentage of the cash value
of the business, and yet leave the majority of the company’s
ownership to the next generation.
Unfortunately,
as is the case with wealth diversification, most business owners
and their financial advisors believe recaps require
giving up control of the business.
Therefore, they are left to choose from among other, often unattractive,
options. These options might
include selling the entire company,
or at least a majority interest, or going public. The latter of
which is not only a logistical challenge,
it also equate in many owners’ minds as just another way to
give up control of their business.
Recaps
Aren’t
for Everyone
If there’s “a catch” to minority ownership recaps,
it’s that it requires a willingness by the owner to enter a
partnership with a financial investor. A well-conceived recap deal
should be based on a mutual partnership to continue to grow the company.
If it’s the owner’s wish to quit his business, either
immediately, or within the next few
years, either he or she should consider other options.
For their
part, mezzanine partners are usually willing to take a non-controlling
interest only when the owner has an emotional stake
in the company’s future. That stake can include passing the
company on to the next generation, or to trusted management. Either
way, investment firms don’t want to have a non-controlling
interest with a partner with diminished interest in the company’s
success.
Likewise, an owner must be willing to accept the new investors as
partners in the business. Some mezzanine firms, like Key Principal
Partners, take the role of advisor and resource, rather than controlling
or demanding partner. Yet, some owners still find even the least
intrusive partnerships difficult to accept.
In Real Numbers, How does a Recap Work?
My clients are usually the trusted
advisors (corporate attorneys, financial planners and bankers)
of private business owners. Usually, once I describe a minority
ownership recap using a hypothetical example, they begin to recognize
how many of their own clients are in very similar situations.
The most
common example I give is of a 45-year-old business owner. He’s not yet interested in giving up control of his business,
or in playing golf full-time. However, he wants to make sure he and
his family is financially secure, independent of his company’s
continued success.
For our example,
let’s assume he owns a $40 million business,
with $7 million/year in cash flow and
a five percent annual rate of growth. In most instances, the owner
can expect to take out $12
million from the business in exchange
for 30 percent of his company. Whereas if he sold the company outright,
he might only get $35 million
for the entire business, and relinquish
all equity and control.
After closing on a minority ownership recap, and using the worst-case
taxation scenario, the owner now has about $7.5 million, and the
financial independence and security that brings. He also has the
resources and guidance of a financial partner, who, if he selected
a quality firm, will work with him to grow the business without endeavoring
to run the business.
How Does the Relationship End?
One interesting aspect of the partnership
a mezzanine firm brings to an ownership recap is its desire to
return its portion of the company back to the owner. If the partnership
is successful, the owner should have multiple options to allow
him to retire the mezzanine debt and regain 100 percent ownership
of his company.
Most mezzanine
deals have a life of about three to seven years. During that time
period it’s assumed the company will grow
and increase revenues. Those earnings
can be used to pay down existing senior debt, allowing the owner
to replace the mezzanine debt with
new traditional senior debt, at which
point he regains complete ownership of his business. Or, increased
earnings can be used to repay the
mezzanine firm outright. At the same
time, if the motivations of the business owner have changed, selling
the entire company or an
IPO are still options.
Selecting a Mezzanine Firm
Earlier I stated that if the partnership
is successful, an owner should have
multiple options to retire mezzanine debt and regain 100 percent ownership
of his company.
The quality of the partnership is
the essential element of a well-structured minority-ownership recap. Not
only will a good mezzanine firm contribute
to a company’s ability to grow (and thereby retire the mezzanine
debt), it will first avoid entering
a partnership that will have a negative impact on a business owner.
The defining
difference among mezzanine firms is the amount of due diligence
each performs – how much time each puts into researching
a company and potential client. Business owners and their advisors
should select firms that take the time to understand their individual
businesses. A mezzanine firm will not enter a partnership if it doesn’t
believe the company’s growth and success will make the deal
beneficial to both parties. Without
significant due diligence, a mezzanine firm cannot make an educated
judgment about that potential.
Once in a
partnership, a mezzanine firm should be more than just a capital
provider. A good firm will contribute its human and other
resources to help the owner overcome
business challenges. As the old adage states, “you get what you pay for,” so
avoid selecting an investor based simply on cost.
Finally,
since a partnership often lasts for three to seven years, it’s essential to make sure the firm’s culture is compatible
to the company’s and the business owner’s. Toward this
goal, take the time to get to know the firm’s associates and
consider talking with some of its other
clients. Make it your role, as a trusted advisor, to bring an investor
to the table that will
work well with the business owner, not
just provide capital.