In the game of poker, there comes a time when you reach a crossroads and take stock of the chips on the table.

Should you keep playing and hope the winning continues? Should you call it a night and cash out completely? Or should you stay in the game and take some chips off the table, protecting some of the winnings you have already earned?

As a business owner, a similar crossroads presents itself when you begin to evaluate the future of your business. You may ask yourself: Am I ready to retire? Is this the right time to sell my business? Am I losing anything if I don’t cash out while the business, or the economy, is doing well? As you answer these questions, it’s important to realize that there are transaction options other than the all-or-nothing extreme. In other words, there are ways to take some chips off the table (i.e., generate some liquidity) while still staying in the game (i.e., continuing involvement in the operations of the business and maintaining some level of ownership).

The following chart summarizes several transaction alternatives that fall somewhere between completing the outright sale of your business and not transacting at all. As evidenced below, there is a trade-off when generating liquidity. Maintaining a greater share of ownership offers less liquidity and more control, while a lower level of ownership offers greater liquidity, but less control.

A chart shows transaction options

Debt recapitalization

A debt recapitalization cashes-out equity by replacing it with debt—commonly referred to as leverage—provided by a bank, mezzanine or subordinated debt provider, or other finance company. This option provides immediate liquidity to a business owner. The trade-off is that the company is then operating with a more leveraged balance sheet and is required to meet interest and principal payments, as well as operate within covenants established in the financing agreements. A debt recapitalization, therefore, may be an ideal undertaking for owners of businesses that maintain a healthy cash flow and can service the debt. In addition to generating liquidity, this option allows for continued, complete ownership of the business.

Minority and majority recapitalization

Business owners can also generate liquidity through a minority or majority recapitalization. These are often appealing options because owners are rewarded now for having built a successful business with the opportunity for a second, future pay-out based on the value of a retained equity stake in the business. Minority or majority recapitalizations are typically arranged and funded in part by private equity firms.

What is a private equity firm and who is involved in these transactions?

A private equity firm, also known as a financial sponsor, refers to any professional investment firm or individual investing in private companies with the intent to grow these companies and then sell them at a higher valuation at some point in the future. The investment horizon—often called the hold period—for the private equity firm has traditionally been three to seven years. According to Preqin, a leading provider of data on private equity, total private capital providers including private equity firms had $2.4 trillion globally in committed, but not yet invested, capital (a.k.a., dry powder) as of the end of the first half of 2019. This marks a record high since Preqin began tracking this data in 2000.

The percentage of your business that you sell in an equity recapitalization transaction can fall within a broad range. Typically, a minority recapitalization falls between 35%- 45%, while a majority recapitalization falls between 60%-90%. Ultimately, the percentage of your business that you decide to retain will be driven by your objectives in pursuing a transaction—liquidity versus retained ownership—and the relative attractiveness of the offers presented by the private equity firms.

Completing a majority or minority recapitalization can be worth evaluating for many reasons, including the benefit of using debt as part of the new capital structure and maintaining some ownership for a period of time after the initial transaction.

Utilizing debt in the capital structure generates higher relative liquidity.

In addition to a change in ownership, a minority or majority recapitalization will alter the capital structure of your business. New equity is provided by financial sponsors who will likely also utilize debt as a meaningful part of the new capital structure. A deal structured with more debt benefits you, the seller, because it reduces the relatively more expensive equity portion of the capital structure. This allows you to generate higher liquidity while maintaining the same or greater ownership percentage as if debt were not utilized.

Further, limiting the amount of equity relative to debt in the capital structure amplifies the financial returns for the private equity investor. This financially engineered structure was the impetus behind the creation and rise of leveraged buyouts in the 1980s, and plays a large part in the investment appeal of private equity funds today.

The amount of leverage used in a transaction is entirely dependent on company dynamics and the comfort level of the owner and their private equity investor. Leverage is typically relatively higher with larger businesses that maintain stable cash flows, and relatively lower with smaller businesses or where significant capital is needed to fund future growth. A majority recapitalization is frequently structured with more leverage than a minority recapitalization, where excess liquidity is often retained in the business.

Maintaining an equity stake creates incentive.

After a minority or majority recapitalization transaction is complete and you’ve generated liquidity, you still have a stake in the game (i.e., continued ownership). The private equity investor will expect you to remain focused on driving the growth of the business, as its success will greatly impact the value of the future payout. This will be your second payout, but the private equity firm’s first. The attractiveness of this structure is evidenced in proprietary data from GF Data®, which shows that 82% of buyouts had meaningful management continuity year-to-date through Q3 2019. More specifically, approximately 50% of the completed private equity investments in 2018 through Q3 2019 included retained equity by the business owner/seller in the new business.1

Recapitalizing your business means one more seat at the table

When recapitalizing a business in partnership with a private equity firm, one of the concerns a business owner may have is the loss of operating autonomy—the investor and part owner will be privy to all aspects of your business.

Establish a productive partnership.

As a business owner, you will need to be prepared for some changes to your role in the business, even if you maintain majority control. A critical component of the equity recapitalization process is to ensure that you have found a private equity investor that you can confidently move forward with in partnership. Another key element is negotiating the operating agreement. This agreement will establish the rules by which all parties operate and interact, including reporting requirements and corporate decision making.

Your partner has the chips to stay in the game.

A private equity investor adds value beyond just providing the initial liquidity. Growing the business, which can positively impact the size of your second payout, requires capital. The private equity firm will often provide the required capital to fund this growth, including investments in working capital, business infrastructure, greenfield expansions, or strategic acquisitions. Further, the experience and relationships of a private equity firm can help fill gaps in your business by providing access to talent and resources that would not otherwise be available to you.

What's next? 

As you approach the time to evaluate the future of your business, whether it’s contemplating retirement or assessing how to tap into that wealth, being aware of transaction alternatives gives you flexibility. There are pros and cons to each option and many factors to consider, but the important thing to remember is that all of these options will capitalize on the successful business you have built to date, diversify your overall net worth thereby lowering investment risks, and provide the opportunity for a second pay-out when you’re ready to cash out completely. The key is to find the best fit for you and your business.

About Janney Investment Banking 
Janney’s Investment Banking practice is a leader in middle-market M&A and financing solutions for public and private companies. They place a high value on their consistent track record of delivering solutions to clients. Since 2009, Janney’s Investment Banking team has completed 605 transactions aggregating $85B in transaction value, working with clients on a highly-personalized basis, providing exceptional service, commitment, and senior level attention.

1 Percentage based on transactions where retained equity was reported

This is for informative purposes only and in no event should be construed as a representation by us or as an offer to sell, or solicitation of an offer to buy, any securities. The factual information given herein is taken from sources that we believe to be reliable, but is not guaranteed by us as to accuracy or completeness. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. Employees of Janney Montgomery Scott LLC or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed within.


About the author

David Allebach

Managing Director, Head of Corporate Advisory Group

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