How Can You Get Cash Out of Your Business? by Scott Ford and David Ryan
At a certain point, business owners hope to be able to take back some of their initial investment out of their company. They may use that money to invest as a means of protection from the ever-changing market that may undervalue their business. Another reason for taking cash from the business is that owners may want to lessen their personal guarantees for loans or they may need the financial capital to buy out a partner.
Sometimes the business may invite a private equity investor or strategic buyer to buy a portion of the business; however, usually this is not preferred by the owner. Most private equity investors buy a larger percentage stake (70 percent or more) in the company. Consequently, the current owner will lose their position as a majority owner, as well as their ability to make company decisions. Another complicated option is Employee Stock Ownership Plans (ESOPs), which is also not preferred by business owners.
Luckily for owners, there is another way that allows them to remain in control of their business while gaining their financial independence. This option is called: Minority Recapitalization – the sale of less than 49 percent of the business to an outside investor.
Many owners, especially those from the baby boomer generation, are not prepared to leave their companies. They prefer to still be involved, but also have the time to enjoy other activities, traveling, spending time with family, volunteering, etc.
To align with the loan, the private equity firm purchases the remaining 40 percent for $2 million, which added to the $5 million loan, providing the total $7 million that was needed to pay Bob. His payment is taken care of in a tax-efficient manner.
Tom now has operational control of the business and he has bought his partner out for cash. Not only has he doubled his ownership interest in the company, but he did so without using his personal finances or having to sign a personal guarantee. In addition he is able to work at the company while enjoying other activities.
For many companies a minority recapitalization is a viable way to take money out of the business.
Contributor Scott Ford is Founder and CEO of Cornerstone Wealth Management Group in Hagerstown. He is the author of Financial Jiu-Jitsu, based on his many years of martial arts training. He is a Certified Gazelles Coach and helps entrepreneurs and business owners operate profitable and efficient firms.
Some private equity firms create opportunities to contribute their capital in a way that works for both the business owner and the investor. By having the investor provide non-recourse debt, which is debt without personal guarantee, and buying a minority equity position, the firms can earn a return while also giving large amounts of liquidity to the business owner. In addition, by maintaining their majority stake in the company, the business owners are able to continue to work towards the success of the business.
So how does this work? Let’s run through a scenario: Meet Bob and his best friend Tom; they own BT Construction Company. Bob wants to retire, but Tom does not; therefore Tom wants to buy Bob’s stake in the company and operate the company.
As a majority owner, Bob owns 70 percent of the equity in the company and Tom owns the remaining 30 percent. BT Construction has recently been valued at $10 million, therefore Bob’s stake in the company is worth $7 million and Tom’s stake in the company is worth $3 million.
Tom has decided to do a minority recapitalization as a way to come up with the $7 million. The private equity firm has given him an interest-only loan of $5 million. This $5 million dollar loan has provided the company with half as much equity available in what investors call “net equity value.” Because the equity is now halved, Tom’s 30 percent stake is now 60 percent of the total available equity. His stake is now 60 percent of the $5 million in equity value, even though it is still worth the same $3 million.