Take cash out of the business- without losing control
Many business owners reach a point where they want to take some of their own money off the table at their company. Some want to invest more of their wealth elsewhere to insulate themselves from uncontrollable outside factors that could devalue the business. They may want to free themselves of personal guarantees they made for loans. In other cases, owners need capital to buy out a partner.
Bringing in a private equity investor or strategic buyer to purchase a stake in the business is an option, but many owners are leery. They don’t want to lose control, which is a reasonable concern. Most private equity groups want to buy a 70% stake in a company or more. Once an outside investor becomes a majority owner, it will call the shots on how the business is run. Employee Stock Ownership Plans (ESOPS) are another route, but they are complicated, so many owners bypass them.
A new alternative to traditional private-equity deals
Fortunately, there is another option that lets owners remain at the helm while completing their financial independence. It is called a minority recapitalization. This refers to the sale of 2% to 49% of a business to a new owner.
Upton Financial has more than 18 years of direct experience in working with private equity groups and privately held businesses. Many of the private equity firms we work with have an advantageous access to low-cost capital through the U.S. Small Business Administration’s Small Business Investment Company (SBIC) program, and, as a result, they are able to provide creative solutions to lower middle market companies.
Many baby boomer business owners are not ready to retire from their businesses. They would prefer to continue to work there in some capacity, but with more freedom for other passions, whether that means deep-sea fishing, visiting grandchildren or getting more involved in their community.
Let’s summarize what was accomplished:
Margaret is now has operational control of the business;
She has bought her partner out for cash, without using her personal savings or signing personal guarantees.
She has doubled her ownership interest
Let’s jump ahead five years. Margaret is now ready to retire and wants to sell the entire company. Along the way, she has won several big contracts. Revenue at Smith Manufacturing has grown 8.5% annually. As a result, the company’s value has appreciated. When George left, Smith Manufacturing was valued at a 5x multiple of EBIDTA (earnings before interest, depreciation, taxes and amortization). Five years later, it is worth a 5.5 multiple, or $18.3 million.
When the company is sold, Margaret’s 60% is now worth $11 million, more than three times the $3 million it was worth five years ago. The private equity firm’s stake is worth $7.3 million.
Even better, Smith Manufacturing has remained healthy. Margaret has avoided a common hazard of private equity transactions, where the private equity firm borrows so much money to buy an ownership stake that the company can’t keep up with the debt payments—and struggles or fails. Without undue strain, the company has paid off the $5 million loan over the past five years.
Exactly how much Margaret reaps from the sale will, of course, depend on the transaction costs, which include fees from professionals such as her accountant and attorney and bankers. The taxes she pays from a federal perspective will be mostly at the capital gains tax rate and state taxes will vary depending upon where she resides. What is clear is that Margaret has made it to the finish line in her business with a much more valuable stake—without losing control.
The more progressive leading-edge private equity firms understand this and realize there is a way to deploy their capital that works as efficiently for the business owner as for them. By buying a minority equity position in a company and blending in a portion of non-recourse debt, the private equity firm can earn an acceptable return on its capital while providing the business owner with tremendous liquidity. And because the original owners still have a majority stake in the company, the private equity investors have confidence that their new partners will have a continuing vested interest in the success of the business.
How does a deal like this work if you are an owner? Let’s say Margaret and her brother, George, own Smith Manufacturing. George wants to retire, and Margaret wants to buy him out and keep the company.
As majority owner, George owns 70% of the equity in the company. Margaret owns the remaining 30%. Smith Manufacturing has been appraised at $10 million. The value of George’s stake is $7 million. Margaret’s stake is worth $3 million.
To come up with the $7 million, Margaret decides to do a minority recapitalization. The private equity firm provides an interest-only loan without scheduled amortization for $5 million, which is equal to half the value of Smith Manufacturing.
With the $5 million loan on the books at Smith Manufacturing, there is now half as much equity available in the company—or $5 million remaining in what investment professionals call “net equity value.” Once the equity is halved, Margaret’s 30% stake now becomes 60% of the total available equity. Her stake—still worth the same $3 million—is now 60% of the $5 million in equity value.
In parallel with making the loan, the private equity firm purchases the remaining 40% stake, for $2 million. That $2 million, added to the $5 million loan, brings us to the $7 needed to pay George. His payment is handled in a tax-efficient manner.