Recapitalization
When deciding whether to sell your Company to an individual, corporation or qualified plan, it is imperative that a recapitalization and\or leveraged buy-out be examined as a possible corporate transition strategy. A leveraged buy-out or a management buy-out is an internal transition strategy that uses the future cash flow and financial strength of the Company to effectuate such a transaction. Many times this type of a corporate transaction is looked at as an alternative to, or in conjunction with, a capital infusion from a private equity group. ATI Capital Group, Inc. ("ATICG") has the ability to calculate, in no uncertain terms, the cost of undertaking such a transaction, the result to the seller and the impact on the business. Let’s take a look as to how a typical transaction might work.
Assumptions
AC Manufacturing Company has $3MM in EBITDA and at five times EBITDA is valued at $15MM. Single owner, Mr. Smith, is willing to sell the stock, not the assets, at $12MM. Investment grade cash flow lenders are willing to loan the Company up to 2.5 times EBITDA or $7.5MM using the assets in the Company as collateral. $12MM less $7.5, leaves a $4.5MM shortfall. Let’s assume Mr. Smith is not willing to take back a note for the difference, but wants management to have the Company; he is not willing to it sell to an unrelated third party. An independent investor would invest say $5MM allowing $5M for working capital. The investor would receive either common or convertible preferred stock, with a dividend preference or cumulative dividend attached to the preferred or common portion of the investment. This is designed to give them an ongoing return on their investment. They would insert one or more members of their organization on the board of directors, and monitor closely the ongoing results of operation of AC Manufacturing. They would also require an exit strategy for three to five years down the road for their equity piece.
Result
Mr. Smith sells 100% of the Company for slightly less than its current worth in exchange for getting a stock sale and capital gain treatment. His total redemption and\or sale allows him to “walk away.”
The Company’s management continues to manage the day to day operations and they purchase 49% for a small amount of cash. Bonuses can be paid to management, which management uses to acquire 49% of the shares in the treasury. The investor infuses $5MM and receives 51% of the total equity of the Company.
Is this the best result for the parties (Investor)?
On the surface, this looks like the investor transaction is a very reasonable transaction for all parties involved, but is it? First and foremost, finding an investor that is going to purchase 51%, infuse capital, allow the owner to walk, and allow management to run the Company is VERY RARE. In any event, if an investor is found, here is just a short list of the questions ATICG would ask before recommending the parties engage in a transaction like this:
- How long is it going to take to pay off the primary debt?
- How much working capital is going to be necessary to not only survive but thrive?
- Does the owner understand the probability of success of this transaction?
- Does management clearly understand EXACTLY what is gong to be required of them to make this transaction work, and are they willing to do it?
- Does management realize the benefit to them should the transaction progress successfully?
- What is the after tax cost to the Company in servicing the debt and paying the required cumulative dividend payments on the preferred stock? The Company has to continue to pay taxes on its income, service the primary debt with AFTER tax dollars and pay the dividends with AFTER tax dollars. How much growth is going to be necessary to be able to buy out the 51% owned by the PEG in three to five years?
- Who is gong to determine the value of the 51% when sold by the investor?
- What if the value is more than contractually agreed to?
- What if the value is less than what is contractually agreed to?
- How is the Company going to borrow the money to pay off the PEG, if it requires multiples of EBITDA that are in excess of what a primarily lender will lend to?
- If management can’t afford to buy, can the PEG sell to a third party?
Answers to these questions could make this option the most expensive $5MM ever borrowed by the Company. ATICG works through all the issues clearly showing all parties (the seller and Company), what they are getting into. We show the Company this alternative side by side with other options that are available in the market place, giving current ownership\management the ability to compare and make the best overall business decision.
Result if the investor is a Private Equity Group ("PEG")
If we assume the same income and value facts, but instead of an investor we assume a PEG, the group would require an 80% to 100% ownership position and they would take control of the board. Some would work with existing management but others might insert their own people. The owner would be required to hold the minority piece (20% to 0.00%). The infusion of capital would have to be negotiated up front and the holder of stock would execute a buy\sell, allowing him to sell for the same per share price as the the PEG gets when it sells in five to six years. Management would not have an opportunity to participate in the potential upside that may result from the capital infusion and if they wish to buy-out the PEG they are looking at starting a five to ten year process, when the PEG decides to sell the Company. Now if all is successful, the selling shareholder may be able to sell his 20% for more than he got for the 80%, but there are no guarantees and he has to stay with the Company, continue to run the day to day operations while "answering to the board" or the representatives of the PEG. Lastly, there is no incentive for the management team to stay on, other than to continue to collect a paycheck, and the employees are left out of the equation all together. What is important to understand is that there are over 7,000 private equity groups controlling over $1 Trillion dollars of other people's money, they are required to invest that money and get a certain expected rate of return on that investment. What is also important to understand, is that your company may be a candidate for a private equity group acquisition and when properly implemented, they can be very successful. Having a independent valuation firm examine the options, and help you determine the best transfer channel, based on your motives, is critical to the success of the process.
