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What is a Recapitalization Exit Strategy?
One of the exit strategies available to company owners is called a recapitalization, or “recap”.
In a recapitalization, an investor (usually a private equity firm) purchases an equity interest in your company using a combination of cash and debt financing. They expect to grow the company and earn an attractive return on their cash investment when they sell the company at a higher price in 3-7 years. Their value creation strategy usually involves initiatives to accelerate growth, increase profit margins, mitigate business risks, and professionalize the business to make it more attractive to future buyers.
Why Recapitalize?
- a buyout of only specific shareholders,
- the transfer of partial ownership to the next generation, and
- equity participation for remaining management.
When they recapitalize a business, PE firms usually acquire a majority (controlling) interest and don’t play a role in day-to-day management. They bring financial acumen, systems and growth capital, sit on the board, and participate as a strategic advisor. They prefer to retain the existing management team, which often includes the owner. Owners who recapitalize and stay on can achieve material liquidity and maintain control over day-to-day operations. Alignment with the investor is of course very important.
Exit Strategies Group maintains relationships with Private Equity groups and other types of financial buyers across the country and is experienced in both sourcing potential equity partners and negotiating recapitalization transactions that fit our clients’ goals.
Al Statz is the founder and president of Exit Strategies Group. He is based in Sonoma County California. For more information on selling or recapitalizing your company, or to discuss your strategic exit options, contact Al at 707-781-8580 or alstatz@exitstrategiesgroup.com.
How Well Do You Know Your Exit Options?
You have built a business that provides a strong income and comfortable lifestyle. However, if you are like most business owners you haven’t made the time to know the range of options you have to successfully exit the business and transfer your wealth. The tax, legal, valuation, deal structure, and insurance considerations are many. Even if you had the time, where do you begin?
Before you can evaluate any of these options, you must first decide what your goals are. Are there other owners to consider? If so, are their goals similar or different than yours? What personal and family issues do you want to consider? Are you strictly looking for the best price? Are you tax sensitive? Have charitable intent? Are you financially prepared? Mentally? The earlier you begin planning, the more options you will have at your disposal.
Once you have determined your goals, you can begin to narrow the list of exit options available to you. Do you intend on doing an internal transfer to a key employee or employees? Family member? Is an ESOP a viable alternative? Is your estate plan designed around your desired exit? Are contingencies planned for and protections in place?
Whether you plan to transfer your interest internally or to a third party, knowing how much your business is worth is a great starting point. Internal and external transfers can imply different valuation standards that can render very different values. You want to know these differences before you make a decision. A business valuation will also give you a good idea if the transfer can be financed.
What is your time horizon? More time is better, especially for external sales. Is the business saleable as is? Aspects of your operations may need improvement before you go to market. How do you select an M&A advisor?
The earlier you begin planning your exit, the more options you will have at your disposal.
Achieving a successful business transfer requires a process. An M&A broker/advisor can lead this process and guide and coordinate the professionals required to help you reach your goals. An owner can attempt to lead this process on their own, but it’s not easy. Your time is probably best spent running your business at peak performance. Still, it’s up to you to appoint a competent adviser to guide the process and ensure that your other professional advisors are on board and up to the task.
For a confidential conversation regarding your exit options, contact one of our senior advisors.
Asset Appraisals May be Needed to Support a Business Valuation
I recently valued a number businesses that required the appraisal of certain tangible assets, such as real estate and equipment – in one case its was an extensive library of manuals and maintenance specifications for a service business. At what point do we look for a appraisal specialist with particular expertise to value such assets?
- Real Estate Appraisals
- the business owns real estate, e.g. for agricultural enterprises or a real estate partnerships
- the business leases real estate from a related party and we need to ensure the business is paying market rent
- Equipment appraisals
- the business is capital intensive
- it has a large amount of used equipment – making rough value calculations unreliable
- Unique assets
- the business has a significant amount of unusual assets that are not common to most organizations
- Non-operating assets
- non-operating assets are items that can be removed from the business without affecting business operations, e.g. an airplane owned by a construction business, or a vacation home
A Pyrrhic Victory
Avoid Seller Let Down
Business Acquisition Financing: What Lenders Want
- Down Payment. Lenders want a buyer to inject 15%-25% of the total project in cash, at minimum, depending on several factors including whether real estate is included in the sale. Common down payment sources are retained earnings, savings, retirement plan funds and gifts from family members. The buyer’s cash injection cannot be borrowed.
- Creditworthiness. Lenders investigate a buyer’s credit at the outset of the approval process. A bankruptcy, foreclosure or judgment usually nullifies their chances, no matter how good other criteria look. Buyers should remove blemishes from their credit history before they apply.
- Track Record. Individual buyers must have experience in the type of business and/or industry they are buying into. Lenders look for management experience, and they prefer to see prior business ownership. Buyers should tailor their resume to highlight applicable management and industry experience.
- Collateral. Buyers with real property to pledge as collateral may compensate for weaknesses in debt service coverage, business assets, experience, credit, or liquidity. Generally, if they have equity in real property, the SBA requires that it be used to secure the business acquisition loan as a secondary source of repayment.
- Business Plan. Buyers have to submit a business plan for the business they are acquiring. Lenders want to see an intimate understanding of the business and industry. In most cases a plan calling for modest growth and incremental change is the safest bet for the buyer.
- Cash Flow. Business cash flows must service the loan and provide adequate income for the owners. Lenders analyze the historical tax returns of the business—allowing reasonable adjustments for owner perquisites and non-recurring costs. The quality of financial records comes into play here. Your business plan also comes into play. Synergistic benefits, increases in working capital and capital expenditure needs are considered in the cash flow calculation.
- Positive Trend. Nothing scares lenders more than negative sales and earnings trends in a business or its industry. Conversely, a pronounced positive trend is a thing of beauty to a lender. They often look back several years to see how the business performed through past economic cycles.
- Continuity. Commitments by existing managers, key personnel, suppliers and customers to continue with the new owner represent reduced risk to a lender.
- Training. Lenders want to see a well thought-out management transition plan. The training/transition period can be anywhere from 1-12 months, depending on circumstances. Be sure you negotiate this point up front and clearly spell it out in the purchase agreement or letter of intent.
- Seller Financing. When a seller finances even 10-15% of a deal, subordinated to the bank note, it shows the lender that the seller is confident in the business under the buyer’s leadership. This deal point is commonly imposed by lenders.
Business Valuation: Step one in the sale process.
If you are considering selling your business, I would like to let you in on an M&A (merger and acquisition) professional’s insight. I have been involved in initiating and managing M&A transactions for over 15 years and have handled deals representing over $250 million in transaction value. Those transactions ranged from $2.6 mm to $90 mm. In addition, I was on a team that helped an international client acquire a $2.6 billion industry rival back in 2000.
How to Sell Your Business for More Than Fair Market Value
If you are selling your business and you want the highest possible price, here is one way to get a premium over its Fair Market Value.
First, consider that the value or price an owner can expect to receive for their business is generally a function of: 1) free cash flow generated, 2) growth expectations, and 3) the risk involved in receiving the cash flows. These factors combine to determine the value for the business entity. Expressed another way, the value of a business is the present value of the risk adjusted future cash flows specific to the selling company.
Each company has a unique set of these factors. A Financial buyer is interested in how these factors measure up for the company on a stand-alone basis, and will determine a price that they are willing to pay for the business, or Fair Market Value, relative to their other business investment opportunities, including other businesses for sale. Most buyers are financial buyers.
But there may be another type of buyer looking to buy your business — a Strategic buyer. This type of buyer has a complementary business, generally in the same industry or a related field, and expects to be able to combine the two companies to achieve synergistic economic benefits. Synergistic economic benefits can take many forms: reduction of expenses through economies of scale, new or complimentary products or services, industry risk diversification, increased market share, customer acquisition, defense of a market position, upstream or downstream vertical integration, increased sales of core products, less expensive than building from scratch, and others.
By combining the two companies, the buyer expects to produce an economic benefit that is greater than that available to the selling company on a stand-alone business. Therein lies your premium to fair market value. The seller is now more valuable by the amount of the expected synergy, to that particular strategic acquirer. The seller’s premium is some portion of the synergistic value. The strategic acquirer can pay a higher price than FMV because they see more value in the selling company. In addition, the strategic buyer is generally motivated to achieve the strategic benefit. This provides the seller with some leverage, and helps the process to achieve a successful completion, particularly when the seller’s M&A advisor brings multiple strategic buyers to the table.
Identifying, educating and motivating strategic buyers is one of the many facets of successful M&A brokerage work. For more information on strategic buyers or the M&A selling process, Email Louis Cionci or call 707-778-2040.
Exit Planning: A New Year’s Resolution
- End commingling of expenses, assets & liabilities. This may result in increased tax liability, but will more than pay for itself by returning a higher sale price. Example: suppose you wanted to sell your businesses in 3 years. If the market multiple of EBITDA (Earnings Before Interest, Taxes Depreciation & Amortization) is 4, for every extra $1 of EBITDA you show on the bottom line, you receive an extra $4 in the selling price.
- Declare all sales revenue.
- Sensible, consistent, GAAP financial statements (from the buyer’s CPA prospective).
- Normalize each of your financial statements. Make notes below each of your year-end statements regarding expenses that are non-recurring in nature, or one-time expenses that are not normal in your business operation.
- Control expenses: if you have a corporation, take a look at your salary, perquisites and benefits. Decide what it would cost if you had to replace your services with someone else. A business broker/appraiser would make this adjustment to arrive at a modified level of earnings that is commensurate with market rates of compensation. If you have more than one owner working in the business, adjust the salary, perquisites and benefits for each of the owners.
- If you personally own the building that houses your operation and the corporation or LLC pays rent to you, check to see that the rent is at a market rate. Differences between market rent and actual rent being paid will adjust EBITDA.
- Pay all of your taxes on time; sales, personal property, payroll, etc.
- Maintain sensible, accurate management reports.
- A well-documented operation pays off by adding intangible value from a buyer perspective.
- Develop or update systems – and have detailed documentation for all processes your business performs.
- Measure, report and act on key performance indicators
- Develop or update employee manuals, policies and job descriptions for each employee.