With merger and acquisition activity and multiples at an all time high, one might ask whether the activity and multiples will continue to increase. No one knows the answer for sure, but a recapitalization is one way for a business owner to capitalize on the current merger and acquisition activity and the high multiples while retaining some ownership for future appreciation.
A recapitalization allows an owner to sell a portion of his company while retaining either a minority or controlling ownership interest, allowing him to participate in the company’s future opportunities. The obvious benefit is that the owner achieves some liquidity for what is most likely his largest single investment. Other benefits include the financial leverage a financial partner affords and the elimination of personal guarantees, if any, for the company’s debt.
A recapitalization is accomplished by the new investor either directly purchasing stock from the current shareholders or by purchasing stock from the company. The company then redeems a portion of the current shareholders’ stock. A recapitalization usually involves leveraging the company’s balance sheet to provide sufficient capital to provide a meaningful liquidity event. A recapitalization differs from an outright sale in that the existing shareholders retain an ownership interest. By retaining this ownership interest, the existing shareholders are able to participate in the future appreciation of the company and the sales proceeds upon the eventual sale of the company.
A Typical Recapitalization:
To illustrate how a recapitalization works, assume Mr. Smith owns 100% of ACME Company. In 1999, ACME Company’s EBITDA was $8 million. PEG Fund proposes a recapitalization for ACME Company in which it will purchase 80% of ACME stock for $20 million. As part of the recapitalization, ACME Company will raises $24.8 million in debt. ACME Company will then redeem 80% of Mr. Smith’s stock for $44.8 million, leaving him with 20%. After the recapitalization, PEG Fund will own 80% of the company, and Mr. Smith will own the remaining 20%.
On the fifth anniversary of the recapitalization, it is projected that ACME Company will be sold for seven times EBITDA. EBITDA in year five will be $14 million, assuming a total of 15% compounded annual growth. The Company will be sold for $98 million and Mr. Smith will receive $19.7 million. Without the recapitalization, Mr. Smith could have sold ACME for $56 million (assuming the same multiple of seven). With the recapitalization, Mr. Smith will receive $64.5 million over a five-year period.
While Mr. Smith could have retained 100% of the company and received $98 million in year five, the recapitalization allowed him to receive the benefits of liquidity and future appreciation while avoiding some of the risks of continuing to own 100% of the company.
The ideal recapitalization candidate would have $4 million or more in EBITDA(depending on the industry and market valuations, EBITDA could be as little as $3 million) with strong growth opportunities. This level of EBITDA creates interest in the private equity community and allows the fund to leverage its equity investment. Generally, a private equity fund looks to invest in excess of $3 million in equity in each deal, with opportunities for add-on investments.