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Most business owners understand that an exit strategy should include maximizing their return on investment (ROI). Traditionally, business owners sought out two strategies to do this:

• Developing a dividend stream (annual cash flow) that pays increasing amounts each year as the business grows
• Selling 100% of the business and reaping the capital gains

However, more and more middle market companies are choosing a recapitalization path as a means to distribute cash to their owners without an outright sale. Other uses of a recapitalization include capitalizing an Employee Stock Ownership Plan (ESOP), buying out some of the shareholders, and having money for expansion or acquisition.

A recapitalization happens when a business changes its financial structure:  adding debt, bringing on new investment, or buying out old investors. Recapitalization, or “recap” for short, indicates a revision of a business’s capital structure.

Types of Recaps

There are several basic forms of recap. Each can usually be structured in a tax advantaged way, such as securing capital gain income and deferring taxes on retained ownership interests.

1. Dividend Recap. A specialty lender provides the company a loan that is distributed to the shareholders. Specialty lenders loan against cash flow on a multiple of EBITDA. Local banks loan against assets such as receivables and inventory. Cash flow loans almost always produce greater proceeds than asset-based loans. WCF Advisors has access to numerous specialty lenders.
2. Minority Recap. A private equity firm purchases a minority share of equity in the company. By itself, this is a safe, debt-free means of providing owner liquidity. Combined with debt, it provides more money to distribute to the shareholders than a dividend recap. Wipfli Corporate Finance has access to private equity firms that invest in minority recaps; however, the universe is limited.
3. Majority Recap. A private equity firm purchases 51% or more of the business, using a combination of debt and equity investment. This provides the most amount of money to be distributed. Generally, a higher valuation is achieved because the investment is a “control premium.” Wipfli Corporate Finance has access to numerous private equity firms that invest in majority recaps.

Recap Prerequisites

In order for a firm to qualify for a recap, the business should meet certain criteria:

Quality of Earnings. A stable, growing earnings history and good visibility of future earnings are necessary to support the debt and investor expectations. Evidence of quality earnings might be supported by long-term contracts, billings to a large number of repeat customers, multiple ongoing billings to large customers, the subscription business model, and more. A history of lumpy up and down annual revenues may not qualify because there is not enough certainty that revenue and earnings are repeatable.

At least modest growth prospects. A deteriorating business with a declining history may find willing investors but only at fire sale valuations. A steady business with few down years historically and an overall steady but low growth rate can attract quality investors. A business with a strong growth history and future will find many willing investors competing to win the transaction.

Size. The ideal candidate will have annual EBITDA of at least $1.5 million. Below this level, the number of private equity groups and lenders who will be interested dwindles; however, they may still be candidates as “add on” investments for existing portfolio companies of private equity groups.

Conclusion

Recaps have become a very attractive avenue for business owners to maximize value, and the market is very robust for these transactions. If you have any questions regarding recaps or how a client or prospect may fit into this value strategy, contact us.
 

WCF Advisors works with companies and their stakeholders related to mergers and acquisitions and financing transactions and with capital providers seeking investment opportunities or assistance with portfolio companies. WCF Advisors’ professionals assist clients to raise capital for growth, recapitalize through a majority or minority sale of equity, sell their business, and develop and execute an acquisition strategy. The entity is a subsidiary of Wipfli.