A private equity recapitalization, “recap”, or “2-stage deal” is a financial vehicle that is being increasingly used by savvy business owners to both fund growth and hedge risk. As an owner of a privately-held business, you can use a recap to:
- Create liquidity by paying down bank debt, removing personal guarantees, and enhancing the working capital of the business allowing investment in organic growth.
- Diversify risk by cashing in a portion of the equity in your business such that you may diversify your wealth portfolio to create peace of mind for you and your family.
- Drive upside by accelerating your company’s growth and positioning it for a higher valuation in a subsequent sale.
- Remove barriers to your success by augmenting your company’s expertise, available capital, and access to strategic relationships.
- Enhance wealth by achieving a second, possibly larger liquidity event when the investor ultimately exits the investment five to seven years after the initial investment.
Novus Biologicals is currently on a path to achieve these benefits from a recap. “Even though our industry has historically been minimally impacted by macroeconomic factors, today’s climate is just too unpredictable” says Karen Padgett, CEO of Novus Biologicals. “We wanted to take some chips out of our business and off the table, as well as have capital readily available for European expansion. Partnering with a private equity group through a recap enabled us to achieve those ends and more.”
Investors today find recaps attractive because they provide opportunities to achieve higher returns in an environment that they can help influence. According to David Kessenich, President of Excellere Partners, a U.S. private equity firm, “The current market provides an excellent opportunity for entrepreneurs with a compelling strategic vision to partner through a recap with a value-added private equity firm. The business platform then has the capital and strategic resources to capitalize on market uncertainty and accelerate growth while competitors are distracted by internal challenges.”
How Does a Recap Work? A Numerical Example…
Stage 1: Let’s say your firm is valued at $15 million. You as the Owner need capital to fund growth, and partially exit through selling 67% of the firm to an outside Investor for $10 million. You retain 33% of the equity in the firm, but the private equity group has allowed you to diversify your wealth and has brought working capital to the business to fund further growth.
Over a five-year period, you and the private equity group develop and implement a strategic plan that includes components for organic growth (growing current markets) and inorganic growth (acquiring other companies) to achieve significant growth objectives.
Stage 2: After executing the growth plan, you and the Investor fully exit through a sale to a third party. The company is now valued at $70 million, and you are realizing the upside of the recap through your remaining equity stake, totaling $23 million ($70 M x 33%).
Benefits to both parties: You have received the working capital you needed to grow the company to almost five times its original size, while still being able to get an additional $23 million in cash. At the same time, you have been able to diversify your wealth to better balance the risks associated with equity ownership in your company. The investor has benefited from keeping you on board, leveraging your expertise and motivation to create a significant return all shareholders.
The above example is an easy and straightforward one to illustrate the concept. In reality however, recaps are complex structured vehicles, demanding the right understanding and expertise. First, you will need an attorney that has extensive experience with multiple recap structures, ideally having represented both sides of the transaction. Second, you will need a tax expert who understands the nuances of these types of deal structures and some of the pending tax code changes relevant to a recap. Third, you need an M&A advisor that is an expert on creatively structuring and negotiating recaps.
An M&A advisor, in particular, will drive deal value by bringing together the right parties and positioning the right investment thesis. An experienced M&A advisor will maximize the size of “the pie”, and then make sure you get your fair share.
“When we first explored the option of doing a recap, we seriously underestimated the complexity it involved. We hired Forbes Mergers & Acquisitions to quarterback the overall process, and they referred us to Kamlet Shepherd & Reichert to handle the legal and tax mechanics…Putting together the right team was the best decision we ever made.” –Karen Padgett, CEO of Novus Biologicals.
Is a recap right for you?
Whether or not it is time for you to start exploring the recap option depends on many factors. The strongest candidates for recaps are companies that are well run, are leaders in their market niche, and that have well defined opportunities for significant growth. Oftentimes the private equity group will prefer a controlling interest in your firm, so while you maintain day-to-day control of the business, you may need to get comfortable with a new partner participating in strategic decisions. If you think a private equity recap might help you achieve your strategic goals, an M&A advisor is your best resource begin a dialogue.
About the author:
Bob Forbes, President, is a Mergers & Acquisitions Master Intermediary with over 15 years of experience in business transactions, as a transaction advisor, business owner, and private equity executive. Mr. Forbes has started, built, acquired and sold numerous companies. He presently serves on the board of directors for the Colorado Association of Business Intermediaries and is an active member of the M&A Source, IBBA, and Association for Corporate Growth.