Recapitalization is the financial reorganization of a company’s debt and/or equity. The goal can be to improve a firm’s capital structure or realize a liquidity event for an owner who wishes to sell a portion of a private company and realize some of the value they have created. Essentially, the process involves the exchange of one form of debt or equity for another, oftentimes whereby an equity owner (business owner) sells a portion of equity to an outside party who takes a minority or majority stake in the business.
Below are points to consider for and against Recapitalization.
By raising debt or equity, a company consequently increases the available liquidity that may be needed to finance further investments, or perhaps an owner’s partial or full exit.
Partial Sale of a Company
A recapitalization gives a business owner the possibility of taking cash out of the business by selling a minority or majority stake in their company. Oftentimes, owners may consider this option a few years ahead of retirement or exit, with a plan to grow the company in partnership with a well-capitalized investor.
A business owner can receive a significant payment today, along with another pay day in a few years’ time (hopefully after new investors have helped to grow the company and increase the value of the retained equity stake). An owner gets to take cash off the table, reduce their risk and diversify their investments. Given the value the owner provides to a business, an active business owner would typically agree to a management position in the company for perhaps 1 to 3 years after closing.
Bringing in a Capable Partner
In an equity recapitalization, a business benefits from the strength of a new owner, so long as the owner performs in-depth due diligence into the background, reputation and track record of the new equity partner. It is critical to take time to identify the right investor to partner with, to independently investigate their previous experience, credibility, motivation and financial stability.
If both parties share the same vision for the future growth of the company, a business owner can benefit from the new equity investors’ range of operational and strategic experience, as well as their investment dollars.
Increasing Management Discipline
Recapitalizing a company often has a disciplining effect on management as a result of the financial and operational processes and reporting that are typically implemented, as well as the accountability to a new investor. This discipline can trigger more insightful decision-making.
Stabilizing the Corporate Capital Structure
In distressed situations, a recapitalization can stabilize a company’s capital structure and cash position.
Operational and Financial Restrictions
If a business owner chooses to raise debt rather than equity, it will bind their company to financial covenants in the credit agreement and place restrictions on investments and distributions to owners imposed by the lenders. Furthermore, costs will likely increase as lenders in subordinated positions may charge monitoring, maintenance and oversight fees on the loan.
Loss of Control
New equity investors (even minority investors) are going to be involved in important strategic and financial decisions. In some situations, owners can become frustrated with the direction of new investors. As part of their due diligence prior to committing to a new partner, a business owner should talk to other entrepreneurs who have partnered with their prospective recapitalization partner or sold companies to them in the past.
Loss of Strategic Focus
In some cases, new equity investors focus too much on the quarterly financial performance of the business. Depending on the maturity of the investment fund and the relationship with their limited partners, there may be expectations of distributions and returns irrespective of the performance of the business. On the plus side, a new investor’s focus on financial rewards could lead to a successful second sale of the company in a few years.
Recapitalizations are a powerful tool, but like any tool, they only perform as well as the experience and controls of the operator. In order to realize the ideal outcome in every unique circumstance, it is a burdensome and time-consuming process and we would recommend seeking advice from experienced advisors who have been through the recapitalization process countless times before.