Let me introduce you to Harold. Harold is the largest shareholder of a successful family business.
Harold, in his 70s, is facing a number of business issues. While his business has been successful over many years, he has very little liquidity outside his ownership in the business and in real estate associated with the business.
His wife is expressing concerns about their lack of liquidity, or in her mind, independent resources to take care of her if (really, when) something happens to Harold. His wife’s concern have risen to the level of a “home issue” he needs to address. She does not want to be at the mercy of the company’s fortunes and/or her children’s’ unproven management talents. That is another issue that needed to be addressed, but not my topic for today.
First of all, what is the company’s situation? The company is a profitable, well-capitalized distribution-related business with sales of about $250 million. It is well-managed at the level of individual locations, even if it lacks a long-term, strategic orientation.
Historically, dividends have not been paid. Instead, accumulated earnings have been used to repurchase shares from a group of non-family shareholders over a period of years. The share repurchases enhanced the company’s return on equity, but provided no liquidity for the family. The share repurchases also consolidated family control over the business. Shareholders’ equity (book value) of the business is about $60 million, and Harold holds a controlling interest (also not good planning, but another issue).
Some Possible Alternatives
So what can be done about the liquidity issues, or rather, the issue of lack of liquid assets for Harold and his wife? There are several possibilities:
- Institute a Regular Dividend. The idea of paying a dividend is not particularly attractive to Harold, since it would be paid to all shareholders and there will be significant “leakage” to the non-family shareholders. And a normal dividend will provide liquidity only gradually. Truth be known, Harold probably doesn’t want to pay a dividend that would provide liquidity to his children, who also hold stakes in the business.
- Leveraged Dividend Recapitalization. Another possibility is to put some leverage on the company and pay a substantial dividend. The company is in healthy financial condition and an attractive candidate for bank financing because of its historical profitability, solid balance sheet and market position. Again, Harold, who would achieve significant liquidity from this strategy, is reluctant to pay the dividend to the other shareholders.
- Leveraged Share Repurchase. Another suggestion to consider is a leveraged share repurchase where the company would acquire a significant number of the Harold’s shares. Since Harold can sell below control and still maintain control through a voting trust he had previously set up, he doesn’t mind this option.
After discussing these with his professional advisors as well as other alternatives, including that of not doing anything at all, Harold decided upon a leveraged share repurchase of a good portion of his own shares.
What is a Leveraged Share Repurchase?
Simply put, a company goes to a bank or other financing source, arranges a loan for the purpose of purchasing a significant portion of the equity of a business, funds the loan and buys the shares, and then, over time, repays the loan. There are, however, a number of milestones or considerations to be met along the way.
- Sourcing the Funding. Harold’s company has a long-standing relationship with a regional bank and has had a working capital line of credit for a number of years with this bank. He approached the bank with the concept of adding a term loan to the capital structure specifically for the purpose of purchasing about $20 million of stock from Harold. The lenders are agreeable in principle, so he is able to avoid “shopping” for financing.
- Proving the Concept. While the lenders are agreeable in principle, they want detailed projections of the company’s income statements and balance sheets indicating likely performance with the new loan facility. Projections are prepared under a variety of potential economic environments. The projections show ample coverage of both principal and interest under a variety of stress-testing of the forecasts.
- Solvency an Issue? In the case of Harold’s company, which had a substantial net worth, both before and after the recapitalization (i.e., the borrowing of funds with an additional layer of debt and paying for shares, thereby reducing the equity portion of the balance sheet significantly), the lender’s counsel must determine if a solvency opinion will be required. The company’s counsel determined that the financing would not be in violation of state law in any way and the financing is approved. Note that had Harold’s company been a successful service company which required substantially less retained earnings for normal operations, the recapitalization would likely have taken equity below zero. In essence, the market value of shares purchased becomes a deduction from reported equity. Because of this, many leveraged recapitalizations do require solvency opinions.
- Terms of the Loan. The terms of the loan are negotiated with the bank. Note that Harold did not shop. This means that we have to be careful in the negotiations to be sure that the company obtains reasonable terms.
- Engaging in the Transaction. You might think that this will be a no-brainer, but it is not. With the entire transaction in place and ready to close, Harold gets cold feet. He raises concerns about the amount of the loan and remembers previous bad times in the company’s history. The loan amount is reduced (and the share repurchase) by a couple of million dollars, and the loan closes. The company uses the proceeds of the loan to repurchase a portion of Harold’s shares and Harold receives cash as consideration. He pays his taxes and moves on.
- Reinvesting the Proceeds. Harold interviews several financial advisers and finds one that he and his wife are comfortable with. The selected financial adviser invests the proceeds in a reasonably balanced portfolio that provides the balance of income and growth potential they consider appropriate.
Corporate Finance Tools for Private Businesses
The transaction I just described between Harold, his company and his regional bank, was a direct application of corporate finance tools in the private company environment. Public companies engage in similar transactions with some frequency. While many public companies now have plenty of cash with which to engage in share repurchases, they also borrow funds from time-to-time for the same purpose.
Private equity firms engage in leveraged recapitalizations with significant frequency. These transactions could be leveraged dividend recapitalizations or leveraged share repurchases, depending on the circumstances.
In my experience, most owners of successful closely held and family businesses simply do not think about using reasonable leverage as a tool to redistribute stock ownership, provide liquidity for certain shareholders, provide special dividends, or other transactions designed to provide liquidity for their shareholders.
If you’d like to talk about the potential for a leveraged stock recapitalization or a leveraged dividend recapitalization for your business, give me a call (901-685-2120) or email. Any discussions we might have, of course, are completely confidential.
Until next time,