In the last post we discussed the potential use of an ESOP as an alternative for personal liquidity and ownership transition.  That discussion was entirely nontechnical and reflected  some of my personal experiences.  In this post, we will examine another partial liquidity alternative for owners of closely held and family businesses, a leveraged share repurchase.  This post will address conceptual issues.  In the next post, we will develop an example leveraged repurchase transaction to illustrate these concepts and how they really work.

Why Consider a Leveraged Share Repurchase?

There are a number of valid reasons to consider a leveraged repurchase of shares as a shareholder liquidity option.  For the shareholder selling in a leveraged share repurchase, benefits include:

• Achieving Partial Liquidity.  These transactions are a means to achieve partial liquidity for investments in closely held business wealth for selling owners.  Leveraged share repurchases can also be used to purchase all of the shares owned by a shareholder if that is the desired result.
• Creating Means of Diversification.  The proceeds, after taxes, can provide a meaningful source of diversification from the wealth concentrated in a closely held or family business.
• Providing Tax Advantage.  In addition to providing opportunities for substantial liquidity, leveraged share repurchases enable selling shareholders to receive capital gains treatment on their sales.

So leveraged share repurchases may be good for selling shareholders.  What about for the remaining owners?  There are key benefits for them, as well:

• Enhancing Return on Equity.  A leveraged share repurchase uses borrowed funds to purchase existing shares to retire them.  As result of the leverage (borrowing) and the repurchase of shares, pro forma shareholders’ equity will be reduced.  Pro forma earnings will also decline somewhat.  But the decline in earnings will normally be less than the decline in equity, so return on equity will be enhanced.
• Enhancing Expected Growth in Value for Remaining Shares.  The enhanced leverage from the repurchase transaction will, assuming that future performance is satisfactory, accelerate the expected growth in value of the remaining shares as the debt is repaid.
• Enhancing Dividends for Remaining Shareholders.  Assuming that a company was paying a cash dividend prior to the leveraged recapitalization and is able to maintain the same dollar amount of dividends, the dividends per share and the dividend yield on the remaining shares will increase.
• Enhancing Price/Book Value.  While book value per share will likely decline with a leveraged repurchase, the price/book value multiple should increase.  This increases the amount of value over book (value added) per share.

The above benefits relate to remaining shareholders.  There are a couple of additional benefits shared by all shareholders who maintain ownership in a company following a leveraged share repurchase.  These include:

• Optimizing Capital Structure.  For companies that are under-leveraged in relationship to their industry peers, leveraged share repurchases provide a means of optimizing their capital structures to provide higher returns for (remaining) shareholders.  We’ve touched on that in terms of increasing return on equity, but that is the result of creating a more optimal capital structure.
• Keeping Management Attention on Repaying Debt.  If you are a selling shareholder, you know that management will be focused on performing sufficiently well to repay the debt from the transaction timely.  If you are a remaining shareholder, this can be a comforting benefit.

Leveraged share repurchases are one valid vehicle for managing private wealth that is tied up in closely held and family businesses.  Public companies and private equity firms regularly engage in leveraged share repurchase transactions.  There is no reason that your company should not consider this corporate finance tool as an option for providing partial shareholder liquidity, optimizing capital structure, and enhancing shareholder returns.

What is  Leveraged Share Repurchase (Buy-Back)?

A leveraged share repurchase is a fairly straightforward transaction with two key elements:

• Leverage.  A company  borrows funds (leverage) from a bank or other lender.  Note that excess company assets can also be used in a leveraged share repurchase if they are available.
• Share Repurchase.  The funds are then used to repurchase shares of one or more shareholders for any of a variety of reasons.

While the “definition” of a leveraged share repurchase is straightforward,  a number of moving parts and players will be involved if a transaction will be successful.  Leveraged share repurchases can be an important tool for helping you manage the private wealth in your closely held or family business.

At its simplest, a leveraged share repurchase enables a company to provide an equity return (i.e., liquidity for a selling shareholder) by borrowing funds from willing lenders at a lower cost than the company’s cost of capital.  In other words, the borrowed funds replace equity value, which is provided to selling shareholders.  The risk of a company is therefore increased (more debt and less equity).  If a company is under-leveraged relative to its peers, the leveraged share repurchase provides one vehicle for optimizing or improving its capital structure.

“Capital structure” may sound exotic, but your company’s capital structure reflects the mix of financing you use to support your balance sheet.  With a leveraged share repurchase, you would substitute equity with debt.

There is no free lunch.  With a leveraged share repurchase, a portion of company risk is  shifted from equity holders to lenders.  Selling shareholders get liquidity and a lowering of risk, presuming they use the net proceeds to diversify their overall portfolios.  However, to the extent that leverage increases for a company, the risk for the remaining shareholders (and the company) also increases, since they support more debt financing with a lower equity base.

When I suggest considering a leveraged share repurchase as a tool for managing private company wealth, I suggest using reasonable amounts of leverage to help manage the extra risks brought on by a transaction.

What Parties are Involved and What Do They Do?

Conceptually, as we have just seen, a leveraged share repurchase is fairly straightforward.  There are, however,  a number of moving parts and players in successful leveraged share repurchases.  Your company and its board of directors must consider the interests of not only any selling shareholders, but also of the remaining owners, the company itself, and its lender(s).  Some or all of the following parties will be involved in leveraged share repurchases.  All of the implied functions will be (or should be) considered:

• Company.  Your company has to have the willingness and ability to engage in a leveraged share repurchase.
• Board of Directors.  Your board of directors must be willing to approve a transaction, which means that the company has to be concerned about the reasonableness of the transaction from its viewpoint and from the viewpoints of any remaining shareholders.
• Selling Shareholder(s).  There must be one or more owners willing to sell their shares in a proposed transaction.  Note, however, that the transaction could be forced by a triggering event with a buy-sell agreement.
• Price Setter.  Someone has to set the price for a transaction.  While that might be negotiated between the company and the selling shareholder, your board of directors might desire that the price be set by an appraisal analysis.  That would involve a valuation firm or other qualified financial adviser.
• Bank or Other Lender.  Needless to say, the leverage in a leveraged share repurchase comes from a willing lender who finds the pro forma expected performance of your company sufficient to satisfactorily meet its underwriting requirements.
• Financial Adviser.  If leverage increases significantly, the bank will prepare on its own, or more likely, require a pro forma analysis of the company’s expected future performance under a variety of possible outlooks.  Your financial adviser will help navigate these areas of lender concern.
• Attorney for the Company.  The company’s attorney must be involved to be sure that any loan and/or share repurchase agreements are satisfactory from the company’s viewpoint and that the pro forma situation of the company will comport with applicable state laws.
• Attorney for the Lender.  The attorney for the lender, which the company will have to pay for, directly or indirectly, will advise the lender regarding any solvency issues created by the transaction and will review the loan agreement from the lender’s perspective.
• Attorney for the Selling Shareholder(s).  Even the selling shareholders may need counsel, depending on the complexity of the overall transaction and the amicability and/or intensity of the transaction.
• Fairness Opinion.  For a number of larger closely held businesses with multiple owners, the fairness of the price, from a financial point of view, may be a topic of discussion.  In the event of potential controversy, or if the board of directors believes it is in the company’s best interests, a fairness opinion from the financial adviser may be advisable.
• Solvency Opinion.  If the transaction puts significant leverage onto a company’s balance sheet and raises potential issues related to solvency, the lender may require that a solvency opinion be obtained from an appropriate financial adviser simultaneous with the closing of the transaction.
• Personal Financial Advisers.  Depending on the nature of the shareholder group, it may be advisable for the selling shareholder (or the other, remaining owners) to have discussions with personal financial advisers who can provide advice regarding the impact the transaction might have on their personal situations.

All the various players perform their parts, and leveraged share repurchases can and do occur with closely held and family businesses.  However, in my experience, relatively few successful closely held companies use the leveraged share repurchase option as a regular tool in their toolbox for managing private company wealth.  It is a good tool in the right circumstances.

Coming Next: An Example Transaction

I know that all of this talk about a leveraged share repurchase can seem nebulous.  In the interest of time and length of posts, I’ll stop this discussion now.  The next post will illustrate the mechanics and benefits of a leveraged share repurchase by walking through an example transaction.

As always, if you wish to talk with me about any business or valuation-related matters, or to discuss management or ownership transition issues in complete confidence, give me a call (901-685-2120) or email (mercerc@mercercapital.com).

Until next time,

Chris