Recently I spoke with a business owner who had almost sold about half of his company to a private equity investor a few years ago.  The facts will be changed in this story so that neither he nor I should be able to recognize his company.  However, the conversation highlights a potential opportunity for owners of private companies with the right characteristics to raise significant liquidity without selling any of their equity.

The Sale Did Not Go Through

Assume the following about a fictitious company and owner:

1. Earnings.  EBITDA is $4.0 million.  Margins are steady and cash flow is pretty even over the course of each year.
2. Debt.  There is no debt and there is low capital intensity to the business.
3. Potential buyer.  A qualified buyer is highly interested in taking a stake of up to 60% of the company at an EBITDA multiple of 7.0x, implying enterprise and equity values of $28 million (since there is no debt).
4. Interest of seller.  The seller would not mind selling up to just less than 50% of the company.  If he did so, he would receive proceeds before taxes of $13.7 million assuming a 49% sale of equity.
5. The seller, however, believed that his company, because of its growth potential and the ability to replicate its operations nationally, should sell for an 8.0x multiple at the minimum.  So the owner turns down the private equity firm’s offer.

The seller remained owning 100% of his company and with little outside liquidity and almost no diversification from his investment in it.  Business owners often avoid leverage for their companies, not realizing that as 100% owners of a business they retain all the risk.

An Alternative Path to Liquidity

In speaking with this now fictitious owner, Fred, I asked him: “Fred, what if I could show you a way to get substantial liquidity from your business without selling any of it?  In other words, you could have both liquidity and remain the owner of 100% of your company’s equity.”

“How could we do that?”, he replied.

“Well, Fred,” I said, “we can do one of the same things that the smart money in private equity funds do quite often.  We can engage in a leveraged dividend recapitalization of your business.”

“What in the heck is a leveraged dividend recapitalization?” he asked.

I replied, “In concept, it is fairly simple.  We go to a bank, borrow some money at the company level and at a level of debt where you don’t have to personally guaranty the loan.  Then we have the company pay that money to you in the form of a taxable dividend (or distribution).  Then, the company would repay the loan to the bank over time.”

“That sounds pretty simple,” said Fred.  “Why hasn’t anyone ever mentioned this idea to me?”

“Fred, I don’t know, but the idea is on the table now.  Would you like to see how it might work in a little more detail?”

“Of course!”

10,000 Foot Overview of a Leveraged Dividend Recapitlization

So I outlined a transaction looking something like the following:

1. Leverage.  Fred wants to get about $10 million in after-tax liquidity for diversification purposes, so we can back into the amount of leverage necessary.  I suggest that he start a little lower, and that we look for a loan at an amount equal to 3.0x EBITDA, which would create a $12 million transaction (3.0 x $4.0 million).  With estimated total taxes of 28%, he could obtain $8.6 million of liquidity with this level of transaction. That’s a lot more than Fred has now.
2. Financing.  In today’s lending market, such financings are not a given, but based on the company’s steady cash flow and history of profitable growth, it should be feasible to arrange such a financing on a non-recourse basis.
3. Taxes other than dividends.  I’m not an expert on taxes, so I told Fred we would have to engage his accountant to lay out all of the tax ramifications of the transaction.  Debt is repaid in after-tax dollars, so there will be a future drain on cash flow relating to the taxes to be paid.  This may be avoided under some circumstances if there is already a substantial net worth in the business.

Based on a seven year amortization for the $12 million of debt, the amortization would run about $2.15 million per year.  That’s a pretty good strain on cash flow, but it should be manageable with $4.0 million of EBITDA.  And, if the company continues to grow, the debt service will become relatively smaller, or Fred could choose to accelerate the repayment.

A Little More Detail

Fred asked about the added risk of the debt on the company’s balance sheet.  It is true, there would be debt on the balance sheet where before there had been none.  And that create some additional financial risk.  However, a loan of 3.0x EBITDA should be manageable in a lending environment where lenders make cash flow loans at levels exceeding 4x or even 5x EBITDA.

And I suggested that Fred look at his own personal risk.  With no debt on the company’s balance sheet, he has 100% of the risk of owning it, and 100% of the risk associated with occasional bad things that happen to good companies.  If he creates a portfolio of $8.6 million outside of the business, his personal risk is in some sense reduced.  If a tragedy happened to the company and he lost it, he would have substantial independence that would be lacking without this transaction.

I’ve oversimplified the financing part of the transaction as well as the need to understand all aspects of taxes.  These things require work, and often considerable work.  Bankers want credible projections that show the company’s ability to repay the debt.  They will likely want an appraisal so they can calculate the loan to value ratio for coverage purposes.  The loan negotiation will be fairly intensive.

Fred can call me or another adviser for this kind of help.  It won’t be free, but in relationship to the One Percent Solution, which suggests allocating a percentage of private company wealth to managing that wealth, the cost would be relatively minor for the benefit of diversification.

What Else is Good for Fred?

Fred has $8.6 million of net liquidity after the leveraged dividend recapitalization of his firm.  And he still owns 100% of the company. That may not be the best estate planning concept, but it would be true for Fred.  Now let’s project out what doing this transaction might accomplish for Fred over the seven year loan amortization period.

• Assuming Fred’s $8.6 million of liquidity is reinvested and achieves a return of, say 7% over the seven years, the portfolio would grow to $13.8 million.
• Assume that the company’s EBITDA grows at 6% per year over the period.  EBITDA would grow to $6.4 million. Fred can use the increasing cash flow of the business to accelerate the debt amortization, to facilitate more rapid growth if prospects are good, or to pay higher distributions, enhancing his ability to increase his liquidity portfolio. If the company is worth 7x EBITDA at that point, it would be worth $44.8 million.
• At any time during the loan amortization period, Fred has the ability to sell the company, take on a partner, or merge with someone else.  The fact that he has some leverage won’t prevent these things.  Lots of companies have leverage.  So Fred has flexibility.
• In Monday’s post, I talked about the relatively few key decisions that business owners must make and implement during interim time, i.e., the time between the current status quo and the business end game.  This one decision on Fred’s part would be a great first step towards insuring financial freedom for his business end game and the rest of his life.

Fred asked me at the end of the more detailed discussion of a leveraged dividend recapitalization, “Where do I sign up?”

Actually, the real Fred has not done anything to date, at least with me.  And lots of Freds who could do something like a leveraged dividend recapitalization with their companies either do not know about the idea or are intimidated by it.  They may also have a false understanding of risk.  By avoiding debt at the company level, they retain 100% of the risk as shareholders.  Transactions can be structured at varying leverage levels to accommodate varying risk tolerances.

Some Light Reading

Transactions like leveraged dividend recapitalizations are accessible for many private companies.  Chapters 9 and 10 in mybook, Unlocking Private Company Wealth, address leveraged dividend recapitalizations and leveraged share repurchases.  They make for pretty good reading.  This book is available with my Buy-Sell Agreements for Closely Held and Family Business Owners in a bundle for only $35 (plus s/h) in what we call the Ownership Transition Bundle, which also comes with additional free resources.

Until next time,

Chris