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Funding From the Private Capital Markets Can Help You Reach Your Strategic Goals Without Bringing in Equity or New Partners

CEOs may pursue multiple avenues to growth and strengthening their company’s strategic position. Investing internally via capital expenditures (CAPEX) or making key hires may be appropriate for some companies, while others may find more attractive opportunities in acquisitions.

A business owner may have as a priority the diversification of their personal wealth so as not to be overly concentrated in the business.

Other business leaders may need to reorganize ownership of their companies.  This could mean concentrating ownership through the buy-out of shareholders who no longer wish to participate in the company. It may also entail passing ownership to the next generation or an executive team.

These actions share a common denominator: the need for external capital.  For a company to achieve its fullest potential, a CEO and their advisors need to understand how much capital is available to them, from whom and at what price. This is especially true if shareholders do not want to give up equity or bring in new partners.

Many CEOs hold a now obsolete view that commercial banks are the best, preferred and perhaps only source of non-equity capital for their companies. Even trusted advisors such as attorneys and accountants can share this bias. And while commercial banks remain excellent sources for asset-based lending, they may not be able to provide cost-effective capital beyond what can be secured with tangible assets.

Funding alternatives abound for CEOs

The corporate landscape has evolved; a greater percentage of companies produce profits and cash flow uncorrelated with or disproportionate to their tangible assets. Essentially, there has been a shift from manufacturing toward services. Companies that provide services, such as technology, distribution, marketing, light manufacturing, healthcare and others, do not require heavy investment in property, plant or equipment, or other physical assets.

CEOs of such companies may find that their trusted commercial bank cannot provide capital beyond the liquidation value of their tangible assets, totaling no more than 1x or 2x EBITDA, even though their business is highly profitable and has a track record of high quality of earnings.

Fortunately, the private capital markets have evolved and grown in recognition of this shift in the U.S. economy.  In addition to commercial banks, debt capital can be sourced from a large and rapidly growing pool of institutional non-bank lenders.  Pension funds, insurance companies, business development companies, family offices, credit opportunity funds and hedge funds are among the capital providers in this market, which currently number over 6,000 participants providing over 50% of the private commercial credit in the United States.

These institutional entities are not bound by the same regulations as commercial banks, allowing them to lend against cash flow and quality of earnings, rather than the liquidation value of tangible assets.  A borrower EBITDA of $5 million is generally the minimum to attract this type of capital, with no upper limit. Types of financing range from senior secured all the way down the capital stack, and current market conditions provide borrowers access to senior debt of 1.75x to 5.5x EBITDA depending on the amount and stability of EBITDA.  The amount of additional capital available to companies can be significant.

Raising capital for the right reasons

 Regardless of the type of capital you wish to raise, it has to be in the context of a rational business strategy.  If your focus is growth, how would having 2x-4x your current presumed funding capacity impact the company’s strategic plan?  Would that increased funding allow for more aggressive organic growth?  Would it allow you to consider more significant acquisitions to fuel enhanced competitiveness, drive growth and increase the value of your business?

There are numerous situations where an owner would benefit from recapitalizing their business, but the limitations imposed by the false belief of needing to raise equity or sell their companies unduly narrow the array of perceived options.

For example: Imagine a CEO who is uncomfortable with having a disproportionate percentage of their personal wealth concentrated in their company.  A recapitalization could be used to fund a dividend, allowing for the de-risking of their personal wealth portfolio. Another familiar situation is a desire to buy out partners or other shareholders who no longer wish to have their lives and financial risk tethered to a private company.

Common wisdom might suggest selling the company or bringing in a private equity investor, even if the CEO has no wish to sell or take on new partners.  However, a debt recapitalization allows the buy-out of some or all such shareholders, concentrating ownership with the CEO and aligning shareholder interest while avoiding governance issues.

Knowing how much funding is available to your company may provide fuel to reach your strategic goals, and even recalibrate your vision.  Whatever your funding requirements, business owners and CEOs should know that they have alternatives.  The Private Capital Markets have the depth and flexibility to allow you to reach your goals without compromising control of your company.

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Cashing In Without Cashing Out: Dividend-Levered Recapitalizations

You own and run a successful company.

You feel strongly that your company will do well, grow and increase in value.

You want to continue to run your business and don’t want or need any, or any more partners.

The company is worth a lot. It may represent 60%-90% of your net worth.

Even though your company is doing well and has rosy prospects, there is always the possibility that things will go wrong and your business will falter.

Having the majority of your wealth tied to a single asset creates great risk. You wonder, “How do I mitigate that risk while continuing to own and run my company?”

A most efficient way to mitigate your risk of wealth concentration is to do a dividend levered recapitalization.

This uses the same financial engineering that private equity firms employ. The difference is that you can:

  • Maintain your existing ownership position
  • Take almost as much capital out of your company as you would in a PE deal
  • Maintain management control and continuity
  • Avoid the fees PE firms charge and disruption they can create

An example of how a levered recap mitigates your risk of wealth concentration in your business might go as follows:

  • Your company has EBITDA of $5 million
  • The Company borrows $20 million – 4x EBITDA – on a NON-RECOURSE basis
  • $5 million remains with the business for working capital
  • $14 million is paid out to you as a dividend, with ~$1 mil paid in fees & expenses to the various parties to the transaction
  • Your cost of capital in today’s market will be 6%-7% above LIBOR
  • The multiple of EBITDA and interest rates available improve as EBITDA grows

The $14 million you take as a dividend will generally have significant tax advantages vs. receiving annual profit-sharing at ordinary income rates.

You and your family have greater financial security if anything should happen to your business.

What happens to your company? Isn’t the risk to the business increased?

The answer is, not really.

Management hasn’t changed and the company has adequate working capital to continue to grow and thrive. After taking the dividend out of your company, debt is quickly amortized: not so fast as to eliminate growth investments, but fast enough to “de-lever” your company rapidly.

In the example below, the assumption is that your company’s EBITDA will grow at 10% annually and that you will want to balance debt amortization with growth investments and continued cash distributions to shareholders.

Year 1

Year 2

 Year 3
Company EBITDA $5.0 million $5.5 million $6.0 million
Existing Debt $20.0 million $19.0 million $16 million
Amortization – Scheduled $1.0 million (5%) $1.0 million (5%) $1.0 million (5%)
Remaining EBITDA $4.0 million $4.6 million $5.2 million
Amortization – ECF Sweep

(see note below)

 NA $2.0 million (~50% After Tax Cash Flow) $2.2 million (~50% After Tax Cash Flow)
Ending Debt $19.0 million $16.0 million $12.8 million
Ending Total Leverage 3.80x 2.90x 2.13x

 

This example demonstrates that by year 2 after the dividend, shareholders can again begin to take distributions from the company, and that the ratio of debt to EBITDA reduces from 4x EBITDA to begin to 2.9x at the end of year two, and 2.13x at the end of year three. Please remember that 1x EBITDA is your working capital line.

2.9x EBITDA – 2.13x EBITDA do not represent a high leverage ratios that should create risk to your business.

In years 2 & 3 after required debt amortization, you have the option to apply the second 50% of after tax cash flow to distributions to shareholders, further balancing your wealth portfolio. You may also apply those funds to growth initiatives.

An alternate path is to apply those funds to faster debt amortization. If this tact is taken, ending debt at the end of year two will be $14 mil – 2.55x EBITDA. At the end of year 3, ending debt will be $10.6 mil – 1.77x EBITDA; a conservative level.

It is important to re-iterate that a dividend recap is a RISK MITIGATION STRATEGY for balancing your wealth between your company and personal holdings.

The borrowings described above are NON-RECOURSE to you. Should something go wrong in your business, you and your family have – in this example – $14 million more held outside your business to mitigate risk to your personal wealth.

This article covers a lot of ground quickly and may leave you with more questions than answers. If you do have questions, please contact Mark Taffet at mtaffet@mastadvisors.com

 

 

Mark Taffet is CEO of MAST Advisors, Inc., an M&A and strategic advisory firm focused on maximizing value for middle-market companies. Information regarding specific aspects of the private capital markets has been provided by SPP Capital Partners, an investment bank focused on raising funds in the private capital markets, and an affiliate of MAST

NOTE: Cash payment of Excess Cash Flow (“ECF”) sweep amortization occurs after the yearly audit is completed. ECF is generally defined as EBITDA less the following: (i) capital expenditures for the period; (ii) cash taxes; (iii) principal payments; (iv) cash interest expense; (v) cash management fees; (vi) restricted distributions for each year. ECF is a highly negotiated term of any credit agreement.

 

 

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