Recapitalizing for ROI

Most business owners understand that an exit strategy should include maximizing their return on investment (ROI). What does this mean and how can we accomplish this?

In the Part 1 of this two-part series we will be taking a look at achieving ROI through recapitalization. Read on to learn more about the basic forms of recapitalization and prerequisites for it.

To realize ROI, owners should move the cash out of the business and into his or her own pockets.

Traditionally there are two primary ways of producing ROI:

• Developing a dividend stream that pays increasing amounts each year as the business grows.
• Selling 100% of the business and reaping the capital gains.

This article discusses a third way: Funding a large personal investment portfolio by recapitalizing the business.  

Business ROI vs. Portfolio ROI

A savvy wealth manager knows that a diversified investment portfolio will offset business risk.

A recapitalization happens when a business changes its financial structure: adding debt, bringing on new investment or buying out old investors. Recapitalization, or “recap” for short, indicates a revision of a business’ capital structure.

More and more middle market companies are choosing a recap path as a means to distribute cash to their owners without an outright sale. Other uses of a recap include capitalizing an ESOP (Employee Stock Ownership Plan), buying out some of the shareholders and having money for expansion or acquisition.

There are several basic forms of recap. Each can usually be structured in a tax advantaged way, such as securing capital gain income and deferring taxes on retained ownership interests.

Recap Prerequisites

In order for a firm to qualify for a recap, the business should meet certain criteria:

Quality of Earnings. A stable, growing earnings history and good visibility of future earnings is necessary to support the debt and investor expectations. Evidence of quality earnings might be supported by long term contracts, billings to a large number of repeat customers, multiple ongoing billings to large customers, subscription business model and more. A history of lumpy up and down annual revenues may not qualify as there is not enough certainty that revenue and earnings are repeatable.

At least modest growth prospects.  A deteriorating business, with a declining history may find willing investors, but only at fire sale valuations. A steady business with few down years historically and an overall steady but low growth rate can attract quality investors. A business with a strong growth history and future will find many willing investors competing to win the transaction.

Size. The ideal candidate will have annual EBITDA of at least $3 million. Below this level, the number of private equity groups and lenders who will be interested dwindles significantly. Sokoloff & Co. recently took a firm to market with EBITDA in the $8-$10 million range. Nearly 100 PE firms reached out to us, we received 31 expressions of interest and received a number of excellent competing offers before selecting the winner.

Part 2 of this article will feature a case history comparing use of a recap vs. continuing to hold 100% of a growing business.

Stay tuned.

Sokoloff & Co. is a member of Axial. The firm advises buyers and sellers and has taken a number of its clients through the various transaction structures portrayed herein.