Friendly Investors Who Have The Deal For You

By Noel Urben

They offer cash, plus a second bite of the apple, without seeking control.

Many owners of family businesses continue to believe that in order to get a substantial amount of the value of their business in cash they must offer the company's stock publicly or sell the entire company. Today, this is no longer true. There is now another alternative, called recapitalization, which in some transactions allows the owner to get the cash he seeks and still retain operating or voting control of the company.

Recapitalization is defined by Webster's as "a revision of the capital structure of a corporation." Such transactions evolved in the early 1980s as a variation on the more prevalent leveraged buyouts of subsidiaries, divisions, and entire companies. On the one hand, they arose to meet the needs of private owners who were seeking liquidity for estate or other personal reasons. But they also came about because institutional investors became willing to invest substantial sums in highly illiquid securities of privately held companies without demanding either voting or operating control.

In a recapitalization of a private company the owners might be able to obtain as much as 60 percent to 70 percent of the value of the business and still retain control. In return for providing or arranging the financing for such a transaction, the lender and institutional investor will require that most of the money they put up in loans or securities be senior to the common stock. As part of the financing structure, the investor will also purchase common stock directly or through the use of convertible securities or warrants.

In other words, the institutional investor is willing to provide the owners with a substantial portion of the company's value so long as it is assured of getting its funds back first — before any appreciation in the common stock is shared.

If up to 60 percent to 70 percent of the value of the business is paid out to present shareholders, the lenders and institutional investors are, in effect, left holding virtually all the risk capital in the company. In view of that risk, the investors' desire to have these funds returned before sharing any future appreciation with the present owners is not unreasonable. While the private owners get the cash they want, they still have a significant amount of ownership, and, if the business appreciates, they will thus share the benefits of what might be called "a second bite of the apple.

Family firms typically recapitalize when the owners have different views of the business. Some may feel the future outlook is bright and want to maintain their stake in it, while others may feel the prospects are gloomy and want to get their money out. Often owners simply worry about having all their estate tied up in one business. They want to get part of their capital out in order to diversify their investments, but they would still like to operate the business and have meaningful ownership, as well as pass ownership to the next generation.

A recapitalization which our firm oversaw five years ago shows how all these goals can be achieved. The company in question, a rapidly growing specialty retailer founded in 1980, generated about $30 million in revenues in the year prior to the recapitalization. The nonactive shareholders, who provided virtually all of the startup money, owned 49 percent of the business. They felt it was time to liquefy their investment.

At the time the entire company probably could have been sold for between $20 million and $22 million. But the founder, who was the president and largest single shareholder, believed it was far too soon to sell the business and wanted to continue to grow it. His spouse, who was active in the business, was sympathetic to this view. But she also realized the need for estate-planning liquidity.

An underwriter advised the family that a public offering was not feasible, given the size of the company and the lack of a receptive stock market for new issues. Our firm, BT Capital Corp., suggested they consider recapitalization.

Under the recapitalization, the shareholders received substantial cash and a strong continuing interest. Along with $1 million of preferred stock and 49.9 percent of common stock (for $49,900) in the new entity, they received a total of $14 million in cash. No matter what the future performance of the business, the $14 million in cash (net of taxes) would be theirs to keep.

Of that $14 million, BT Capital provided $10.5 million in eight-year subordinated notes at current interest rates. (Since interest only accrued in the first three years, the firm was assured of having a substantial amount of sheltered cash flow to use for future growth.) In return, we also received a 49.9 percent common stock interest in the business, for which we also paid $49,900. To retain a 49.9 percent interest in the new company, the shareholders also put up $49,900. Two non-owner managers of the company each put up $100 for a total 0.2 percent stake, and the company's bank provided the rest of the funds in the form of a term loan. The bank also provided a line of credit for working capital.

The deal satisfied the needs of all of the parties. The inactive shareholders received a significant portion of their "value" and were content. The founder-president also achieved some liquidity; at the same time, he was able to continue to grow the business and to pass most of his continuing interest at a very modest value to the next generation. He could be reasonably assured of maintaining voting control, since the old shareholders together with the two managers who owned a 0.2 percent slice represented 50.1 percent of the voting power.

In return for our risk capital, BT Capital acquired a stake in a solid company with attractive prospects. In addition, we would obtain repayment of our subordinated notes before any future appreciation in the value of the business was divided among the company's original stockholders and ourselves.

The subsequent performance of the company shows just how large the "second bite of the apple" can be. For the fiscal year that ended in early 1992, the business achieved sales of $146 million — nearly five-fold what it had generated in the year prior to the recapitalization. Based on a recent offer from a large company, the shareholders' equity interest of 49.9 percent is now worth about $20 million. Not bad for an investment five years ago of $49,900, and on top of the $14 million received at the time of the recapitalization.

There are countless other scenarios in which a recapitalization can satisfy family members' need for cash without requiring them to give up control of the business. However, the desires and motivations of private business owners vary, and a recapitalization isn't for everyone. If the family won't accept any outside ownership, clearly this type of transaction is not possible. They will also have to provide the institutional investor with the means to eventually exit from the company, if it wishes, through a stock repurchase, or through a public offering, or sale to a third party of the investor's shares. Finally, if the family's primary objective is to get the highest possible price for all or part of the company, a recapitalization may not be the solution. In this case, a sale to a strategic buyer or a public offering of shares (the stock market willing) might be preferable.

In a recapitalization, the single most important decision facing the owners is the choice of the institutions that will be their partners. The owners should, of course, check out the reputations of the people and the institutions. In addition, the feasibility of a recapitalization will be influenced by 1) the respective parties' current valuation of the business; 2) the company's future outlook; 3) the family's acceptance of outside ownership; 4) willingness to let the investor get his "risk money" back before dividing future appreciation; 5) an exit strategy for the institutional investor; and 6) the current availability of credit.

More than anything, however, a successful recapitalization depends on trust and the ability of the partners to work together.

Noel Urben is president of BT Capital Corp., a subsidiary of Bankers Trust New York Corp.

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Issue: 
Spring 1992

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