Sooner or later, most family business owners will face a quandary: How can they enjoy the fruits of their labor without having to sell the company or relinquish majority control? Mezzanine funds offer them the chance to take cash out of their business, yet maintain majority ownership and management control for themselves and the generations to come.
Most independent business owners are surprised to learn that they can liquefy a significant portion of shares without giving up control of their company or going public. And indeed, most financial investors require a majority ownership. But a limited number of capital firms offer ownership recapitalizations (also termed dividend recaps) that require only a minority stake in the company.
To finance such recaps, the firms use mezzanine securities, specifically subordinated debt and preferred equity. Mezzanine securities are a hybrid of senior debt and equity. Like senior debt, the securities are loans that earn interest. Like equity, they are unsecured and long-term in duration, and the firms participate in the equity ownership of the company. The overall cost of mezzanine securities is higher than senior debt, but lower than equity.
Why consider a dividend recap?
In most cases, a private business owner’s shares aren’t liquid. Regulations and restrictions imposed by shareholder agreements severely limit an owner’s ability to exchange a portion of his ownership for cash. Although the owner may take out nice salaries and benefits, most of his wealth is tied up in the company and depends on its continued success.
A recap allows an owner to “take chips off the table.” When used for wealth diversification purposes, a recap provides the owner with peace of mind that her financial security is ensured, but doesn’t require her to withdraw from the game or miss out on future earnings.
Dividend recaps are also an effective way to transfer business ownership from one generation to the next. Normally, the same issue of liquidity of shares can be an obstacle to a business owner’s desire to pass the company on to the next generation.
If 100% of a company’s shares are held by the business owner, how does she “sell” the family business to the next generation without asking them to come up with the funds individually? A minority ownership recap allows the owner to withdraw a significant percentage of the cash value of the business, yet leave the majority of the company’s ownership to the next generation.
Other options—like selling the entire company, selling a majority interest or going public—are often unattractive and tend to be viewed as tantamount to relinquishing control.
Recaps aren’t for everyone
If there’s “a catch” to dividend recaps, it’s that the business owner must be willing to enter into a partnership with a financial investor. A well-conceived dividend recap deal should be based on a mutual partnership to continue to grow the company. If the owner wishes to quit the business, either immediately or within the next few years, she should consider other options.
Mezzanine partners are usually willing to take a non-controlling interest only when the owner has an emotional stake in the company’s future. The owner may want to pass the company on to the next generation, or to trusted management. Either way, investment firms don’t want to have a non-controlling interest if their partner’s interest in the company’s success is diminished.
Likewise, an owner must be willing to accept the new investors as partners in the business. Some mezzanine firms take the role of adviser and resource rather than controlling partner. Yet some owners find even the least intrusive partnerships difficult to accept.
How does a recap work?
Consider a 45-year-old business owner who is not yet interested in giving up control of his business, or in playing golf full-time. But he wants to make sure he and his family are financially secure, independent of his company’s continued success.
Let’s assume he owns a $40 million business, with $7 million per year in cash flow and a 5% annual rate of growth. In most instances, the owner can expect to take out $12 million from the business in exchange for 20% of his company. On the other hand, if he sold the company outright, he might get only $35 million for the entire business, and relinquish all equity and control.
After closing on a minority ownership recap (under the worst-case taxation scenario), the owner now has about $7.5 million, and the financial independence and security that brings. He also has the resources and guidance of a financial partner that will work with him to grow the business without endeavoring to run it.
Tips for a happy ending
One interesting aspect of this relationship is that the mezzanine firm aims to return its portion of the company back to the owner. If the partnership is successful, the owner should have multiple options that will allow him to retire the mezzanine debt and regain 100% ownership of his company.
Most mezzanine deals have a life of about three to seven years. During that time, it’s assumed the company will grow and increase revenues. Those earnings can be used to pay down existing senior debt, allowing the owner to replace the mezzanine debt with new traditional senior debt, at which point he regains complete ownership of his business. Or, increased earnings can be used to repay the mezzanine firm outright. At the same time, if our now 50-year-old business owner has decided to play golf on the senior PGA tour, selling the entire company or an IPO are still options.
Selecting a mezzanine firm
• Search for a partner. The quality of the partnership is the essential element of a well-structured minority-ownership recap. A good mezzanine firm will contribute to a company’s ability to grow (and thereby retire the mezzanine debt). Such a firm will avoid entering a partnership that will have a negative impact on a business owner.
• Make sure the firm has done its due diligence on you. The defining difference among mezzanine firms is the amount of due diligence each performs—how much time each puts into researching a company and potential client. A mezzanine firm will not enter a partnership if it doesn’t believe the company’s growth and success will make the deal beneficial to both parties. Without significant due diligence, a mezzanine firm cannot make an educated judgment about that potential.
• Look for more than a capital infusion. Once in a partnership, a mezzanine firm should be more than just a provider of capital. A good firm will contribute its human and other resources to help the owner overcome business challenges.
• Take the time necessary to really know your mezzanine firm. Since a partnership often lasts for three to seven years, it’s essential to make sure the firm’s culture is compatible with the company’s and the business owner’s. Take the time to get to know the firm’s associates and consider talking with some of its other clients. Make it your mission to bring an investor to the table that will work well with you and your family.
Don’t choose solely on price. As the old adage states, “you get what you pay for.” The firm that offers the best rates may not be offering the best partnership. In the end, your relationship with the mezzanine firm is what ensures a healthy business for generations to come.
Samir Desai is a vice president at Key Principal Partners, a private equity firm that provides mezzanine and equity financing to middle-market companies throughout North America. (www.keyprincipalpartners.com).