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CEOs, Lenders, Private Equity

Recap for ROI Part 2- A Reluctant Seller Considers Alternatives

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Last week we talked about how to achieve return on investment through recapitalization. Part 2 of this series compares the use of recap vs. continuing to hold 100% of a growing business.

“Mega” Corp. is a thriving services business. The firm’s earnings have grown 10% to 20% every year. CEO and owner Joe Mega receives millions of dollars of dividends every year. He loves the business; his employees and customers love him. Talk to Joe about selling his company and you won’t get your next phone call returned.

So what is there to worry about? Technology shifts, revised regulations, changing market demand, litigation and every other threat known to man; any one of these outside risk factors can come to bear on the best of businesses, dealing a crushing blow, reducing value and ROI exponentially.

Recap vs. Continue to hold – mixing business and portfolio returns

We assume that Joe’s business has a current market value of $100 million and no debt. Joe Mega asked us to compare the returns received if he holds the company for another five years vs. undertaking a majority recap now.

The result is surprising: Factoring in relative risk, there is little difference in the financial rewards that come from holding 100% of the company for the next five years and selling 55% of the business now.

We modeled Joe’s after tax returns two ways:

Scenario 1:  Joe continues to own 100% of the business for five years while projecting 20% per year growth of earnings. A sale of 100% of the business then occurs at the end of five years.

 Scenario 2:  Joe does a 55% Majority Recap now. Business earnings are projected to grow at a rate of 20% per year. He receives cash from the recap and invests it in a typical stock and bond portfolio that generates a 10% pre-tax return per year. He then continues to receive a 45% share of future dividends from the business. Finally, he receives the proceeds from an eventual sale at the end of five years.

Our models utilize the widely accepted practice of discounting future cash flows, based on risk.  The higher the risk, the higher the discount of future cash flows in determining the current value. The future business cash flows from Mega Corp. are riskier than a moderate yield investment portfolio. Therefore, we discounted the after-tax cash flows from Mega Corp. by 15% and the after-tax cash flows from Joe’s portfolio by 8%.

A few other factors come into play in a sale or majority recap scenario that typically are not available if Joe continues to hold 100% of the company going forward.  One major benefit is the ability on the recap to step up the assets to the full valuation, allowing the deduction of goodwill from future income. Thus debt is repaid sooner and after tax dividends are greater.

Summary of Results

The below table summarizes the five year results, discounted to portray today’s net present values of the after tax cash flows from each scenario. There is little difference between the two.

The primary gain following the recap route is the peace of mind that comes from knowing all of Joe’s eggs are no longer in a single basket. Whatever may happen, he is assured of an excellent and optimal return on his original business investment.

We varied the model using the same entrance and exit multiples, ranging from 6x-8x EBITDA. As expected, results at each multiple level were similar. Sometimes the initial recap is at a lower multiple and the ultimate exit is a higher multiple. In this case, Joe’s recap returns would be significantly greater than holding 100% of the business over the five-year term.

Conclusion

Risk management requires diversifying some principal from the business into a personal portfolio, sooner rather than later. This is almost always the right choice.

There has never been a better financial environment: Bank loan rates are at all-time lows, other forms of debt are available and knocking on every door trying to get placed, the private equity industry has over $1 trillion they need to invest in the next few years.

All of these funding sources are willing to invest in good private middle market companies and allow shareholders to take the money provided as capital gains, dividends and distributions.

They want to fund your personal investment portfolio with additional capital, expert advice and strategies to grow the business. And often the money is patient capital, willing to ride through the inevitable ups and downs that will occur. They also want you to continue as a significant owner of the business.

A recap is an intelligent alternative to holding 100% of the business in anticipation of reaping greater financial reward in the future.

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

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