What Are My Options?

by Charles V. Lemmon

How important is cash? Cash is the lifeblood of a business. Cash is the dominant reason why most owners sell.

How important is liquidity? In financial terms “liquidity” means an asset can be easily and quickly converted to cash. Liquidity at the time of a sale is critical to the success of a transaction.

Clients frequently meet with C.V. Lemmon & Co., Inc. (“C.V. Lemmon”) to explore options for cash liquidity. Perhaps an owner/entrepreneur is contemplating a sale for estate planning purposes. Perhaps an owner simply wants to “take some chips off of the table.” Perhaps an owner wants to diversify his assets, or perhaps he desires to buy-out a family member or an inactive shareholder.

Owners of private companies face an interesting dilemma for liquidity because the major asset comprising their net worth frequently is centered in their business. Many owners desire cash liquidity both for personal reasons and to finance growth. As one alternative, an entrepreneur could sell his entire company for maximum immediate cash, but he may loose upside value if he is still too young to retire. An owner may additionally forgo value if his company is about to “explode” with near term business volume.
As another alternative an individual or group of entrepreneurs could take their company public, but that is easier said than done. The investing public would prefer not to “cash out” owners and management, who may loose their drive for growth. Additionally, few independent-minded entrepreneurs are fully prepared for the scrutiny and pressures of short-term oriented market analysts.

So what option provides personal cash, cash liquidity for growth, favorable tax treatment, and preserves meaningful management ownership for continuing upside? The best option may be a Private Company Recapitalization (“Recapitalization”).

What is a Private Company Recapitalization?

A Recapitalization is the partial sale of a successful company to a financial partner. In addition to receiving a significant portion of the company’s value in cash at closing, an entrepreneur may retain substantial minority equity ownership together with continued responsibility for running the company. With the selected financial partner providing assistance on financial, strategic and M&A issues, the owner/entrepreneur will continue to grow the business. Additional depth of management will be created so there is less reliance solely on the entrepreneur. Then, at the appropriate time, the company could go public, could be sold in a private sale, or could undertake another Recapitalization, giving the owner a “second bite at the apple”, which could be even bigger than the first.
A financial partner may be an individual or an institution. Most of the Recapitalizations arranged by C.V. Lemmon involve institutions, which are in the business of investing in successful, privately held businesses. While these partners bring the resources and non-emotional experiences of a large institution, the investing managers are personable and attentive. C.V. Lemmon always stresses that owners interview the financial partner extensively to feel comfortable that corporate cultures, philosophies, and expectations are fully compatible.
The financial partners brought by C.V. Lemmon believe there are many small to medium sized companies, which can achieve important strategic goals partly as a result of a partnership with an experienced equity fund.
The benefits of a Recapitalization include:
1. Liquidity. These transactions allow an entrepreneur to “Take chips off of the table” without harming the company or overloading it with debt. Additionally, it is common that the financial partner eliminates all personal guarantees tied to the company.

2. Control. While ownership control will likely be transferred to a financial partner, day-to-day operating control remains with management. In fact, a financial partner is reluctant to get involved in the business; but instead, relies on incumbent management to lead the business.

3. Substantial Equity for Sellers and Management. Recapitalizations can be ideal for sellers who desire personal liquidity, yet wish to participate in future growth of the business. This is achieved while sellers continue to operate the company substantially as they have in the past. The financial partner always ensures that the management team is rewarded with incentives for the value they create while managing the company.

4. Flexible Structures. Investments are tailored to meet the needs of both the selling shareholders and operating managers. Additionally, the financial partner is sensitive to the employees and the surrounding community.

5. Confidentiality. Most financial partners are private with no public registration requirements or mandates for public disclosure, even after a transaction is completed.

6. Fast Closing. While most Recapitalizations close within 60 – 90 days from the date of initial introduction to the financial partner, it is possible with focused effort, and for an exceptional opportunity, to close a transaction within 45 days.

7. Power For Growth. Financial partners are most intrigued to invest if the target company not only has internal growth opportunities, but also is poised to identify and lead the process of acquisitions and consolidation. Successful add-on acquisitions can rapidly and dramatically increase the value of an enterprise.

After a closing the financial partner works closely with management and the Board of Directors to provide advice and assistance in areas such as financial options, strategic acquisitions, and other long-term issues. Post acquisition activities include:
1. Sounding Board.
2. Partner for Growth.
3. Financing Alternatives.
Some clients who chose the Recapitalization alternative subsequently described the transaction as creating the ability to have their cake and eat it too. Specifically, the structure allowed the selling shareholders to meet their personal liquidity objectives while keeping a significant piece of company ownership going forward. Management still runs all operations, but they also have a well-funded financial partner to fuel future growth.
Recapitalizations only work for successful and profitable companies, which have proven histories of exemplary cash flows. Qualified candidates must have strong market positions and proven management teams. In addition to a track record, cash flows and management, a qualified candidate must have the ability to grow.
The Recapitalization option does not work where management desires to cash out and leave the business. It does not work for start-ups or turnarounds. It does not work unless a business has a demonstrated market advantage and the ability to grow.
Most financial partners are investing money on behalf of others, who participate in the form of a trust or a fund. Therefore, the financial partner has a fiduciary responsibility to its investors to understand its investments and protect those investments.

Show Me an Example:

Assume that an owner/entrepreneur’s company is worth $40MM. The owner/entrepreneur wants to retain 20% ownership going forward and is comfortable running the company with $18MM of debt. A financial partner may invest $14MM of equity and arrange $18MM of non-recourse financing through an institutional lender. An owner/entrepreneur would receive $32MM in cash while retaining a tax-free 20% ownership position worth $8MM.
In the example below, the $32MM could be shared proportionally among all current shareholders. Alternatively, some owners could cash out entirely, while others could receive a mix of cash and continuing ownership.
Sources of Funds ($MM)
Debt $18
Equity from Financial Partner $14
Shareholders’ Retained Equity Value $8
Total $40
Uses of Funds ($MM)
Cash to Shareholders $32
Shareholders’ Retained Equity Value $8
Total $40
Continuing Ownership
Financial Partner 80%
Shareholders 20%
Total 100%
In contrast to the above example, an outright sale would result in the owner/entrepreneur receiving the full $40MM, but no continuing ownership. Going public, on the other hand, may result in raising $12MM – $20MM for the company (diluting an owner’s ownership to 60% – 80%), but the owner/entrepreneur would likely receive little or no cash in the IPO.
A Recapitalization is an ideal option for an owner, who wishes to sell a portion of his company for liquidity or estate planning purposes, while retaining significant equity ownership to participate in the company’s upside. This alternative allows an owner to achieve personal liquidity without sacrificing operating control of the company, which he has painstakingly grown.

Charles V. Lemmon is President of C.V. Lemmon &; Co., Inc., a private M&A advisory firm in Dallas, Texas. Charles Lemmon can be contacted by telephone @ (214) 207-9694 or by e-mail at cvlemmon@cvlemmon.com.