Posted In: Business Transactions & Corporate Counseling, Corporate Counseling & Mergers, Acquisitions and Divestitures
By Molly Z. Brown on January 12, 2022
In this Business Blog mini-series, we will explore liquidity event options outside of an outright sale of the company. Over the last several years, legal changes have facilitated a robust growth in the private capital market as investors shifted more capital towards private companies causing private placement offerings for debt, equity, and hybrid securities to be more common. This trend has followed the enactment by the U.S. Congress of the Jumpstart Our Business Startups (JOBS) Act In 2012. The JOBS Act eased the shareholder requirement for registration as an SEC periodic reporter by increasing it from 500 to 2000 shareholders and implemented exemptions from registration for securities offerings to facilitate capital raising by small businesses.
In this installment of our mini-series, we will explore options available for liquidity events by private companies with Cascade Partners' Director, Arjun Murthy.
Arjun brings a wealth of experience in corporate finance, mergers and acquisitions, and financial operations. Arjun earned his Bachelor of Arts degree in Finance from the Eli Broad College of Business at Michigan State University and his MBA with concentrations in Corporate Strategy and Finance from the Stephen M. Ross School of Business at the University of Michigan.
Molly: Arjun, what options are available today for companies seeking a liquidity event but not a full sale of their company?
Arjun: Companies seeking a liquidity event can do so through a recapitalization, which is a type of capital raise that is facilitated by outside capital, focused on reorganizing a company’s debt and equity structure. The typical driver of the transaction is to provide partial liquidity, a partner, or growth capital, without engaging in a full sale of the company. When contemplating a recapitalization, multiple strategies can and should be pursued simultaneously to maintain flexibility, drive value and ensure a transaction meets all critical objectives.
There are many reasons companies should consider a recapitalization, including:
- The company’s situation
- To generate partial liquidity for active and inactive shareholders
- A shift in ownership within a multi-generational family business
- To diversify net worth for legacy planning
- To secure growth capital for acquisitions or specific strategic initiatives
- A failed sale process, but shareholders still desire liquidity
- To refinance an existing capital source/lender
Market factors play a significant role in deciding whether or not to seek a recapitalization. Some market considerations present today include:
- Taking advantage of current tax laws thus minimizing future tax obligations
- A strong credit appetite in the middle-market for high-quality borrowers
- Numerous capital sources; significant private equity and credit capital has been raised in the markets over the past several years and still needs to be deployed
- A historically low interest rate environment
- An overall valuation environment that is attractive for business owners
Recapitalizations can and should be structured to meet the specific needs of the ownership and management team. Traditionally speaking, there are four primary ways to structure a recapitalization, with each option providing advantages and disadvantages:
- Senior Debt Financing – Debt
- Mezzanine Debt Financing – Debt
- Structured Equity (1% - 49% of equity is sold) – Equity
- Majority Equity (51% - 90% of equity is sold) – Equity
Molly: What are the Pros and Cons to Debt, Equity, and Hybrid Securities for Private Companies?
Arjun: Determining the objectives of the shareholder(s) upfront is critical to establishing the right path forward with structuring a capital raise. While there are routes to simultaneously pursue both debt and equity solutions, there are specific considerations that are important to contemplate when exploring capital raising options.
First, determine the ultimate objective and end goal from the capital raise. Is the goal of the raise to provide liquidity to the shareholders or growth capital for the business? Key questions such as "Am I looking to continue to operate my business within my current role”, or "Do I want to give up ownership?" are essential considerations for thinking through capital raising structures.
Debt vs. equity considerations: While both debt and equity solutions can provide the liquidity necessary for capital raising objectives, there are differences between the two solutions.
With debt, a company is not giving up ownership of the company. It is also typically a cheaper alternative to selling equity, especially in the historically low-interest rate environment we're in today. While debt is cheaper and non-dilutive to the ownership, it provides new restrictions on the company through covenants and can be secured by a form of guarantee, likely a personal guarantee with senior financing solutions. Investors are not typically involved in the day-to-day operations but can bring strategic resources to the table. It is important to understand the financial implications of bringing on a debt partner, such as the company's financial wherewithal to support the new debt structure (e.g., paying interest and principal payments). In many situations, privately-held businesses have operated in a "debt-lite" environment, and when seeking a liquidity event, it is important to understand what a new capital structure will do to the company, its operations, and its ability to service the requirements of investors.
With equity, a privately-held organization will be giving up ownership of the company, sometimes through minority or majority control; both situations do not have to involve "selling the company" outright. While equity is more expensive than debt, it is less risky and typically no financial covenants are established, but there will be restrictions for shareholders. Instead of personal guarantees, board seats are provided in exchange. The company will likely be operated differently than before the establishment of the partnership, as the goal of equity investors are to bring real operational and strategic change to a business, in order to enhance value.
Ultimately, while both debt and equity solutions (often paired together) provide capital raising options, there are serious considerations that need to be determined before establishing a new capital structure.
Molly: In our experience, companies with a liquidity and capital plan in place, prepared in conjunction with investment bankers and legal counsel, are best positioned to complete a liquidity event successfully. Do you work with companies to advise them on liquidity and capital planning from a financial advisory perspective, and how has that work positioned your clients to achieve better liquidity event results?
Arjun: This is a great question that I think is often overlooked by business owners. Having the right advisory team in place, ideally years before a transaction, will provide for a successful outcome. What do I mean by having an advisory team in place years ahead of time? It means establishing a relationship with a competent and business-savvy advisory team with experience in consummating transactions, and who takes a collaborative partnership approach with their clients. With this team in place ahead of time, you allow the advisors to learn your business and ensure proactive measures are being implemented before any transaction (e.g., legal/tax structures, financial plans, succession planning, etc.). I'd like to say that having a great attorney is enough, but having the "right" team, including investment bankers, not only creates the competitive tension within a process that is critical in driving value but also ensures the "right" deal is being negotiated with the "right" partner.
At Cascade, we take a very hands-on and consultative approach with our clients in a variety of roles, including preparing a capital plan ahead of time, assisting them with building the financial model and implementing other operational improvements. By taking this approach, our clients' valuations often tend to be higher than what would have been experienced from a traditional transactional client/advisor relationship approach.
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