Recapitalization (“recap”) as a method for partial sale of business

Krzysztof CIESIELSKI
M&A and Corporate Advisory Director at RSM Poland

Normally, when a business is to be sold, one of the following scenarios is given as the reason:

1. The owner has decided to retire and there is no one to replace them at the helm;
2. The business is a well-developed and thriving machine, but, because the owner likes challenges, they decides to sell it and start building something else from scratch.

The third motive may be a disastrous situation of the company. However, we should not be under any illusion here – if the business is weak, all of its weaknesses will come out in the due diligence stage, so there is no chance of a potential investor missing them.

On the other hand, it is not always the case that the owner wants to sell the whole of their business. Moreover, and not infrequently, the owner is not even willing to sell the controlling stake. However, there are situations where selling a part of a business seems to be a good and reasonable solution.

Business is growing (but we can't afford it)

A growing company often needs cash. Usually in much larger quantities than it can generate itself. What then? The owner can borrow the money. From himself or herself, i.e. from their own pocket (and it may turn out that quite a lot of money is needed from this pocket) or from someone else’s pocket. For example, the owner can go to a bank. However, if the owner does not want to invest their own funds or sign a personal bank loan guarantee, there is a possibility to obtain money from an external investor.

Investor - a necessary evil?

When I talk to private business owners, I hear various opinions about investors. Not all of them good. Businesspeople usually perceive investors as a bad or worse choice. How come? An investor enters my company, gets a controlling stake and interferes in the management? Or the investor takes a minority stake and makes money not doing anything? Unfortunately, that is how it works in practice. Business needs capital which is held by investors. When raising capital from an investor, you have to reckon with the need to tolerate someone from outside.

External investors can be divided into controlling (majority) and non-controlling (minority) ones.

A controlling (majority) investor is an investor who, through a transaction, takes control of a business. This is the case when an investor (often a venture capital or private equity fund) invests money in exchange for the company's shares, gaining a more than 50% interest in the company's equity, or when controlling rights have been granted in other ways, e.g. by way of an amendment to the articles of association which ensures such effective control.

A minority investor does not take control of a company.

An investor is not as bad a solution as people say

As one can easily guess, sellers (business owners) prefer minority investments while investors prefer to invest where they can take control of a company. A majority investor not only has a greater opportunity to introduce changes in how the business is managed, but can also influence the direction in which it is developing. A minority investor usually invests in a company with the sole intention of making money on an increase in the value of such company. And such an investor often has little or no possibility to exit the investment project within a defined time period. So is it possible to find a minority investor (apart from the stock exchange and free float requirements as this is not the topic of this article) who will be well-recognisable, stable and patient? Yes, it is. Moreover, it can be a globally recognised bank or private equity fund.

However, it should be remembered that the owner's attitude is crucial here – regardless of whether they are looking for a majority or minority investor.

You have to be ready for to have an investor in your business and to treat the investor as a partner. The investor risks their own funds, and these are needed by the company. Seeking an investor is therefore a good solution if there is a mutual understanding and the cooperation is based on a partnership approach. After all, both sides want to and can make money on the business in such an arrangement.

Asset diversification as the cure for headache

For many business owners, the company is their whole life – and livelihood. This means that if their business goes bankrupt, the personal finances of the owners are seriously threatened. Selling part of a business to an investor is a way for the owner to improve financial liquidity and reduce risks. What works very well here is recapitalization (or recap for short).

Recap offers great opportunities provided that we find the right investor. This is an interesting solution in the times of economic downturn, especially when the owner is convinced that the company will grow after that time. Recapitalization reduces personal risks as cash is obtained in exchange for shares in the company's equity, and a source of capital is secured for further business investments and/or acquisitions.

Recap very often ends with the sale of the business. This means that everyone exits the business.

Business owners often ask themselves a question: "Should I pay myself a dividend or reinvest profits in the business?" The partial sale of a business is the perfect solution to this dilemma. By way of such a transaction, the owner is able to pay themselves a dividend and secure a source of capital for further development. And there is even more – the owner gets another cash injection when the company is fully sold. For an owner who wants to retire within a few years, recap can be a very good way to secure their private property and provide funds for running and developing the company until then.

Recapitalization also works well in situations of disputes between owners. Especially when one of them wants to leave and the other cannot afford to buy them out. An outside investor can be quite a good solution here.

Recapitalization step by step

Let's see how the so-called minority recap works in practice. Let us assume that you are the owner of a company whose current market value of 100% of the shares is PLN 20m. For simplicity's sake, we will also assume that the company is free of debt. In discussions with an investor (a private equity fund) the structure of the recap transaction was negotiated as follows:

• 65% will be financed by debt,
• 35% will be financed by equity.

This means that, when the transaction is completed, the company will have a debt of PLN 13m on its balance sheet. Let us also add that the negotiations also stipulated that the owner will retain a 70% stake in the company's equity after the transaction and the remaining 30% interest will be held by the private equity fund.

Therefore, as a result of the transaction, the owner will receive an amount of PLN 15m. However, it should be remembered that they will retain a 70% stake (calculated on PLN 7m of equity).

However, that is not all. Let's assume that the owner manages to double the value of the company over a time period agreed with the private equity fund (e.g. seven years) and the company is now worth PLN 40m.

What does that mean? If the owner decided to sell 100% of the shares for the original price, they would receive PLN 20m. However, if the owner chose to recapitalise, at the end of the day they would get as much as PLN 39m (15+24)!

And what if the owner is looking for a short-term pay-out long before the final sale of their business? This situation occurs quite regularly and is known as dividend recapitalization, or dividend recap.

Dividend recap

This process can be performed during a recapitalization. This is another loan obtained by the owner for the company based on the current value of the company. It will be treated as a second loan secured by a pledge. The money received as a loan does not return to the company, instead, it is used as distribution to shareholders (also called a dividend). However, it should be remembered that the owners will have to settle this additional loan when the company is sold. The result will be a lower payment for the company (and a higher repayment to the lender). Although this may not seem advantageous to the existing shareholders, this strategy is in fact favourable to them as it reduces their overall risks with an earlier payment of the dividend.

One of the biggest challenges of dividend recapitalization is a scenario in which the company's situation deteriorates instead of improving within the planned time horizon. Looking at dividend recapitalization from the technical perspective, a company is once again indebted during the recap – with the sole purpose of making a one-off dividend payment to the owners. In other words, they add an additional debt for the company. The problem is that, while the existing owners benefit from dividend recapitalization (in the form of the earlier payment), they are not responsible for this additional debt when the company does not grow as expected. Therefore, dividend recaps are often viewed negatively. It seems that companies do not benefit from this, while their owners do. Such additional debt is also believed to put a burden on the business exposing it to volatile market conditions and, potentially, bankruptcy. Therefore, dividend recaps are usually seen only in thriving businesses.