Recapitalization: Pros and Cons
- A recapitalization (or recap) can be an effective way for owners to reap some rewards from their work years before a transition.
- There are at least nine potential advantages and a handful of disadvantages to choosing a recap.
Recapitalization or Recap is one of the exit strategies available to business owners. It involves the partial sale of the company to private equity firms or venture capitalists. The business sale could be of a minority stake or even a massive 70-80% stake, depending on the unique purpose behind it.
Usually, business owners aim for a successful exit, a smooth business transition from one generation to another, or a comfortable retirement. Recapitalization helps business owners get to the next level in their journey with the company.
What is Recapitalization?
Recapitalization helps stabilize the capital structure of a company by restructuring its equity and debt. It usually involves an exchange of one form of financing for another. For instance, a company may raise bonds to collect funds to pay off preference shares.
When we consider Recapitalization from the exit strategy perspective, it helps business owners share the risk with another investor, usually a private equity firm. They gain both capital resources and access to professional strategic counsel to maximize business value. This strategy helps owners’ cash in more when they wish to exit.
Private equity firms invest in businesses intending to grow them, earn good returns on their investment, and resell them as synergistic businesses after five to seven years. They have investment dollars, which they need to use wisely and deliver within a timeframe. So, they provide resources and assistance to fuel new growth into the businesses they buy.
A Recapitalization strategy allows the owners to maintain control of their business activities. Private equity firms focus on growing the company and prefer to invest in businesses having active owners or strong management who continue to run the business as usual.
9 Potential Advantages of Recapitalization
#1 – Business Growth
Private equity firms help business owners with all requisites to build a great business and increase value, be it funds or expert domain-specific guidance. They also provide the owners with the potential for financial reward while reselling the business.
The business obtains a well-planned succession strategy, a strong management team, a stable infrastructure, suitable systems, and robust accounting processes.
Private equity partners also help owners with growing the size of the business. They reduce risk factors that adversely impact business value, such as cyclicality, customer concentration, or reliance on one supplier.
#2 – Liquidity for business owners
Most business owners invest massive time and personal savings into starting and growing their businesses. There comes a time in the business cycle when they wish to establish a safety net by freeing up their investment and using the funds for other purposes such as children’s education, retirement, etc.
The business owners would sometimes wish to diversify their funds after taking the company to a certain level. Recapitalization is the perfect strategy to liquidate their investment in the company while not completely exiting from it. This process saves them from the risk of carrying all their eggs in a single basket.
Five to ten years before the owners want to leave, a well-timed recapitalization strategy helps position the organization for a rewarding exit when the time is right.
#3 – Multiple Recapitalizations
A recapitalization is an excellent option for owners in the mid-life of their careers, who can pursue it to achieve their desired business growth. Most ambitious business owners use recapitalization as a channel to get the required funding and expert guidance to accelerate profitability and expansion.
It is not uncommon for company owners to enter into multiple recapitalizations with different investors at separate business phases to achieve distinct goals.
As different private equity firms specialize in growing companies of a specific size, a company can grow by recapitalizing with one investor and obtain financial gains from the subsequent sale by the investor. When the company enters the second growth phase, it can enter into another recapitalization with another investor.
The investment and support requirements of a company change after it completes the first growth phase. Thus, it needs an investor specializing in meeting those needs. Hence, there is a requirement for a new recapitalization.
With every recapitalization, the share of the business owners in the company might reduce. However, their financial gains increase because the company flourishes and gets more profitable at every level.
So, when business owners put in the additional years of investment in a growing company, it helps increase their equity value. The amount they thus obtain is more significant than what they might get if the company sells before recapitalization.
#4 – Professional growth of the business
Recapitalization and partnering with Private Equity Firms or Venture Capital Firms help companies increase management rigor. They help organizations to stay accountable, make the business more informed, and make data-driven decisions.
Private equity firms specialize in making companies more attractive to buyers by developing them for resale. They also help business owners maximize value for their companies.
#5 – Meeting additional funding requirements
A Private Equity firm can invest in the risky and costly start-up phases of a business. It can also withstand the initial operating losses. When a financially strong partner believes in the big picture of a company and commits to growing its value over time, it also acts as an insurance layer.
That’s because most small companies are vulnerable to acquisition by bigger competitors or industry players. Also, they are not likely to have additional cash to pursue growth strategies.
#6 – Achieving the desired strategy
When many stakeholders form the majority for a company, it becomes difficult to achieve consensus on important decisions and critical initiatives. If the maximum number of owners are satisfied with the status quo, they do not vote for the proposed decision.
Itâ€™s because all the stakeholders may not work for the company and share the same goals. Some decisions negatively impact business profitability, even if sometimes only for the short term. The management team that forms the minority cannot convince the majority of passive stakeholders.
Such situations could bring the organization to a standstill, as it often happens with family-run businesses. The company can benefit from buying out passive stakeholders and focusing on the active ones committed to business growth.
A recapitalization helps the company get active stakeholders aiming to grow the value of the company. A Private Equity Firm or a Venture Capital Firm provides investment, absorbs the temporary loss in profitability due to the decision or initiative, and improves the companyâ€™s bottom line.
#7 – Like-minded network
A recapitalization allows business owners to work with people committed to growing the business and increasing its value. Private Equity or Venture Capital Firms have immense experience in maximizing the value of the companies they buy.
On the other hand, working with a network of peers not interested in the company’s progress can feel like a lonely vacation. The recapitalization partner keeps the business owners motivated to achieve their desired goals.
#8 – Protection from unforeseen events
Events such as economic downturns, terrorist acts, high-impact natural calamities, pandemics, etc., are rare. However, they can take a business down in the absence of continued investment and expert guidance.
A recapitalization partner helps business owners protect personal assets during Black Swan events and get them through.
#9 – Avoiding negative impact on business value
At times, business owners do not take their company to the market until they want to retire. This scenario exposes them to the risk of not getting the correct value.
Selling a 100% stake requires the buyer to both own and run the business. In the absence of the original owners, a management team, or a succession plan, most prospective investors perceive the venture as risky, thus reducing the business value.
On the other hand, an unfavorable market condition could coincide with the business owner’s retirement time. They must keep running the business until market conditions improve and recover their target value from selling it.
With a recapitalization strategy, these two scenarios do not arise for the business owner. They can go for the recap well before retirement, not worry about the impact of adverse market conditions on the business, and get a larger share at the exit.
Potential Disadvantages or Limitations of Recapitalization
#1 – Business owners want to exit fast or immediately
As the recapitalization model requires a business owner to work actively for up to five or ten years, people seeking immediate or fast exit should not opt for this strategy.
However, if a succession plan is in place or a strong-stable management team is ready, business owners can enter a recapitalization deal.
#2 – Loss of control
While business owners maintain a say in day-to-day activities and crucial decisions after recapitalization, the recapitalization partners have a significant influence on the strategic and financial decisions of the business.
Owners not comfortable giving away the majority stake in their business find it hard to work with partners. While choosing a recapitalization partner, the business owners should ensure that business goals align with the partner’s intentions.
#3 – Immense pressure for growth
Suppose private equity or venture capital firm has invested late in the life of a fund and wants to realize gains early. It is more interested in short-term profitability rather than long-term growth.
Here the expectations of the business owners and the actions of the recapitalization partner do not align. Due to its urgency to show results, the private equity firm pressures the company to grow and exit fast, which might not appeal to the owners.
Summing it all up
If your client is considering a recapitalization, encourage them to seek references from the recapitalization partner before finalizing an agreement. They should speak to other owners who partnered with the firm and find out their experiences.
Business owners should seek absolute clarity from the recapitalization partner on critical business, strategic, and financial decisions to ensure success. Also, they need to understand the extent of their directional control post-recap.