Mirus Capital Advisors

Advice for Entrepreneurs, Explanations of Common Financing Jargon, Fund Raising, Private Equity, Banks

Recapitalization: When does it make sense for your business?

Recapitalization is a common term to describe a transaction that impacts the stock ownership or the debt structure of a business. For a business to “recapitalize” there must be some transaction where new capital, either in the form of debt (a loan) or equity (an investment) comes into the business. Businesses recapitalize for many different reasons, but here are a few common examples:

1. Liquidity for Shareholders: The founders of a business are planning to retire. They might recapitalize the business with debt in order to reduce the value of the stock before selling to the management team, or to outside investors. Here is how it would work:
   • • Assume the business has a value of $12 million, and bank debt of $2 million. In that case, the equity (stock) of the business is worth $10 million.
     • At $10 million, the management team or investor group would need to come up with $1 million just to buy 10% of the stock. If the management team paired up with an investor could come up with $3 million, the retiring shareholders would receive $3 million in cash for 30% of the business.
     • If the business were to increase its borrowing from $2 million to $7 million, then the retiring shareholders could take the extra $5 million out of the business as a dividend, reducing the equity value from $10 million to $5 million.
     • The management team and investor then invests $3 million, which now buys 60% of the stock. In total, the retiring shareholders receive $8 million from the recapitalization.
2. Expansion Capital: A business owner wants to expand his manufacturing business into a new geographic region. Outfitting a new facility and absorbing all of the start-up costs would require $3 million of new capital. He had already borrowed $4 million from a bank to acquire and expand the business, so more debt is not an option. However, there are many outside investors interested in owning a piece of the business. Here is how it would work:
   • • The business owner would retain professional help (an investment banker or other advisor) to solicit interest from prospective investors.
     • The advisor would assemble an offering document which describes the business, details the proposed use of the $3 million investment, and solicits proposals.
     • Investors would make a proposal, valuing the business and thereby proposing what stake they would require in exchange for a $3 million investment.
     • Assuming the investors believed the business today is worth $10 million, they would subtract the $4 million of debt to determine the “pre-money” (pre-investment) value of the equity as $6 million. The post-money value would therefore be $9 million (the pre-money value plus the $3 million investment), in which case the investors would receive 1/3 of the stock in exchange for their investment of $3 million.
3. Paying Down Debt: During the credit bubble in 2007, a business owner expanded his business by borrowing $12 million to acquire one of his competitors. At the time, the business had $5 million of EBITDA, and the debt was easy to find. However, the debt will mature at the end of 2010, and he is concerned that with lower earnings (now $3 million), he won’t be able to refinance the $9 million now outstanding on loan. However, by bringing in a new investment of $4 million, he can increase the equity capital and pay down the debt, allowing the business to comfortably refinance. Here is how it would work:
   • • The business owner would retain professional help to solicit interest from prospective investors.
     • The advisor would assemble an offering document which describes the business, details the proposed use of the $4 million investment, and solicits proposals.
     • Assuming the investors value the business at 6x EBITDA, the total value of the business would be $18 million. The pre-money equity value would be equal to $9 million (which is the $18 million less the debt outstanding). The investor would therefore be investing $4 million of the $13 million “post-money” value, for 30.7% of the stock.
     • With the new investment, the business can pay down $4 million of the debt, and would therefore have to refinance just $5 million at year end.

If you are interested in recapitalizing your business, the investment bankers at Mirus Capital Advisors can assist you with evaluating your various options, and recommend the best solution for your business.  Contact me at fullerton@merger.com, or visit our website, www.merger.com.