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  2. Perspective
June 04, 2004 02:00 AM

Is it time for an equity partner?

Ira Kaplan
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    You've grown your business nicely since inception. However, current challenges have caused you to take stock of your goals. Your net worth is tied up in the business. Time to sell?

    Are you willing to make the investment necessary to take the company to the next level? You believe in its prospects, but you'd like to mitigate the risk associated with having your assets concentrated in one place. You would like to provide security for your family, but going to work still excites you. Additionally, there's the matter of the next generation: Your son or daughter has shown the ability to run and grow the business if given the resources.

    Externally, there are the challenges of manufacturing moving overseas. The company needs to come to grips with the need to outsource to withstand competitive pressures.

    Then there are acquisition opportunities. Consolidation is happening around you. Challenges and opportunities. Should the company undertake these challenges on its own?

    If your balance sheet and earnings are strong, you may want to consider a recapitalization of your company through partnering with a private equity or subordinated debt fund. There are substantial dollars available from both for good investment opportunities. Of course, partnering has its costs. There are issues that you should consider in going down this path.

    Consider whether you are prepared to give up economic and board control of your business. Whether you sell a majority or minority stake in the company, there will be significant board participation and “blocking rights” that your investor will have with respect to important transactions. Borrowing from a subordinated debt fund, however, will result in less dilution through the issuance of warrants.

    Recapitalization, or leveraged recapitalization, is a financing technique that is in favor among institutional investors. In a control investment, the existing owners will take substantial cash out of the business and give up board control, although there generally is an opportunity through some retained ownership to participate in the upside potential of your business a second time. This transaction will look and feel much like what it is, a sale of your business. You will have a seat on the board and an employment agreement. And, as is the case with all institutional investors, the investment in your business will have a life cycle, typically of five to seven years. Investors are your partners, but not for life. They also have investors to answer to and the way they do so is to look for an exit, which typically is a sale of the business.

    Another way to take chips off the table is to align yourself with an investor that will undertake more of a recapitalization of your business through purchasing a minority interest in the business, or through using debt financing to recapitalize the business, or a combination of both.

    If your balance sheet and cash flows are strong enough, you may be able to use debt financing to finance a substantial dividend to the owners. This is especially attractive given the low tax rate on dividends.

    Cash flow senior lending is more available today to finance these deals, as is subordinated debt. What the owners can take out will depend on the business's historical performance, including the predictability and stability of its cash flow. With this transaction comes the financial covenants that typically accompany a loan to a leveraged business.

    Also, most subordinated debt lenders will be issued warrants in your company that, when combined with the interest on their loan, will provide them the return they will insist on. Because their loans are subordinated to the senior lenders, these lenders are taking a near equity risk in your business and require a much higher rate of return than do banks and other senior lenders, although a lower return than pure equity investors. Subordinated lenders typically will not require board seats, but will have a board observation right.

    The advantage of using outside capital is the deep pockets that accompany it, often together with industry expertise and contacts that can fuel the growth of the business. Frequently, these investors have achieved in other businesses the success that you are interested in. They may know how to get sales to the next level, access foreign markets, provide the capital to bring the next product to market, or to expand geographically. They frequently bring outside advisers or directors to the table who can add substantial value to the enterprise.

    By and large, this all sounds pretty good. So what is the downside? You will have a partner that will not hesitate to insist on changes, including management changes, if it believes they are warranted. You will be reporting to a partner with a time horizon on its investment. Your business may be more highly leveraged.

    Those factors will require a mind-set change on your part. But you will have mitigated the risk associated with having your assets concentrated in a single investment and, if things go well, you will have a chance to achieve a second lucrative pay out. Given the right business and the right time in the financial markets, this is worth considering.

    Ira Kaplan is a partner in the Cleveland law firm Benesch, Friedlander, Coplan & Aronoff LLP.

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