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Capstone Headwaters Report Exploring Leveraged Recapitalizations As an Alternative to Selling a Business

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Capstone Headwaters Report Exploring Leveraged Recapitalizations As an Alternative to Selling a Business Exploring Leveraged Recapitalizations as an Alternative to Selling a Business www.capstoneheadwaters.com Introduction to Leveraged Recapitalizations Many owners of mid-sized private companies spend much of their working lives building a business yet ultimately reach a point where they seek to enjoy some of the financial rewards of their life-long efforts. However, many of them soon realize that the bulk of their personal net worth is tied up in a singleasset–thecompany. Sinceequity positions in closely-held companies are fairly illiquid, most owners believe that it can only be monetized through the complete sale of the business, a belief that can sometimes lead to a decision to sell before the timing is right. Instead of an all-or-nothing ownership choice, however, many such private company owners have turned to recapitalizations(or“recaps”)asameansto“takesomechipsoffthetable” while continuing to operate and control the business going forward. Conceptually, recaps encompass a wholerangeofpossiblefinancial alternatives, from a modest re-leveraging of the business to fund a one-time dividend (a “dividend recap”) to the sale of a majority (but less than 100%) of the equity to an outside investor (a “majority recap”). Range of Financial Options to Gain Liquidity Leveraged Recapitalizations Do Dividend Minority Majority Complete Nothing Recap Recap Recap Sale No Equity < 50% Equity > 50% Equity 100% Equity Sold Sold Sold Sold Dividend Recap – In this structure, the excess debt capacity of the business is used to fund aone-timecash dividend to shareholders to provide a meaningful amount of liquidity without any dilution in the ownership or management of the business. Minority Recap – This structure involves selling less than half of the business (typically20%-40%)toan institutional investor, while providing a business owner with a greater level of personal liquidity and a well- capitalized partner without ceding operating control of the business. Minority recaps are typically used when the company’s debt capacity alone is not sufficient to meet the owner’s liquidity needs. The new investor will eventually need liquidity themselves which is typically triggered through an exit mechanism after a certain period of time (often five years) – at that time the company is often sold or the minority position is repurchased. Majority Recap – Often referred to as a leveraged buyout (LBO), a majority recap results in thesaleofmorethan half the ownership (60%-80%) and typically uses both debt and equity to finance the transaction. The business owner continues to have a minority ownership in the company post-transaction, a key operating role in managing the business, and typically enjoys what is sometimes referred to as a “second bite of the apple” when the investor eventually sells the business some five to seven years later. In each of these recap transactions, the business attracts incrementally greater levels of new capital to provide significant liquidity to existing shareholders while potentially meeting other estate planning goals of the owners. This new capital can take the form of debt or a combination of both debt and equity capital depending upon the amount of liquidity desired and the longer term goals of the owners. Illustrative examples of these recap scenarios are included in Exhibit A on page five. In the balance of this report, we focus on the first of these transaction scenarios, the dividend recap. Page | 1 Dividend Recap: An Effective Tool for Estate Planning Renewed interest in dividend recaps has emerged in recent years, driven by a confluence of economic forces including the formation of many new non-bank lending institutions, significant fundraising by new lenders, and relatively low interest rates that have made it easier and cheaper to borrow debt. Given the pressure faced by lenders today to put their money to work, the market remains quite receptive to dividend recaps. These transactions are not limited to professional investment firms and larger corporations alone but are increasingly available to owners of mid-sized private companies as a cost-effective means to meet their owner’s twin goals of wealth diversification and liquidity. Dividend Recap Example Background – Pickett Snack Company is a family-held manufacturer equally-owned by four shareholders (25% apiece). Financially, the company generates about $100 million in revenues and $12 million in earnings before interest, taxes, depreciation and amortization (EBITDA). In years past, Pickett had secured bank financing (secured by personal guarantees) that had been gradually reduced to only $18 million (or 1.5x EBITDA). Given the health of the overalldebtmarketandthe aggressiveness of lending institutions currently, this level of debt would be considered conservative in today’s market. Financing Transaction – After reviewing the financial goals of its shareholders and weighing the pros and cons of seeking outside debt and equity capital, Pickett shareholders decided to pursue a relatively conservative dividend recap. Through a competitive process conducted by an investment banking firm that targeted institutional lenders, management received several proposals before selecting a financing package consisting of both senior debt and junior debt totaling $48 million (4.0x EBITDA), a level modestly below the company’s perceived debt capacity. After refinancing the existing debt, the net proceeds of the capital raise were distributed equally among the four shareholders as a special one-time dividend. New Financing Structure – The new capital structure in this example consists of a revolving credit line, senior term loan, and junior term loan secured from institutional lenders on favorable terms that reflect current market conditions. Due to the shareholder dividend, Pickett’s overall debt leverage is now higher than it had been previously, yet still prudent in relation to the company’s credit capacity and levels that are common in the broader market. Transaction Results – By pursuing the dividend recap, Pickett’s shareholders were able to accomplish several key objectives: • Diversified (in part) their personal net worth away from the family business • Forestalled the date at which a complete sale would be pursued • Maintained complete ownership of the business among the shareholders • Secured competitively-structured debt capital with no equity dilution • Reset loan pricing, covenants, amortization, and other terms to today’s more aggressive levels while eliminating personal guarantees on the new company debt Page | 2 The Rationale for Dividend Recaps Private companies often reinvest their earnings and cash flow right back into the business and, as a result, their owners can find that the vast majority of their net worth becomes tied up in the business. Dividend recaps have emerged as a way for private owners to finance a one-time cash dividend as a means to gain partial liquidity, diversify their net worth, and meet other goals (i.e., eliminate personal guarantees on debt) while deferring the need to sell the whole business. While the financing strategy offers liquidity and wealth diversification to its shareholders, company owners should also consider the inherent risks and potential consequences before pursuing a dividend recap. The most obvious consequence of such a transaction is the creation of incremental debt on the business without any increase in revenues or cash flow, which could hinder a company’s ability tofunditsongoingoperationsor weather unforeseen events. Advantages/Benefits Risks/Other Considerations Diversification of family net worth Debt-funded dividends are too large to Take some “chips off the table” now while allow the company to weather preserving control of the business unexpected downturns Defer the need to ultimately sell the business Excessive leverage constrains operating Eliminate the personal guarantee on debt financial flexibility or limits ability to Reset loan terms (rates, covenants, pursue new opportunities amortization) to today’s more favorable levels Additional reporting requirements Candidates for Dividend Recaps While attractive, dividend recaps are not a viable option for every shareholder nor every company. For older business owners who plan to retire soon, a complete sale of the business to a strategic buyer likely makes the most sense. However, for more middle-aged owners, a dividend recap may represent a good solution to protect their personal net worth while continuing to control, manage, and grow their business until retirement becomes more imminent. Furthermore, not every company is a viable candidate for a dividend recap since the primary requirement is the ability to utilize new debt in the form of asset-based and/or cash flow-based financing to fund the transaction. Highly-leveraged businesses, volatile or capital intensive businesses, and those experiencing financial difficulties find it difficult to pursue such a transaction. Characteristics of ideal dividend recap candidates include: Prime Shareholder Candidates Prime Company Candidates Owners with majority of wealth concentrated Current outstanding debt is relatively modest in the business History of revenue growth and profitability Owners seeking some personal liquidity but History of consistent, predictable cash flows not near-term retirement Modest capital expenditure requirements Strong company (defensible market position, minimal regulatory or technology risk) Deep and experienced management team Lack of customer concentration Positive
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