Recapitalization in private equity, also referred to as “recap”, commonly refers to the process of restructuring a business’ mix of debt and equity.
The goal of a recapitalization is often to rebalance the company’s capital structure. To do so, investors exchange different forms of financing with one another.
As a result, the business’ debt-to-equity ratio will change by either adding more equity or debt to the balance sheet.
Specifically, leveraged recapitalization refers to a private equity strategy in which the target business takes on a significant amount of added debt. This strategy serves the goal of either paying out a dividend or a share repurchase.
Recapitalization is a popular option leveraged by founders looking for a partial exit.
More specifically, in a majority equity recap, a private equity investor can buy out a majority of a founder’s shares. This creates a large one-time liquidity event for the founder, as most of their interest in the business is bought out.
Having sold a controlling ownership stake, founders can then decide to stay involved in their venture’s operations or leave the day to day behind.
The benefit of a majority recapitalization is that the founder can sell their remaining equity once the business is sold again in the future.
This second liquidity event is a great hedge for the future upside of the business and can often be very lucrative if the private equity investor is successful in increasing the company’s valuation over time.
While a founder might phase out of the operations of the business, recapitalization is also an opportunity for the management team to buy or earn equity in the company they are running.
Many private equity investors actively encourage these management buy-ins in order to align incentives with the leadership team once the founder or founders have left the company.
Companies can employ recapitalization as a strategy for multiple reasons.
Retirement may not be on every entrepreneur’s mind, but majority recaps offer a great way for founders to take some cash off the table without losing all financial upside in their business.
In case retirement is actually the founder’s aspiration, recapitalization allows them to leave the company’s operations while keeping some equity. With this strategy, future dividend payments can be secured for example.
Another reason for a recap can be changing the equity distribution within the company. Shifting ownership from one partner to another is common during the transfer from one generation to the next.
Another shift in ownership can be done when transitioning more involvement to the management team, as discussed.
Lastly, raising growth capital can be a strong motivator for a recap. In order to pursue a big growth opportunity, onboarding a financial partner to infuse the company with capital can be done with a recap.
Minority recaps are an alternative to both majority recapitalization as well as full acquisitions. Here, an investor provides equity capital and debt in exchange for a minority stake of the founder’s ownership in their business.
In a minority recapitalization, less than 50% is sold. Most commonly, the stake acquired by the investor lies somewhere between 20% and 49%.
Similar to majority recaps, the minority equivalents can be used for founders to achieve some liquidity without losing future upside.
The main difference lies in the fact that the founder remains in control of their business. They tend to stay actively involved in the business’ day-to-day activities.
The proceeds from the ownership transfer can be used for shareholder liquidity and / or the pursuit of growth opportunities.
A minority recap (also referred to as a “minority acquisition”) can be leveraged by founders in different circumstances.
One example could be that shareholders have diverging goals. A co-founder could look to exit the business while another one would like to continue to operate the business. Here, the leaving founder could sell their stake in a minority recap.
Diversification of wealth is a goal that many founders have but few can attain. Most founders see their entire net worth tied up in their business. Minority acquisitions help them take money out and reinvest it in other assets.
Another valid case can be onboarding a strategic partner. These partners will likely want to participate in the value they create for the business, hence founders are encouraged to part with some of their shares.
Raising growth capital can also be achieved through recapitalization in order to fuel future growth.
But before considering a minority recap, the business should still be growing quickly. Investors are much more likely to grant entrepreneurs an option for liquidity if they can participate in a company with plenty of upside potential.
All in all, minority acquisitions primarily make sense if founders want to take some cash off the table, while staying in control of their business.
Diversification of wealth, onboarding new partners or a changing cap table can be motivators for such deals.
On the investor side, minority recaps can be interesting to participate in a business’ value creation without losing the founder or to get a foot in the door and gather insights before acquiring a majority stake.
Majority recapitalization, on the other hand, helps founders partially exit their business to hand over operations, while staying invested in their company.
Transitioning ownership, and involvement of the management team are great reasons to motivate a majority recapitalization.
Further resources: Investopedia, SBDC, Exit Promise, NB Group
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