SUCCESSION PLANNING
Eat your cake and have it, too

The leveraged recap can be a viable alternative to selling the family business--especially when the company still has good years ahead

BY MIKE COHN

Phil Burns had built his manufacturing business in California from modest beginnings in a rented warehouse. After 30 years, the private company was an industry leader, with over $100 million in sales. The company needed to expand and had identified an attractive business in Europe that could be acquired for a reasonable price. The target company also had relatively new equipment, which could be easily modified to grow the company’s burgeoning international business.

Phil’s daughter was the company’s CFO and in a few years would be ready to take over the company. Phil was excited about his company’s prospects but was also concerned that most of his net worth was tied up in the family business.

At 67, Phil was approaching retirement and sometimes worried about still having all of his “chips in the game.” He knew he could sell the business but wasn’t ready to take that step. The potential European acquisition would require personal guarantees for the financing. Phil found himself uncharacteristically waffling on the decision to buy the European company.

Across the US in Connecticut , Tom Orkisz had a different dilemma. His dad had been a brilliant entrepreneur and started a business manufacturing “snap-lok” plastic boxes to hold bakery products and other fresh foods. The senior Orkisz had designed a clever locking mechanism to keep the box closed and keep food fresh.

Tom had been running the family business for five years and becoming increasingly concerned about his dad’s procrastination regarding succession planning. Business had been good, and the company was growing rapidly.

Tom worried that if something appened to Dad, he would have to buy out five siblings who were not involved in the business. In Tom’s case, time ran out when Dad died unexpectedly of a heart attack.

Tom’s dream of growing the business into an industry leader seemed blocked by almost insurmountable family, tax, and legal problems relating to his Dad’s unplanned estate. Dad had recently divorced. An estate tax would be due plus a sibling buyout would be required for Tom to continue the family business.

In both of these cases, a leveraged recapitalization (“leveraged recap”) was used to solve tough problems. For Phil Burns, the leveraged recap allowed him to sell 80% of his company and create personal liquidity, reduce his financial risks, and diversify his assets. Phil also continued to run his company, acquire the European business, retain a 20% stake in his company’s future, and importantly, continue to prepare his daughter for the CEO role.

Tom Orkisz used the leveraged recap to raise capital to buyout siblings and then with the family problem resolved he negotiated with the IRS to finance the payment of his Dad’s estate taxes over a 15-year period.

Are leveraged recaps a new animal? Jim Dwyer, of MPI Securities in Princeton , explains that leveraged recaps emerged from the leveraged buyout days of the 1980s and 90s.

According to Dwyer they have been become popular for two reasons:

1. accounting rules often make recap accounting more attractive to a company’s income statement than goodwill accounting which occurs when a company is sold, and
2. equity investors have learned that a number of successful private company owners want liquidity but also want to participate in the future growth of their businesses.

Who Are These People?
Private equity groups, such as New York-based ZS Fund, raises its capital in a private equity fund from institutional investors such as Chase Capital or from wealthy investors such as the Hillman family of Pittsburgh. Another private group, de Visscher & Co. of Greenwich, CT, used the resources of Philadelphia's Pitcairn family to help them launch their Family Capital Growth Partners LP. Heritage Partners was formed by a group from BancBoston who saw an opportunity to invest in middle market companies.

These equity groups are investors who generally seek 25%-35% annualized rates of return on their investments. The rate of return for the investor is typically realized from three sources: upfront fees, an annual coupon or dividend during the investment period, and a value-realizing-event from selling, refinancing, or taking the company public in five to seven years and getting out.

A particular fund will invest in a number of companies to gain diversification for its own investors and reduce its risks. Their minimum investment may be as low as $3 million but typically is $10 million or higher.

Are You a Candidate?
The criteria to get the attention of an investment group varies but is typically $5 -$25 million of pre-tax income (operating profit), a strong management team, a high return on capital relative to industry peers, and a strong market position.

Bob Horne of the ZS group notes that most entrepreneurs are debt averse so the leveraged recap is especially attractive because it puts cash in the owner’s pocket, and then ZS goes on the hook for corporate borrowing to fund the target company’s growth initiatives. Any debt that ZS acquires is non-recourse to the family receiving the funds.

Horne notes that the leveraged recap is not for the entrepreneur who needs absolute control, or believes his or her business has peaked. ZS is similar to other investor groups in characterizing their role as a quiet partner, not as an operator. Horne explains “we sit on the company’s Board, help with strategic decisions, and through our resources we can provide growth capital. Our ideal candidate is confident in their own abilities, is receptive to having a partner and welcomes what a partner can bring to them. They learn that after the transaction, day to day life is the same.”

Horne notes that only about 5%-10% of the businesses in which they invest have credible business plans and forecasts at the outset. An owner who knows her business, has an industry niche, and a good track record is more important. One of the outcomes of the due diligence process (described below) is that a plan is usually developed for the bank, for the new equity partner and for management to understand expectations.

Due Diligence Process
Due diligence is a two-way street for the current business owner to find the right partner and for the equity fund who is the potential investor to be convinced it’s the right deal for them.

For the business owner it should involve a search to determine which investment group you can best “partner” with. Some of the equity funds will invest only if they can buy a 50%-80% interest in your business. Others will agree to take a minority interest of less than 50%. Some will want a more active role and others will be more of a silent partner.

So, before you start shopping for an equity investor, you may want to hire an investment banker, or put together an advisory team to help you make the right decision with the right people. Jim Dwyer, of MPI Securities, points out you might want to work with a strategic partner instead of an equity investor to help you realize your goals. As an example, Ford or IBM might be a strategic partner who can provide capital as an alternative to an equity group.

Dwyer suggests five questions you should ask a potential investor in your business so you can better understand their view of the world:

• What is their transaction record? How long have they been in business, what types of companies do they invest in, for how long, and with what experience.
• What is their relationship with their capital sources? New relationships can get anxious if there is an economic downturn and push for a faster exit than originally anticipated. On the other hand, if their investors keep rolling their money into new funds with the same group it’s a good sign of investor satisfaction.
• What is their record of closing transactions? The due diligence process can take up to six months which is a lot of time to spend “courting” if you are not sure they can close a deal.
• Will they let you talk to some of the companies they have invested in? What kind of partner have they been after the deal is done?
• What’s their portfolio strategy? Is it short or long term? Are they patient or activist investors? Can they tap foreign markets? Do they bring in new management?

After you have done a search and decided which investment group you want as your partner, their due diligence process can take up to six months. They will want to understand your company financials, so audited statements can be a plus here. They will also focus on your company’s cash flow. Are you generating positive cash flow or are your profits tied up in receivables or inventory?

Don’t be surprised if there is also some inquiry about family issues. Jim Murphy of deVisscher & Co. notes their fund invests in family businesses so “we also want to get comfortable with the family stockholder group. Is there a family council? Is the family “on board” with the plan?” Family conflict may be just the reason the leveraged recap is attractive—to be rid of troublesome shareholders. But make sure that the decision-makers are behind the buy-out idea before spending time and money pursuing an investment group.

The next step may be a Letter of Intent (LOI) describing in general terms what you are trying to accomplish. Once you have signed the LOI you’ve committed to the process. Next comes detailed due diligence which involves your CPA and attorney and, if the investor group gets your permission, they may want to talk to some of your customers and suppliers. If your business is difficult to understand they may hire an industry consultant to help them learn more about your prospects and risks.

They will then do their own internal valuation analysis of your business so it helps if you have already done some of your own modeling so you can anticipate their numbers. Once they are satisfied, they bring in their own lenders to finance part of the transaction.

There may be three sources of capital in structuring your particular deal. One source is obviously the investor group who is putting up the equity. But their equity may only be 25% or so of the total funds. The balance will come from banks in traditional and/or mezzanine financing. The debt portion of the deal will depend on a number of factors including current market conditions and the bank’s outlook for its own loan portfolio.

For example, financing in 2001 is considerably tougher than it was in 2000 meaning that the cost of borrowing for your equity group will be somewhat higher. Since your investor’s cost of borrowing is more expensive, they will generally look for higher returns to justify their investment.

A lender such as Fleet Capital in Boston may provide the senior financing while a mezzanine lender may provide subordinated debt (junior to the senior lender) or structure their “piece” as convertible preferred stock, which has characteristics of an equity investor and bank debt.

How Deals May Be Structured
Bob Horne at ZS described a typical structure with an S corporation, a $50 million market value and no debt. ZS creates a new LLC (limited liability company) and capitalizes the LLC with $42 million; $12 million of it from a ZS equity fund and $30 million borrowed. The LLC then purchases 84% of the S Corporation for $42 million.

Assume the S corporation has a $25 million book value reflected in the company’s previously-taxed but undistributed retained earnings. By selling 84% of the company to the new LLC the owners recognize taxable gain only to the extent of 84% of the amount received in excess of the $25 million. The owners retain 16%, become a member of the LLC and are then entitled to 16% of the future profits of the LLC.

Figure 1 illustrates this concept:

What About Control? How Patient are the Investors?
Equity investors who are providing capital to support a business growth plan may be content with a minority investment as long as no cash is going out to existing shareholders.

When cash is being withdrawn to buyout family members or other shareholders, or simply to provide diversification and reduce the owner’s risk, the equity investor typically will want to acquire a controlling interest in the business. But even a minority investor will want some provisions to protect their investment.

“Protection” for the equity investor may take several forms. One is “observation rights” on the company’s board. They are invited to attend meetings but do not vote (and therefore avoid liability).

Or, they may require a change in the company’s bylaws to require a super-majority vote on certain issues or special consents. Examples of decisions that might require special consents include corporate borrowing in excess of a stated amount, shareholder distributions, changes in compensation or bonus plans, capital expenditures, and budget approvals.

Furthermore, most equity investors will want a “put” right so they can sell their interest in the business back to the company after five or six years. The price may be the higher of fair market value, or a formula price reflecting their original investment.

Rarely do equity investors claim to exercise their put right since the plan is to grow the company for five or six years and then either sell it, do an IPO (initial public offering), a new leveraged recap with a new equity group, an ESOP (employee stock ownership plan) or a new refinancing.

Equity investors are patient as long as management is achieving or exceeding the business plan, although they all recognize there are events outside of one’s control that cause plans to go awry. Good communication with the investor group is a must to keep everyone in the loop on how the business is, or is not performing, after the deal is done.

1. Bob Horne notes that when a company doesn’t perform as projected, the problem is typically the company’s market (the market changed),
2. management (not as strong as expected), or
3. the economy weakened and negatively impacted the business. The company may be asked to buy out the equity investor if the deal is not working. Horne captures the dilemma: “we are not heavy handed but we need to do right by our limited partners.”

After the Deal is Done
Years down the road are the former owners happy? If they had a good business and a good plan at the outset, and know how to take advantage of the partnership that equity investors provide, the answer is generally “yes” because of several reasons:

• The psychic pleasure of seeing your “baby” (the family business) grow as the result of the financial and intellectual capital contributed by the investor group.
• The business may be more successful because the owners reduced their personal risk and as a result were willing to take more business risk. Horne observes “it’s like taking a thoroughbred racehorse and entering it in more races.”
• The risk profile of the business owner changes. There is a tendency to say “yes” to new ideas instead of “no” when you are not using 100% of your own money.
• The investor group can help the business owner do acquisitions for their own account. One viable growth strategy for family businesses is to buy other family businesses in their industry who have not solved their own succession plans. The investor group brings financial resources and experience to the acquisition process.

The leveraged recap can be a viable alternative to selling the family business—especially when there are good years ahead for the company. For next generation family members who want to run the business, they can learn discipline and gain important skills in the five to six year period of involvement by an investor group, while knowing that at some point the family business may revert back to 100% family ownership.

The process of considering the leveraged recap can also bring up unresolved issues about the business that need to be addressed. So, whether you pursue one or not, the concept may be worth kicking around.