Understanding Recapitalization and Its Effects On Your Business
Deciding when to sell a business can be a complex challenge for any owner, but this is especially true in the software industry.
The current market is buzzing with activity across all product categories and verticals. The world’s reliance on technology solutions has grown exponentially and doesn’t show signs of slowing down. It’s also natural for someone to want to retain something they created. You see great potential in your company, and you want to be part of the company’s path forward. Selling 100% of your company too soon could be the mistake you kick yourself for years to come.
But going all-in on one venture is risky, too – both financially and strategically. Who’s to say how long the market will see sustained growth? Or that one type of software solution will flourish while others take a hit? Or even that your team has everything it needs to reach the kind of growth you envision?
Business ownership doesn’t have to be as cut-and-dry as stay or sell. There are options that allow people to keep part of their business without taking on the full risk of having all their proverbial eggs in one basket.
Recapitalization offers owners the opportunity to retain a portion of their business while gaining capital infusion from investors, as well as the organizational and industry expertise that comes with this type of partnership.
In this post, we’ll cover what you need to know about private equity recapitalization, including why it’s seen as a viable option for ownership and what to expect from having a private equity partner.
What is a Recapitalization?
Private equity recapitalization is the process of bringing a new majority owner into a business. Essentially, recapitalization allows owners to sell a portion of their business while retaining enough to benefit from the company’s future growth.
Let’s say someone sold 80% of their business to a private equity (PE) firm for $100 million. Of that $100 million, $80 million goes to the company’s shareholders. The remaining 20% of the business is retained by the original company going forward. The original seller now has a minority stake in the business and can invest their money in other pursuits. Then, they would likely have an opportunity to retain that equity piece or sell all or a portion of it 4-5 years down the road when the next transaction occurs.
There are also minority recapitalizations (where companies sell less than 50% of their business), though this isn’t as common in private equity. PE firms are most often approached by people either selling 100% of their business or a majority of it, as we outlined in the aforementioned scenario.
Can Companies Plan for Recapitalization?
Although recapitalization isn’t the same as an official exit, it’s a similar enough option thatit can be planned for in terms of having updated financial records and relevant business information in order.
As companies grow, they can reasonably anticipate that they will eventually need better, more strategic leadership to take them through higher and more complex stages of growth. SEG’s Kris Beible notes that as companies reach $5 million to $10 million in value, they’ve hit a point where they need to start “professionalizing” their business. Companies with a firm grasp on their own leadership limitations, then, could plan for a recap.
Certain industries are also more likely to plan for recap than others. It’s common for software companies to plan for either a complete exit from or a reduced role in their own businesses, even as they’re diligently striving for their company’s success. Understanding the typical ownership patterns of your industry can help you determine if a recap is worth planning for.
Four Main Reasons to Consider a Majority Recapitalization
There are many reasons why company owners consider recapitalization a potentially beneficial ownership option. Let’s take a closer look at some of the more common scenarios when recap could be the smartest route.
The company owner wants to stay involved in some capacity
M&A is common in the software industry, but that’s not to say that every executive is ready to remove themselves from the business they’ve been part of since day one.
Demand for SaaS is high:SaaS deal volume grew 40% in 2021, and valuations are skyrocketing across multiple verticals. Given this, it makes sense that people in this industry would be highly interested in retaining part of their companies, even as they pursue other opportunities. A recap is a way to ensure they benefit from this growth.
Companies may consider recap during a down market. Ownership may want to retain a portion of their business because they believe the market will turn but want to de-risk in the meantime. Plus, the company could use the infusion of cash to get by in the down market.
Maintaining some ownership could even be as simple as wanting to stay involved with a company they built. Even if they are less involved in day-to-day operations and have a more passive role on the team, some people want to keep a level of involvement in the company they built from the ground up. Recap offers that kind of flexibility.
Shareholders want to realize liquidity for their aggregate efforts
The main reason for recapitalization in PE is to gain liquid assets for your business. With a majority sale of the business, companies receive an infusion of cash for the work they’ve done thus far and can accelerate the company’s future growth.
Beible explains that at a certain point, founding leadership realizes the limits of their skill set, “but they still see massive opportunity in the marketplace for their business to grow. If they’re going to give up control [in their company], they might as well sell and see a good amount of liquidity. If you’re going to hand the keys over to someone else, you want to see a majority of money or liquidity coming in.”
Fund business expansion by selling to an experienced partner
As we mentioned earlier, businesses hit certain inflection points where they’ve grown as much as they can with their original team. In these instances, it benefits companies with long-term visions to bring in people with more experience and money to capitalize on the right growth strategies.
PE firms can provide the organizational and operational expertise that growing companies need to reach the next level. Companies seeking PE partners must be certain both parties share a vision for growth to ensure a harmonious partnership.
Reduce financial burden and/or pay down debt
Business ownership can be risky. Every industry has found itself at the mercy of a down market at some point, and even the best forecasts can’t accurately predict market performance 100% of the time. Leaders see recap as a way to reduce their risk (i.e., less of their own money is tied up in the company, and they’re not as personally affected by market fluctuations). Much of the perceived risk is now on the PE group as the company’s majority owner.
Reducing financial risk through recap also allows people to diversify their net worth. With fewer assets tied to the original company, they can invest in other business pursuits and create more options for the future.
What is the Recap Process?
Depending on a company’s level of preparedness, recapitalization might take several months – or even longer. Maintaining accurate business and financial records is always a smart idea, but it’s especially important for companies planning for recapitalization as it can streamline the process and move the deal along more smoothly.
Consulting anM&A advisor with majority recapitalization experience is another way to ensure efficiency. M&A advisors bring a depth of industry and market knowledge to help navigate your way through the variety of PE firms seeking partnerships. They can also provide guidance on optimal deal structure. Their services are key to making sure every option is thoroughly researched and knowing whatever structure you choose makes the most sense for your company.
Additionally, M&A advisors can draw from a wide network of PE firms to find ideal candidates. They can align your vision for the company’s future with investors who have the necessary resources to achieve those goals.
Similarly, PE firms want to invest in people who are excited about the future of their company. They want a partner who is equally committed to improving the company’s performance and recognizes when they need new leadership and resources to perform at the next level.
Most majority recap partnerships last three to seven years (five is considered average) before the PE firm prepares to sell the business. As a minority shareholder, the original owner doesn’t have the power to decide who the PE firm sells to. However, if it’s a good partnership, both parties will have already agreed on what would make sense for the company going forward.
Regardless of who the PE firm sells to, the original owner has a few options.
retain their stake in the company.
sell their stake and make a complete exit from the business.
sell a portion of their business and still retain a portion of their business.
What Business Owners Can Expect After Recapitalization
Business owners pursuing recapitalization should expect certain things to change post-ownership. These changes are imperative to the company’s growth and are enacted with the goal of the company becoming more professional with new management guidance. PE owners are motivated to pursue growth on behalf of everyone with an equity stake in the company, which requires making essential and strategic changes.
In many ownership situations prior to recap, a single owner will manage their business the best way they see fit for as long as possible; however, that way may not be sustainable for a number of reasons:
Their business model may not necessarily follow industry best practices.
The current operating tactics can’t achieve the growth the company is capable of.
They don’t have a financial model (or the right one) to operate from.
They’re not measuring the right growth metrics.
With a recap, PE owners are brought in to expertly guide the company toward its full potential through proven methods, like:
Expanding more opportunities to people by creating different company roles.
Creating and operating against financial models.
Developing company- and department-specific KPIs and goals to target.
Meeting to assess performance on a monthly, quarterly, and annual basis.
Holding quarterly board meetings.
Developing a detailed succession plan to sustain the business through unforeseen circumstances.
These changes can be a lot to process for entrepreneurs who have been committed to running the businesses their way. In some instances, owners will choose not to actively participate in making major changes, letting the PE owners handle them instead. Other times, minority owners see this as an opportunity to learn. Gaining a better understanding of why these new practices are necessary and how they will benefit the business over the long term can help them be a better CEO in future business ventures.
M&A advisors with recap experience can help prepare entrepreneurs for these shifts, how they serve the business’s best interest, and what these moves mean for the company’s future.
The changes that come with recapitalization happen for a reason: to provide upward mobility for employees and ultimately make the business stronger.
Recapitalization affords founders the benefits of ownership without shouldering all of the financial risk. Though it can be a complex undertaking, the right partner and strategy can drive significant growth and better performance for your company in the long run. Learn how our M&A advisors can get your majority recapitalization on track byreaching out today.