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Below are two discussions focusing on equity and debt-related recapitalizations.

Recapitalization: Purchasing Equity

Private companies often have more than one shareholder and, from time to time, one of them may want to liquidate his investment. In this discussion, we will imagine an investor wants to sell his 20 percent stake in the company. The remaining four shareholders have an opportunity to purchase these shares but must arrange financing for the deal. The shareholders must determine how to value the shares being sold and how to fund the payout.

There are a number of methods for valuing the shares of a minority investor, including public company comparable valuation and discounted cash flow valuation.

Change-of-control buyout transactions often require that an investment banker analyze the company, assign a value and evaluate competing bids, although this may not be required if the five owners can agree on a share price. We will assume in our example that after some analysis and negotiation the owners determine the 20 percent stake in the company is worth $5 million. Now the remaining shareholders must determine how best to finance the purchase of these shares.

Funding the Payout

If the value of the shares being sold is greater than the company's cash balance, a third party source of capital is required. It is up to the remaining shareholders to determine whether they would prefer to finance the buyout with debt or with equity.

If the company's cash flows or assets can support additional debt, then the remaining shareholders are probably better off financing the payout with debt. This is because debt costs less, and is usually less complicated to arrange, than equity.

If the company has a lot of room to take on leverage, senior term debt is probably the solution because it is the cheapest form of capital. However, if the company's cash flows or assets will not support senior debt, another option is subordinated mezzanine debt. Subordinated debt, sometimes known as mezzanine debt, is long-term capital and is often the most appropriate financing for a minority buyout.

While debt is cheaper than equity, the remaining owners should consider that debt has a claim to the company's assets, whereas equity does not. This means the remaining owners will become junior to a debt provider in the event of a sale or liquidation. Bringing in a new equity provider does not subordinate the remaining owners, although it will require relinquishing more ownership in the company. Debt also imposes certain financial responsibilities on the company, such as interest and amortization payments, while equity does not.

If the company is uninterested or unable to fund the $5 million transaction by taking on debt, then it must find an equity investor. The process of finding an equity investor is the same in a recapitalization as in a buyout or acquisition. The company will need to circulate a business plan or offering memorandum to interested investors. To accomplish this, it may be necessary to retain an investment banker to help develop the memorandum and contact appropriate investors.

The task for the remaining owners is to find the cheapest source of equity possible. Just as the remaining owners had to negotiate a price with the outgoing shareholder, they will also have to negotiate a price with the new provider of equity. For example, although the minority shareholder is selling 20 percent of the company for $5 million, the new investor who is providing the $5 million for the payout will not necessarily receive 20 percent of the equity. It could be more or less, depending on the company's negotiating position and the investor's perception of the business.

The Mezzanine Solution

It is often difficult to purchase a minority shareholder's equity with senior debt. This is because equity is permanent capital and is the foundation of a company's capital base. Senior debt, on the other hand, is regarded as short-term financing. In the likelihood that senior debt is not appropriate for the buyout and the remaining shareholders don't want to bring in another equity investor, it is possible for them to increase their ownership without investing additional capital.

Mezzanine financing will often allow them to do this. Mezzanine is a type of subordinated debt which receives a portion of the equity in the form of warrants. This debt is quasi-permanent capital and is structured to take on much of the same risk as equity. However, unlike most equity investors, mezzanine lenders are accustomed to providing junior capital without receiving a majority stake. Mezzanine does not require as high a return on capital as equity because it receives a portion of its return in the form of interest payments and has a claim on the company's assets.

Finding mezzanine capital will require circulating a business plan or information memorandum to prospective lenders and evaluating their term sheets. The mezzanine lender usually requires representation in proportion with his equity stake on the board of directors.

Equity Considerations

Recapitalization: Refinancing Debt

Sometimes a company develops in such a way that its debt no longer matches its needs. Consider two examples:

  • The company is stronger than when it received financing and is able to find cheaper debt.
  • The company is weaker than when it received financing and is close to breaking its covenants. The current lender lacks confidence in the company. The company should replace the lender with a source of capital that will solve these problems.

Under the first scenario, the company should try to source capital that will move up its capital structure--debt that is, perhaps, more secured, more senior and, therefore, cheaper than its current debt. It should seek a lower interest rate, improve the terms of its advance rates and accelerate its amortization schedule to get the debt off its books more quickly.

If the company follows the second scenario, it will require capital, whether debt or equity, that is more aggressive than its current debt. If the company is still able to source debt, the debt will inevitably be more expensive than its current debt. This is because the lender is accepting more risk due to the company's flagging performance. Accepting more expensive debt is prudent if the company is breaking covenants, if it is unable to meet amortization requirements and if the current lender is unwilling to change the terms of the debt. Rather than risk default, it should seek another lender to replace the existing debt, extend the amortization schedule to meet the company's cash flow and write more flexible covenants.

Of course, debt may no longer be appropriate for the company in the second senario. Recapitalization may require equity. In such a situation the company must find an equity investor who will repay the lender in return for ownership in the company. Sourcing equity capital in this situation is the same as in other transactions, and will require circulating a business plan or offering memorandum to potential investors.