Economics of a Recapitalization

A recapitalization is a financial transaction where a company owner decides to sell a controlling portion of his or her equity to a buyer in exchange for cash. The buyer is typically a private equity firm (PEG) that uses a combination of cash and debt to purchase the equity. The owner will normally keep a significant equity stake and retain day-to-day operating control of the business. A recap is an excellent option for the business owner who has created significant wealth in the business, wishes to reduce his financial risk or create some personal liquidity but doesnt want to sell the business currently and perhaps even has a desire to continue to grow the business. Here are some of the most common reasons a company owner would consider a recap: Achieve meaningful personal liquidity while retaining operating control of the business Remove personal guarantees on outside debt and use outside equity to support growth initiatives Expand through acquisition and/or add new products and services Provide equity incentives for the management team to ensure continued growth and success of your business

In a typical recap, a PEG would acquire a portion of the business, typically in the 80-90% range, although this can vary widely based on the owners wishes, and the owner would retain 20-40% in the newly restructured company, full operational control of the business and access to additional capital and resources. As an example, XYZ Tool & Die is a thirty-year old business with one owner, aged 52. In 2012, the business generated $25 million in revenue with an EBITDA of $3.5 million. The business has no debt. The owner feels the business could grow to $50 million through acquisitions but doesnt have the financial resources or appetite to assume financial risk at this stage in his career. To accomplish his objectives the owner entered into discussions with several private equity firms. The owner entered negotiations with several PEG and structured a recapitalization with one firm. In the first step of a recapitalization, the PEG values the business at $18 million, or 5.1X EBITDA. The PEG agrees to buy 86% of the business for $15.5 million and the owner agrees to reinvest $2.5 million, or 14% of the value of the company in the recapitalized business. The PEG and bankers decide the business can support $9 million in debt. The PEG invests $6.5 million in equity alongside the $2.5 million the owner reinvested. Consideration $18,000,000 $2,500,000 $15,500,000 % of Purchase Price 100% 14% 86%

Total Purchase Price Owner reinvests (tax free) Owner cash at closing

The following chart outlines the typical capital structure of a recapitalized business. Note that the $2.5 million the owner reinvested is worth 30% of the recapitalized business. That is because $2.5 million represents 30% of the total equity in the recapitalization. Additionally the PEG would set aside an equity pool for management. In this case, the management equity pool is 15% Recapitalization Total Purchase Price Debt Equity Owner PE Group Management Pool Ownership $18,000,000 $9,000,000 $9,000,000 $2,500,000 $6,500,000

30% 55% 15%

Assumptions for growth needed. The chart below shows three potential exit scenarios. Growth factors include organic along with the size and availability of acquisitions. The chart projects EBITDA based upon various sizes of successful acquisitions. It is assumed any acquisitions would be funded with a similar capital structure to the original recap, which would include bank debt, cash flow from the business and some additional equity from the PEG.

Exit EBITDA Exit Price (less debt) Owner Exit Management Exit

Low $6,000,000 $31,000,000 $9,300,000 $4,650,000

Medium $7,500,000 $45,500,000 $13,650,000 $7,250,000

High $10,000,000 60,000,000 $18,000,000 $9,000,000

An analysis of the recapitalization shows that the owner would receive from $24.8 million to $33.5 million between the initial recapitalization of the business and the final exit. This does not take into account any of the management pool of equity the owner may have chosen to give himself. In the medium and high scenarios, the owners second bite at the apple is almost equal to the original value of the business. The initial transaction enabled him to diversify his personal financial holdings and substantially reduce his risk to having the bulk of his net worth tied to one business. And the recap allowed him to gradually reduce his day-to-day responsibilities and focus on the growth and acquisition plan, which led to substantial upside at the end of five years.