Recapitalization: Everything You Need to Know
Recapitalization (recap) takes place when a company undergoes a restructuring of its financials and debt and equity are re-assessed and re-allotted.17 min read
What Is Recapitalization?
Recapitalization happens when a company undergoes a restructuring of its financials. When this occurs, debt and equity are re-assessed and re-allotted. Usually, the goal is to improve the company's overall stability or status. Recapitalization may also be done in an attempt to optimize the company's structure for its capital. It generally occurs with the exchange of one type of financing for another. For example, shares may be exchanged for bonds.
Recapitalization is the way to organize a corporation's capital structure, including stock ownership and the rights and liabilities connected to each class or genre of stock. For shareholders of a business held together, this type of recapitalization is a nuanced, progressive strategy. In this sense, when undergoing recapitalization, a business is literally reorganizing — rights are being reorganized as they relate to stocks. The process is also called reorganization and involves dividing the rights associated with the company's stock.
Why Consider Recapitalization?
A business might choose to swap equity for debt or debt for equity for a number of good reasons. Recapitalization may be done to:
- Defend against a takeover.
- Decrease taxes.
- Find a new strategy in the middle of a crisis.
- Accommodate venture capitalists.
- Improve net value and liquidity.
- Allow venture capitalists to exit the business.
- Prevent a drastic drop in stock price. If the price of a company's stock suddenly goes down, the management may consider recapitalization in an attempt to prevent further drops in the price. This situation is the most common use of recapitalization.
- Prevent a takeover. If a company is on the verge of a hostile takeover by another company, recapitalization may be a prevention strategy. Taking on more debt could make the company look less appealing to companies that may be considering an acquisition.
- Reduce the burden of finances. A high debt-to-equity ratio often requires the payment of high interest rates and puts more financial burden on the company.
- As part of a bankruptcy proceeding. If a company has filed for bankruptcy or is facing the threat, recapitalization may be part of the strategy to reorganize. Any capital structure changes must satisfy all involved in the proceedings, including investors, creditors, and the bankruptcy court.
Types of Recapitalization
There are various types of recapitalization and many strategies to consider, including:
- A company exchanges debt for equity or vice versa. An example is if a company chose to issue debt to purchase its equity shares.
- Stock is issued to make a purchase of debt securities. This raises equity capital compared to debt. Debt investors also need partial payments when their principal matures. This exchange can help a company maintain the cash it needs to pay equity holders.
- A company exchanges one financing form for another. For example, it might choose to remove preferred shares from the capital structure of the business and swap those out for bonds.
- A company gives debt incentives and then uses the cash to purchase shares or dividends. This literally capitalizes the company, increasing its debt. A benefit is that interest payments are tax deductible. The interest decreases the tax bill and increases capital returned to investors.
- During financial hardship, governments recapitalize across the country's banks. This is especially true when the value of the banks and financial markets are decreasing.
- A company may also issue bonds and use the funds to purchase its own stock shares back. The U.S. government did so throughout the Troubled Asset Relief Program (TARP) of 2008.
How Does Recapitalization Happen?
The recapitalization process must be approved by most of the company's shareholders. Then, a readjustment of a firm's capital structure occurs in one of these ways:
- Giving new stock shares.
- Trading bonds for stocks as a portion of a leveraged buyout.
- Redistributing once bankruptcy has occurred.
Corporate Recapitalization Strategies
You own a corporation with a close friend. In the corporation, there are 100 shares of outstanding stock issued and one million authorized. You own 75 percent and your friend owns another chapter, holding 25 percent. To recapitalize all of the stock, you initiate non-voting, common stock. This stock is issued with objectives, requirements, and your shareholders.
At the end of the recapitalization, you retain 75 percent and the other shareholder has 25 percent. However, the investment has been fundamentally altered — the division of voting and non-voting power has taken a toll on the value of the stock in light of the discounts for lack of control. Once this reorganization takes place, you give up all of your non-voting shares to your heir.
Here, you again separate the authority to control from the hands-on work. Your heir has 67.5 percent of the business, but since the heir's stock is the non-voting kind, it's not a controlling impetus. It carries a lower financial value in the market because it does not signify the sort of authority or power that voting stock does. You now only own 7.5 percent of the business yet you retain complete control over the work. It is a good strategy when used alongside other methods. Examples include gifting programs, sales ventures, and an Intentionally Defective Grantor Trust (IDGT).
Recapitalizing a corporation is most commonly done to arrange the rights of the stock to be as similar as possible to the structure of a limited partnership.
If equity was replacing debt in a company's capital structure, an example of this would be if the business issued stock as a strategy to purchase debt securities. As a result, that business would increase the proportion of equity capital to debt capital. An investor will require a business to routinely pay down its debts and return any principal upon the terms of maturity. Swapping debt for equity can be done to help a company use and maintain its cash flow for business purposes, for capital returns to stockholders, or for reinvestments into the company.
If the company chooses to use the funds from issuing debt to issue dividends or purchase stock back, recapitalization has taken place because the ratio of debt to equity has increased in its capital structure.
After recapitalization through moving stocks, the power to vote is maintained only by a certain number of shareholders — much like a general partner within a limited partnership — and most of the stock is owned by shareholders who don't move. In this sense, a recapitalization allows you to separate out the business itself from the means you use to advance it. You still own the tools and the rights, but you are slightly more removed from the practice.
Think of the business as a remote control and a TV. By recapitalizing, the business owner can retain the remote control but will no longer own the TV. In this example, the TV is the stock that doesn't include voting rights and the remote control is the stock that does retain its rights to vote.
Leveraged Recapitalization Strategy
Leveraged recapitalization is when a company takes on more debt in order to submit a significant dividend or to buy shares. In the end, the company can turn out to have improved financial standing — even though this seems contradictory to how debt is normally seen. This positive status is known as being in excess of the "optimal" debt capacity.
If a nation's or company's debt becomes larger than its equity, the profits it reaps per share will decrease in reaction to that change. However, the shares will eventually become more stable because the company will have less debt overall. That means there are fewer costs, vis-à-vis payments and principals to be given. Without the debt, the company can enjoy higher profits and pass them along to shareholders.
Once the dividend has ultimately been submitted and paid off, the market value on all the shares will fall. When a financial recapitalization causes a price to go down to 25 percent or below its previous value, the share is known as a "stub." If the recapitalization is a positive one, then the dividend and stub values will be higher than the pre-recap share price.
Further value emerges from the tax shield as the company, which now has a debt capacity from cash which is higher than what it needs to sustain itself, increases its leverage. To calculate this, the Modigliani-Miller formula multiplies the debt by the company's tax rate.
This strategy may be used to prevent a serious or potential financial crisis. Debt is used to intentionally limit usable cash and debt capacity. Bidders may come back to the company to find calculations that are closer to the past levels. Meanwhile, the recapitalization also gives the managers a larger percentage of ownership and authority. Of course, many such recapitalizations are intended as a takeover. Companies that use this strategy are often quickly bought out.
Leveraged recapitalization can be a productive strategy, with cash flowing into shareholders' hands. Debt can provide a sense of organization and obligation that improves performance and duty, and that new efficiency can boost shares. Across the board, positivity seems to be the usual response from the market.
Under this type of buyout, the ratio of debt to equity will increase significantly, resulting in a change to the capital structure.
Case Example: Sealed Air's Leverage
Sealed Air's Leverage, HBS Case 9-294-122, occurred when the head members of a company attempted recapitalization as a watershed tactic. This created great distress, adjusted compensation systems, and switched manufacturing methods. Financing divisions greatly impacted the entire company's structure, management, and value.
This situation teaches us that the main concern when it comes to recapitalization is whether operating improvements are made. Monitor the post-recap balance sheet. If a company is on the right track, then the major debt responsibilities will encourage management to increase efficiency and cash flow in order to pay off the debt.
It's also important to give claim holders the chance to exchange their holdings. For instance, shareholders might be allowed to exchange their bonds for shares or vice versa.
You might assume that no one would actually choose to trade one security for another unless the new one was worth more. However, research suggests that some exchanges lead to negative financial results in the negative while others yield positive net returns. It all depends on which of the following effects an exchange has:
- The leverage goes up or down.
- There are implied increases or decreased in future operational cash flows.
- There is an implicit undervaluation or overvaluation of a commonly held stock.
- The share of management ownership goes up or down.
- Management control over cash goes up or down.
- There are positive or negative signaling effects.
Taking these into consideration, you can understand the effects of various types of trades. For example, when you exchange common stock for debt, you receive a net return of 14 percent. When you change common stock to preferred stock, the return is 8.2 percent. You should be able to evaluate the net effect, positive or negative, of various types of exchanges.
Dual-class recapitalizations are even more intensive. They create a second class of common stock with limited voting rights as well as a preferred claim within the company cash flow via a high dividend. For instance, the company may propose to create one type of share with five votes and another with only one vote but much higher dividends. In these cases, it is often the heirs or family who have the high-vote shares.
Most of the time, the firm reveals a new setup as it gives out its voting shares to present shareholders. The shareholders then sell the limited right shares to the public, confirming the objective of the business' security.
Another type of recapitalization is an equity recapitalization. In this situation, a company will issue new shares of its equity to raise funds that will be used to purchase debt securities back. For companies with high ratios of debt to equity, this move can be extremely beneficial. When the ratio is high, the company takes on a bigger burden in that all debt securities have interest that must be paid. Additionally, high levels of debt can make a company look less attractive to a potential investor because of the increased risk.
In certain cases, nationalization is an option for an equity recap. In this situation, the government of the country in which the business has its headquarters purchases enough shares of the company's stock to take control. The purpose of nationalization is to save a company from bankruptcy that proves to be valuable to the economy of that country. Nationalization might also occur if a business has acquired assets illegally and the government needs to seize those assets.
Benefits of Recapitalization
Some business people mistakenly believe that selling to a private equity will mean you've lost control of your shares. Indeed, for those owners who want to share part of their business but continue to direct it, a private and secluded equity recapitalization is worth considering. These are the actual benefits of a private equity recapitalization:
It Creates New Developments
Imagine a CEO works out an agreement with a firm in which they offer a 70-percent stake in the company at a $20-million value. The owner covers the cost of it all with 50 percent equity and 60 percent debt with the company holding $12 million in debt. The new equity value result is $8 million, but the business' value is $20 million. Once the CEO takes their stake, which is $2.4 million, they'll gain a pre-tax installment of $17.6 million.
Most private equity companies require five to seven years before they return value to their investors. Therefore, they will probably work hard to develop the business, reduce its debt load, and then seek out an opportunity for its liquidation. Maybe the business will be sold to another company, go public, or be sold to an individual. Regardless, the owner can get the remaining value from the percent kept in the company.
It is natural, to some extent, for business owners to be attached to their own businesses. However, this can put you at risk. A business owner can spend years trying to get back the money they put into a business. Therefore, it's important to diversify your business as much as you can.
One excellent way to make this happen is by selling a part of your organization to a private company. That way, you can take funds from your investment and free up collateral to invest elsewhere, preferably in different fields. Another option is to take the funds and use them for other purposes, such as a new business, covering your child's college years, or buying a new home.
It Can Increase the Stock Prices
The forces of supply and demand are at work when a company goes through the process of recapitalization. If that company buys its own stock shares back, the increase in the number of shares being purchased will help drive the price per share higher. Making this move can also take advantage of a lower share price as a way to increase the number of shares in the company's reserve, thus being able to meet any future requirements for capital.
It Reduces the Risks of Concentrated Wealth
For security purposes, it's normal to keep wealth in a company. Usually, owners do need the funds from the sale of their business in order to pay for their life's needs. However, there can be risks to concentrated wealth, too, such as:
- Large-scale financial changes
- Geopolitical movements or changes
These factors affect value as well as cash-flow income, and as business owners approach retirement, their bounce-back potential is limited. Recapitalization is an opportunity to liquidate your company while also dispersing your wealth, relatively speaking, in a secure environment. You'll have the reliability of capital as well as expert support for further development.
A private equity transaction helps an owner sell their company two times over. In such a system, the owner will sell part of the business in a primary transaction but retain some ownership despite that. Later, five to seven years from the original transaction, the business will again be sold and the owner will receive a second liquidity at a higher valuation.
For example, imagine a business owner who worked hard for 25 years. He worked many hours per week, and the business was successful despite the ups and downs of the economy. This business owner would like to work fewer hours per week, but he does not want to let go of his company entirely. He has also been informed that it's risky to have all of his capital tied up in one asset.
What can he do? He learns about the process of corporate recapitalization. Now, his business wealth can be spread out.
His revenue is already growing at a rate of 15 percent. The earnings before interest, tax, depreciation, and amortization (EBITDA) are $4 million, and the company is $2 million in debt. The entire value is $24 million.
The equity company creates a sister company, which buys the assets from the primary company, and finances the purchase with 40 percent equity and 60 percent debt. The owner still retains 25 percent of the company. The expenses from this transfer were 4.5 percent of the total business's worth.
Many years into the future, the sister company has expanded, grown, and developed until it is worth $50 million. The EBITDA is $9 million. The sister company sold some assets to another buyer for a profit. When this closed, debt was $3 million. The owner's equity at this threshold is 21.5 percent, having been diluted to create equity incentives for senior management.
In the transferring of equity recapitalization, the owner discovered $30.95 million in net pre-tax proceeds instead of the $20.9 million that would have accrued if he had sold the entire company. That means he earned $10 million more. Plus, the owner is not personally bound to the business' debt and costs.
A private recapitalization can get rid of the dangers of wealth concentration. Diversifying is important for security, long-term prosperity, and future growth.
It Increases Flexibility
If a business is held closely, recapitalization may also be part of a strategy for succession. A private equity firm can help a business owner develop more adaptability with enhanced operations. While financial help is still a primary way for sponsors to lend a hand, a more practical approach can also work wonders.
Private firms have experience. They are equipped to take a direct approach, especially compared to other people who are interested in purchasing. They can be proactive in the everyday goings-on of the business, with senior strategizing as well as boards, meetings, and on-site visits.
Partner with qualified professionals who can help you to plan, carry out acquisitions, and find other pathways toward business development.
It Can Help Your Company Grow
Capitalizations that are leveraged through an equity firm can become empowered, especially when a company's owners do not wish to retire from their work and have great assets in their enterprise.
Often, such people have experienced fluctuating risk over time. They have worked hard to preserve wealth.
With wealth creation, on the other hand, things can begin to look a little bit different. While big spending may be put aside, going into new markets may appear interesting. Lending possibilities for those seeking retirement can be limited; personal guarantees or corporate expansion loans may be requested. An equity firm can help secure what is required.
Altogether, the entrepreneur can become less personally tied to his business work but still maintain investments.
It Can Transfer Wealth
Leveraged recapitalization is also a way to transfer wealth generally. In one case, for example, the business owner might gain a great deal of value from the business. He can give away a good ownership interest to heirs, with tax perks. As time goes on, stock that has appreciated can be sold at capital gain rates by bypassing estate taxes. There are other versions of this, too, such as allowing people on your team to gain equity in the enterprise.
It Can Trigger Valuation Discounts
Another reason why recapitalization is an intelligent move is because it can trigger valuation discounts. Imagine that within your corporation, there are 1 million authorized shares and 1,000 outstanding shares of common stock. You have 75 voting shares and 675 non-voting shares. Another shareholder has 25 voting shares and 225 non-voting shares. Your heir now owns 67.5 percent of the company, but you still have voting control.
A competent lawyer should help you consider corporate recapitalization before any IDGT transfer happens with corporate stock. Then, the process of recapitalization can help you transfer the non-voting interest into the IDGT while maintaining power over your corporation until you no longer need it.
Further, consider recapitalization in order to bring in new shareholders and partners and investors. You can give the non-voting shares to family or those who work for you. With family members who work in your business, exchanging non-voting stock is a good and significant incentive and will aid with taxes. On the other hand, if new investors are emerging, each one will have distinct needs.
Case Example: The Stellar Corporation
The Stellar Corporation is a specialty manufacturer with gains of 38 million in revenues and five million EBITDA.
The founder of the company created the business in the 80s, and now it has done so well that most of his worth is in his own stock. He needs to diversify his portfolio in order to plan for his retirement. He wants to increase revenue, and he has some loyal, dedicated senior executives who were helpful in creating the business and now want more involvement and benefits. He's also received many requests from brokers and private equity groups.
This founder connects with an equity group, and they decide on a transaction: $27.5 million in cash and 40-percent equity kept by the owner. The owner gives his managers a gift of 15-percent ownership and keeps 25 percent. He is happy. He will have $25 million in cash proceeds and he, along with the group, continues to keep and develop 40 percent of the equity. The following is an example of the transaction's structure:
- Six percent annual growth in sales accrues.
- EBITDA progresses within five years, with the shareholders given another $15 million payout.
- Another liquidity occurs along with another level of management.
Case Example: Inservco
Inservco is an electronic manufacturing services (CEM) business that was purchased in 1968. By 1999, the owners had built it up and it ranked among the 100 best CEM enterprises in the U.S.
Even though the owners thrived on the challenge of building the company, they also had lots of value in it. The owners realized they were reaching a time when it was intelligent to unlock much of that worth, but they did not yet wish to retire. What could they do?
At first, they reviewed many proposals from many buyers. MCM was introduced, and they were offered a leveraged recapitalization. MCM was an interesting potential because of key benefits: valuation that was comparable to that offered by other buyers, personal liquidity, the ability to retain current employees, and continued control over the business. They would also gain a partner with experience in corporate development to help them locate and carry out acquisitions.
The owners of the company realized that the best plan was this leveraged recapitalization with MCM. Debt and equity were split 50-50. First, the company divided its equity between preferred stock and common stock. Then, they offered 92 percent of the equity's capital to the initiative. Management gave around eight percent of sale profits to develop a continuing interest of 30 percent. The owners created a situation in which everyone benefited and all aspects were taken care of.
It Can Reduce Costs
Taxes can hit companies hard, especially when they are paying out dividends to stockholders. One of the benefits of recapitalization and taking on additional debt is reduced taxes. The payment of dividends is not tax-deductible but paying interest payments on loans is tax-deductible.
How to Select a Company Partner
Follow these steps when selecting a company partner:
- Check their history of regular earning.
- Ensure they have an adjusted EBITDA of over $2 million.
- Ensure they have limited bank debt and are not seeking to acquire with debt.
- See if they have good growth prospects.
- Make sure they have low capital expenditure needs.
- Check their assumed recurring revenues.
- Determine whether they have a low concentration of customers.
- See if they have EBITDA margins of 10 percent or higher when the owner will support the company by buying 15 percent or more of it.
Risks of Recapitalization
Needless to say, there are risks associated with recapitalization. An experienced lawyer should guide you through the process. Here are some risks, in general, to be aware of:
- Make sure the equity company does not use a great deal of debt to acquire you — they may want to do this in order to gain a higher return.
- The company's value, when it is sold the second time, may not meet the expectations of the owner.
- Once the company is sold, the owner won't be in control any longer. The firm and owner should have a good business plan.
- The firm can make changes to management and often will, thereby affecting the friends or family of the owner.
- Of course, you need to be careful with choosing a good partner. Check the reputation, record, past experience, and use industry know how. Speak with other owners whose businesses they acquired in the past.
Begin the Process
Corporate recapitalization is a fairly new option. It creates new opportunities for owners who would like to separate themselves from their business somewhat while continuing to reap corporate gains and expand their business.
Today, recapitalization is quite a popular movement. Regardless of when you expect to make this change, education is the best way to understand your options. A recapitalization transaction is complex, but it can help with wealth concentration and future planning. It is highly advisable to work with a dedicated and experienced lawyer.
If you have any questions about recapitalization, post your legal need on UpCounsel's marketplace for assistance. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Stripe, and Twilio.