As a business owner, your personal wealth is likely concentrated in the equity ownership of your company — meaning your financial security is largely dictated by the company’s performance and continued success. This exposes you to a large amount of risk should any unfavorable events, such as recession, competitive factors or loss of key personnel impact the business.
So, how do you “de-risk” and diversify your personal balance sheet to create more financial stability for you and your family? There are numerous alternatives, all of which will alter the company’s capital stack, or the proportion and sources of funding upon which the business is built.
The pyramid demonstrates four common funding sources, ranging from senior bank debt to common equity. Each of these sources can provide liquidity to an owner; however, the decision of which source to tap into brings with it a set of advantages and disadvantages, risks and benefits.
Choosing which source to use is often quite personal, as it can involve giving up various degrees of ownership in your life’s work. To make the most out of this complex decision, a foundational understanding of each alternative can help bring clarity to the best course for you and your business. Below are some of the most common liquidity alternatives, funding sources and considerations for each.
1. Senior Bank Loans
Bank loans are the most common method of debt financing. They are the least complex liquidity alternative and the easiest to forecast future impacts on the business. Senior bank loans alter the capital structure of the company by reducing equity and increasing debt. The funding raised by incurring additional bank debt can be distributed to the owner in the form of a one-time dividend. This process is called a leveraged dividend recapitalization.
It is important to consider that if your objective is to reduce personal risk, a dividend recapitalization financed by a senior bank loan that is secured by a personal guarantee does not accomplish this objective. The dividend you are paid is in effect still tied to the financial success of the business. Therefore, even though you receive cash and can diversify into other investments, your new assets are still subject to the risks of the ongoing business. Bottom line, funding a dividend with a guaranteed facility likely isn’t a good option.
Adding debt to the capital stack also magnifies the return on equity and provides a tax advantage to the company in the form of interest expense deductions. The fixed payment amortization of the loan provides certainty over future requirements. However, this can be a disadvantage if your business has inconsistent cash flows. When payment is due, the bank has priority to collect, subjecting the business to default risk.
Due to their accessibility and affordability in comparison to equity, senior bank loans are a popular first choice because they are the lowest cost and, therefore, have a place in any company’s capital stack.
2. Mezzanine Debt
Mezzanine debt falls between senior bank debt and equity financing in the capital stack of a company. Unlike bank debt, mezzanine does not require principal amortization payments. Rather, mezzanine debt provides owners with more flexible repayment options, such as:
- Cash interest;
- Payment-in-kind, where interest accrues but is not required to be paid in cash; and
- Principal payout.
Mezzanine debt may also contain equity warrants, which can enhance the return for the lender through equity participation rights. Lenders with equity warrants share in the upside of a future transaction, such as the sale of the business. Equity warrants, from a lender’s perspective, can mitigate some of the risk associated with the financing provided in a less secure part of the capital stack.
While the cost of mezzanine debt is less than the cost of equity, the yield required by investors is higher than that of bank debt, generally around 12%. However, first time borrowers of mezzanine debt can benefit from institutional ownership of the security, as the reputational impact can enhance the equity value of the company in subsequent transactions. Because principal payments are not due until maturity, mezzanine debt is often called “patient debt,” as cash flows are not allocated toward repayment of principal and can fund growth prospects of the business. The liquidity and tax advantages of mezzanine debt still apply; however, mezzanine can be viewed as more beneficial to the growth of the business.
3. Minority Equity
Moving further up the capital stack, minority equity is the sale of any amount less than 50% of equity ownership in a business. The process of raising equity is much more complex than debt financing due to the many different structures and dynamics of the deal. With equity, much more is at stake. You are giving up some control in the business, meaning elements such as liquidation preferences, dividend rights, participation rights and redemption rights are all important factors to consider in the deal structure.
Finding the right investor is a crucial step in the process. To do so, you must first ask yourself what you are looking for in an investor, and what the investor brings to the table. Does the investor bring value-add experience, relationships or ideas to the business, or is the investor simply bringing their money to the table? Is the investor someone you want to work with, or would you prefer an investor who takes a more hands-off approach? No matter the decision, the investor should fit your needs and wants as the owner, and ultimately should align with the objectives for the business.
The largest advantage of minority equity is the diversification of your individual balance sheet. The sale provides liquidity to shareholders to diversify while simultaneously reducing the concentration of your personal assets in the business. Minority equity may be best suited if you are looking to still be heavily involved in the business but want to begin to diversify and de-risk your personal portfolio. A dividend recap funded by minority equity does not impact the future cash flows of the business, since there are no associated debt-service payments.
Raising minority equity means you forgo at least some control over the ultimate direction of the company. Equity sales can also be the most difficult alternative for an owner, particularly one in a long-standing family business. To some, the thought of giving up a piece of their life’s work can be a challenging prospect to consider.
4. Control Equity
While minority equity gives up some interest in the company, control equity represents a more substantial sale — over 50% of the business. At this point the buyer becomes even more crucial as the future direction of the business is now in their control. Selling control equity may be appropriate if you are looking to transition from management, significantly diversify your portfolio and pass on your legacy to the next owner.
Control equity is not only beneficial in terms of offering more liquidity, but this type of equity also lends itself to more favorable valuations. Buyers will place a premium on the ability to control the future direction of the business. Yet, you as the owner still share in some upside potential of the company through the remaining minority equity. Additionally, to ensure alignment with the future success of the business, many buyers typically require 20% “rollover equity,” which is money from the sale you will be expected to re-invest in the business post transaction.
With some financial stake left in the business and control over decisions relinquished, you will be subject to the decisions of the new equity holders. If your company is your life’s work, working “for” the new owners can be challenging.
Business owners have a challenging job of balancing day-to-day operations while also considering strategic objectives for the future of the business. While operational issues remain a priority, taking the time to consider liquidity alternatives, including the “why” and “when” of each, can greatly benefit you when approaching a transaction.
Whether you are looking to de-risk, gain liquidity, grow or exit the business entirely, each alternative provides certain advantages and disadvantages to achieve your objectives. Starting with a high-level understanding of the alternatives, risks and benefits can help you decide what questions to ask, and when. Working closely with transaction-focused advisers can help you model various scenarios and further explore the alternatives as they relate to your unique situation.
Contact Chris Revnew at crevnew@cohenconsulting.com or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.