How Recapitalization Will Help You to Reduce Risk
There is an irony in success, and if you run a solid business, you face it sooner or later. Having overcome the dangers of starting your business and making it grow, you wake up one morning and realize that you’ve got lots of eggs in one basket and that one misstep can cost you everything.
It is as if in the very act of overcoming risk, you create even more. The greater your success, the greater your risk.
What to do? How do you overcome the fact that as you work to put risk behind you, you pile it up in front?
On Wall Street they counsel you not to concentrate risk, but rather to balance one risk against another--for example, by buying stocks and bonds. It’s good advice, but hard to follow in the rough-and-tumble world of business. In the early going, at least, you stake everything on one bet because you must, and you don’t stop to think about unintended consequences.
But those consequences are not insurmountable, and there exists a financing technique almost tailor-made for the business owner who faces them--recapitalization.
Simple in its essence, recapitalization can do good things for many a business, whether small or large. It can do good things for the business owner, too, because it shifts risk to the shoulders of others--sometimes a lender, sometimes an equity investor.
How?
“When you recapitalize a corporation, you reformat your balance sheet by exchanging debt for equity or equity for debt,” says Jonathan L. Schwartz, a Los Angeles investment banker whose Westwood firm, JLS Capital Inc., focuses on raising institutional debt and equity capital for small and mid-sized growth companies.
“If you want to take some money off the table, you can add debt and subtract equity from your corporate balance sheet to diversify your wealth,” Schwartz adds. “If you bring in an equity partner, on the other hand, you can subtract debt and add equity.”
To illustrate the first option, consider a business with $10 million in assets and no debt, Schwartz says. The owner borrows $5 million against equipment or perhaps cash flow, pockets a dividend in the same amount and ends up with a corporate balance sheet showing more debt and less equity. The owner also ends up with less personal risk; in effect, he or she has moved $5 million in wealth from the corporate coffers to the personal.
Conversely, assume a $10-million company with, say, $2.5 million in debt. If servicing the debt strains cash flow, the owner might sell a 25% interest in the company to, say, his or her management team and use the cash to retire the debt. In this scenario the transaction does not lift risk from the shoulders of the owner, of course. Instead, the owner relieves the business of debt by giving up some equity.
“You can recapitalize a company to increase leverage by increasing debt or increase equity by decreasing debt,” Schwartz says. “You take equity out of the business by adding debt to the balance sheet. Conversely, you take debt off the balance sheet by adding equity.”
Schwartz offers a third example in which the effect is to increase the value of a business, making it attractive to an outside buyer. In this scenario, the owner of a business with $5 million in assets and the same amount in equity borrows $2.5 million, pockets a dividend of $500,000 and uses the balance to buy equipment. Two results flow from the transaction, in Schwartz’s analysis:
* Assets increase to $7 million--that is, the original $5 million in assets plus $2 million in new equipment.
* The $2.5 million in debt drops equity to $4.5 million--that is, $7 million in assets less the $2.5 million in debt.
If cash flow increases from, say, $500,000 to $750,000, Schwartz notes, the company’s cash return on equity--that is, cash flow divided by equity--increases from 10% to 16.67%, an attractive number that should make the business easier to sell if the owner wants to retire altogether.
No matter what scenario you follow, Schwartz says, it makes sense to recapitalize when you want to lessen your personal risk to the fortunes of your own business.
“If you’ve got $5 million of your own wealth tied up in the business and you’re generating good cash flow, you can get some of that wealth out of the business and still continue to grow the company,” Schwartz says.
Juan Hovey can be reached at (805) 492-7909 or at jhovey@gte.net.
