Joseph Safina is CEO of Safina Asset Management, specializing in large-scale funding, M&A, business development and marketing.
Business owners today are faced with a critical decision when they need cash: Should they sell their company or use the strategic advantages of a debt recap? Although selling a business brings in an immediate return on investment, a debt recap presents a viable alternative that offers the best of both worlds in terms of liquidity, ownership and taxes.
Let’s discuss the pros and risks of debt recapitalization, the possible tax benefits for shareholders, and how this strategy compares to the sale of a company at six times earnings.
What Is Debt Recapitalization?
Recapitalization of debt, also referred to as debt recap, is the process of changing the structure of the capital base of a company by replacing part of the equity with debt. This approach enables a company to acquire liquidity, quite often through a leveraged loan, without having to transfer full ownership. The debt proceeds are then disbursed to the shareholders, who in turn receive a return on their investment of equity while retaining their stake in the company.
The Benefits Of Debt Recapitalization
1. Keeping control of the business and ownership
A direct company sale often deprives the owner of control and supervision. In contrast, a debt recap allows shareholders to realize a part of their investment while keeping the operational control and equity stake. This option is especially interesting for founders or family businesses that are willing to keep a long-term perspective.
2. Flexibility for future growth
It may be tempting to sell at six times earnings, but this could preclude future growth that is linked to the company. By recapping, business owners can get the cash flow while keeping growth potential. This ensures the participant remains part of the future value-creation process.
3. Tax efficiency
The main advantage of debt recap can be found in its tax consequences. Most of the time, distributions to shareholders through a recap are considered a return of capital or a dividend and are taxed at lower rates than ordinary income. In addition, the interest on the debt is deductible for the company, thus decreasing its taxable income and enhancing its cash position.
The Tax Benefits Of Debt Recapitalization
Debt recapitalization can also have major tax advantages.
For corporate interest deductions, the interest on the new debt is deductible. For a company with high earnings, this deduction can bring down its taxable income and enhance its financial situation.
For instance, consider a company making $10 million in EBITDA and having debt of three times earnings ($30 million). If $25 million is paid out to the shareholders, they receive the liquidity they need while paying less or deferring taxes than if the company was sold outright.
A Sale Versus A Recap
To understand the financial consequences, consider the following scenarios:
Company sale at six times earnings:
A company that makes $10 million in EBITDA sells for $60 million (six times earnings). After paying taxes on the transaction (assuming a 20% capital gains tax), shareholders end up with $48 million. However, the seller has no further ownership and profit prospects.
Debt recap at three times earnings:
The same company obtains $30 million in debt (three times earnings) and pays out $25 million to the shareholders. Based on the assumption of a lower effective tax rate on distributions, shareholders may receive about $21 million, on average, after taxes. The owners keep control and benefit from the company’s growth and profitability.
Over a five-year period, with a conservative EBITDA growth rate of 10% per year, the earnings of the company may rise to $16.1 million. When the business is then sold at the same six-times multiple, the valuation is $96.6 million. This provides an additional $36.6 million value to the shareholders, which is more than the return from the outright sale of $60 million.
Debt Recapitalization From A Strategic Perspective
1. Growth potential: Debt recaps are suitable for companies with strong growth prospects or steady cash flows. Owners can get the cash flow now and be in a position to receive more in the future.
2. Market conditions: In situations where valuations are low, selling may not properly position the company. A debt recap allows owners to wait for the market to improve.
3. Legacy and vision: For the founders or families who are willing to continue the company’s legacy, recaps are available. Shareholders get the financial reward while ensuring that the company’s culture, employees and mission remain the same.
Risks To Consider
While a debt recap offers many advantages, it’s not without risks including:
1. Increased financial leverage: Adding debt increases financial obligations, which can strain cash flows if not carefully managed. Companies with volatile revenues or low profitability may struggle to meet debt service requirements.
2. Potential for overleveraging: Overestimating the company’s ability to handle debt can lead to financial distress. It’s critical to work with experienced advisors to structure a sustainable debt package.
3. Market perception: Excessive debt can raise concerns among stakeholders, including employees, customers and suppliers. Clear communication about the rationale and benefits of the recap is essential.
Conclusion
Debt recapitalization is an effective tool that business owners can use to get the cash they need without giving up control and getting tax benefits.
For companies with a steady stream of cash flows and growth prospects, this can be a best-of-both-worlds approach allowing shareholders to realize their investment while still being a part of the company’s future. Knowing the details of debt recapitalization and its tax consequences, business owners can make the right decisions that match their objectives.
When it comes to any major financial decision, it is important to seek the advice of professionals such as investment bankers, tax advisors and legal representatives when coming up with a debt recapitalization plan that will serve both your short- and long-term goals. This strategic approach can enable business owners to get the liquidity, keep the control and pay the least amount of taxes, showing that they do not always have to sell their company in order to become financially successful.
Forbes Finance Council is an invitation-only organization for executives in successful accounting, financial planning and wealth management firms. Do I qualify?
Read the full article here
