Taking a Bite of the Apple

 Taking a Bite of the Apple


You’ve got a business. It’s a successful business, but you’re nearing the point where you’d like to lessen your involvement in it. One way to do that would be to recapitalize – sell 60-70 percent of the company to a private equity group. They would increase the value of the company, and in a few more years, it could be sold, and your remaining stake could be worth more than it was when you recapitalized.

Twenty years ago, when Roy Graham of Corporate Finance Associates would propose that kind of arrangement to business owners, they would reply, “Do you think I’m a fool? You want me to sell a majority of my2015-enlightened-speaker-series-logo-300x250 company to a group I barely know?”

But that was then, and this is now. Recapitalization is a very successful business model. To address how it works and why a business owner would consider it, an Enlightened Speakers Series event was held in San Antonio. The speakers were Graham, managing director and principal at Corporate Finance Associates; Doug Frey, who, with a partner, recapitalized a welding inspection business in West Texas; and Jeff Gifford, an attorney at Cox Smith who works with accountants and investment bankers to handle issues that arise in a transaction like recapitalization.

Private equity is big in Texas. In 2013, we were the number one state in private equity investment, with 282 companies getting $87 billion in investments, Graham said. More than 2,600 Texas companies are backed by private equity.

Graham said private equity groups fall into different classes. First, the ones that raise their money through pension funds, university endowments, insurance companies, family offices and high net worth individuals. They find a target for investment, increase the value of their investment, and in about 10 years, sell the business and return the proceeds to the investors.

Another class is a family office. A family’s management team handles the funds, and might invest in a private equity company, or directly into a company. Graham cited Red McCombs as an example of a family office.

The third type of group is the “fundless” sponsor. They don’t have the money to invest, but they present themselves as a private equity firm, find a target company, put that company under a letter of intent and lock it up – usually for 90 days. Then, said Graham, “They go dialing for dollars.” Some fundless sponsors are good, he said, but others might not be able to fund a deal and in 90 days, the deal expires. “You have a very disappointed owner,” Graham said.

The kinds of businesses that go in for recapitalization are also of several different types. One reason to do it is a growth strategy, said Graham. A company that grows rapidly wants to retain all of its earnings for growth, while also utilizing the debt available to it, and is a “great” candidate for recapitalization, he said.

In another scenario, a business has grown over 20 or 30 years, and it might be time to diversify some of the value that’s been created. Unknown risks are always over the horizon. “Do you want to continue to keep all of that at risk when you’re 50 or 55 or 60?” Graham asked. In the event of a financial downturn, some of that money has been taken off the table, and the business owner can continue to run the company in partnership with private equity.

Or, it’s time to buy out a partner. They may want to retire, or maybe the chemistry is bad, but private equity is needed to fund the buyout. “That’s a great use of private equity,” Graham said.

Private equity recaps can vary, Graham said. A majority recap would turn over 60-70 percent of the company to an investor. Or, it could be a minority investment, where they fund only 20-30 percent. In either case, the idea is to partner with the group to grow the value of the company over the long term – usually three to seven years. “If you retain 30 percent of a large pie and grow it to an even larger pie, your 30 percent becomes much more valuable,” Graham said.

Graham offered a few tips for businesses considering recapitalization. Competition for that business is fierce, and a company with a $2 million EBITDA could fetch a transaction value of between $10 million and $16 million – a wide range. Graham said presenting a company in the best financial light is important, in order to get the high end of that range. Bring in competing groups to see which ones to meet with again. “It’s only by going back to those parties that are not where they need to be is how you’re going to get to the number at the higher end of the scale,” he said.

Speakers Doug Frey, former CEO of Desert X-Ray, Roy Graham, of Corporate Finance Associates, and Jeff Gifford of Cox Smith.
Speakers Doug Frey, former CEO of Desert X-Ray, Roy Graham, of Corporate Finance Associates, and Jeff Gifford of Cox Smith.

Next, Graham said, the maximum point of leverage in a transaction is right before signing the letter of intent. “Don’t sign a letter of intent that’s very general,” he said. “Put all of your key points in there that are necessary to make that transaction work for you.” Once the letter is signed, leverage moves over to the other side.

Finally, remember there are many terms and conditions that go into a deal and they are negotiable. Check every competing equity firm – speak to owners of the companies in their portfolios and find out how their relationships work in both bad and good times. How is the chemistry with the equity companies? Each has different ways of treating their portfolio companies, Graham said. Do they have the ability to fund the deal?

Attorney Jeff Gifford cautioned anyone considering a recapitalization to act like a Boy Scout: “Always be prepared,” he said. “Plan, plan, plan and prepare, prepare, prepare. That’s the most important thing to focus on for a private equity transaction.”

That means the owner of a company getting ready for a recap must be thinking of a lot of things, from the personal – estate planning for the family – to the individual’s involvement in the new venture. Step back? Consult? Become a passive investor at 30 percent? “You have to determine these things before you bring in the private equity groups,” Gifford said.

In-house due diligence is vital, he added. Go through all the corporate records, because the private equity firm will. “It’s like selling your home,” Gifford said. “You want to repaint, fix the leaky pipes and update the landscaping for curb appeal. Getting ready for private equity is the same concept at a much higher scale.”

Gifford recommended keeping recapitalization plans under the radar, with just a few individuals helping prepare for the investment banker. “Your biggest fear is that rumors begin that are not true,” he said. “I’ve never seen anything good out of a wide disclosure too early – never seen it.”

He cautioned business owners not to wait until after the letter of intent is signed to bring in the lawyers. “I have rarely seen a LOI, once it is delivered, where our client didn’t give up way too much leverage on the front end,” he said. “There is so much value that we can add to that letter of intent, if you get us involved before the LOI is signed.”

In fact, one of the main reasons recap deals fall apart is that some of the deal issues weren’t anticipated, Gifford said. Graham added that some key elements might not have been included in the letter of intent, and became obstacles that couldn’t be solved.

But Gifford sounded an optimistic note: “Most deals do make and it’s the exception when it comes apart,” he said.

“I’m the story of how recapitalization is supposed to work,” said Doug Frey. He had a 23-year career with Amoco until BP bought the company and laid him off. In 1999, he and a partner bought a small welding inspection company with 14 employees and annual sales of less than $500,000. By 2012, Desert X-Ray had grown to 125 employees and had operations in nine states.

Frey and his partner knew good times in the oil patch couldn’t last. They decided to “take some chips off the table,” and sell a majority interest in their company to Sterling Capital Partners of Chicago. Frey said the initial recapitalization was a bit unusual. Sterling Capital Partners offered $5 million less than the highest offer they’d received. “We felt our ability to work with them and the chemistry would more than offset that difference in the upfront price,” Frey said. “We felt the second bite of the apple would pay off.”

Within a year, with the help of the private equity investors, Desert X-Ray grew to more than 500 employees and $100 million in revenue. “We hit the metrics we had set out over a five-year timeframe in just nine months,” Frey said.

They decided to sell at that point, and a Canadian company paid $300 million. It was a homerun for the equity partners as well as Frey and his business partner.

“We wanted our employees to have some running room and space to grow and jobs to move into,” Frey said. “If we held the company we thought it would stagnate and guys who wanted to grow – they wouldn’t have to spend the next ten years in the same job.”

“For every $1,000 my partner and I put in originally, we got back $1 million,” Frey added. “I am the poster child for life after layoffs.”

Thank you to our Speaker Series sponsors:

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