Benefits of a leveraged recapitalization

Leveraged recapitalization vs. selling outright

The following is a hypothetical scenario whereby Mr. Gary Reasons, the 55-year-old owner of Reasons Cleaning Corp., would recapitalize his company through a leveraged recapitalization versus selling his company outright.

Reasons Cleaning was founded in 1987 and provide tank cleaning services to oil and gas companies located in the Gulf Coast region. The company generates approximately $5 million of annual cash flow and the business is valued at $25 million. The company has $5 million of existing debt on its balance sheet. The net equity value of the company is equal to $20 million ($25 million enterprise value less $5 million debt).

Scenario No. 1

In scenario No. 1, Mr. Reasons could elect to sell his company outright to either a strategic or private equity buyer. In either case, he would be seeking a $20 million price for his equity. Several issues arise regarding the receipt of his $20 million in value. First, he may be asked to take back some of the value in a seller note or an “earnout.” The net effect is that Mr. Reasons may not receive all of his $20 million in cash at close.

Scenario No. 2

In scenario No. 2, Mr. Reasons could elect to bring in a private equity sponsor to invest in his company and refinance his existing debt through a leveraged recapitalization transaction. In a leveraged recapitalization transaction, Mr. Reasons would receive his $20 million of equity value as a $15 million one-time cash dividend payable at closing and the “rollover” of $5 million worth of value into “equity” of the newly recapitalized company that is worth 49 percent of the fully diluted common stock going forward.

The main reasons as to why Mr. Reasons would choose the leveraged recapitalization transaction are:

  • Mr. Reasons will receive a one-time cash dividend of $15 million at close. Thus, Mr. Reasons will receive 75 percent of his total equity value in cash at close.
  • A private equity firm that will be investing alongside the transaction typically has the clout with the senior lenders and mezzanine lenders that no shareholders will personally guarantee the newly refinanced debt.
  • Mr. Reasons will receive $5 million of his $20 million total consideration in new equity worth 49 percent (assumes equity sponsor invests $5 million) of the fully diluted common stock going forward.

Mr. Reasons and his private equity partner have created an aggressive threeyear growth plan. The growth plan that has been devised includes making acquisitions. Mr. Reasons has his cash in the bank, is personally off the guarantees for the bank indebtedness, and is in a position to work with a partner to be aggressive and try to increase the value of the company substantially. Thereby, Mr. Reasons will be working over the next several years to make his 49-percent ownership stake in the company worth substantially more than his original dividend.

This article does not constitute legal or federal tax advice and is not intended or written to be used, and may not be used, for the purpose of avoiding tax-related penalties under the Internal Revenue Code.

For more information, you can reach John Zapalac at (713) 826-7773.

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