Cashing In Without Cashing Out
What with leveraged buyouts, management buyouts, acquisitions, and other reshufflings of ownership, it's a sizzling sellers' market for private businesses. As prices that choice companies are fetching soar past six times earnings before interest and taxes (up from four times EBIT only a few years back), an entrepreneur is hard put not to grab the next offer and take a villa on the Riviera. But then what? By next Monday morning, any true entrepreneur sorely misses the business, in which case it would be handy to sell a smaller share for today's big bucks and still keep control.
Until recently, selling a closely held private company has een pretty much an all-or-nothing proposition. Even if they were generous enough to leave something for the founders, acquirers demanded healthy fractions -- and control. But over the past several months, the option of taking a substantial amount of cash out of one's company and still controlling it has become increasingly ten-able. That's because a trickle of venture capital firms are easing out of the breathless chase for whole businesses and are offering to pay good money for less than half ownership.
The change of heart bodes well for owners, families of owners, or partners who may want to get out while the other partners stay in. Among the VC community's 500 or so firms, it's monkey see, monkey do; so unless the buyout-and-acquisition markets cool off unexpectedly, the trickle is apt to turn into white-water rapids.
Right now, companies with before-tax earnings of more than $2 million are in demand, but as more VC players join in, that is bound to drop. Indeed, something of a trend is underway, agrees William Glastris, general partner at Golder, Thoma & Cressey (GT&C), in Chicago. "There used to be a time when the venture business would say we need to have control since we're putting in that kind of leverage," he says. But now, writing minority deals "allows us to get some money into companies that otherwise we might not be able to invest in -- quality companies that have an idea of price we either can't afford or don't agree with." GT&C is willing to give up control in circumstances where management is "extremely strong, and you can have a lot of faith in them to be able to manage the business in the future." And, of course, similar faith that the bundle of new cash won't divert their attention from the business at hand. Earn-out incentives are often thrown into the deal to help keep noses to grindstones.
To be sure, minority stakes in private businesses are not new products. Neither are leveraged buy-back arrangements in which, essentially, a seller can reinvest in the company he or she just sold. But until now, the market was not brisk. "Entrepreneurs are continually surprised when we tell them they can take cash out of their company and still stay in control," says general partner John Kirtley of New York City's Chemical Venture Partners (CVP), an aggressive minority-stakes bidder.
CVP's setup -- a part leveraged buyout, part leveraged buy-back it has dubbed "recapping" -- basically goes like this. Let's say that in a traditional LBO, the owner/manager would receive $20 million for 100% of his company. Leveraging the deal, the buyer would borrow most of the payment from a bank or other institution. Under its minority-share variation, CVP would pay perhaps $15 million for 49%, instead of $20 million for 100%. That gives the sellers $5 million less; for the difference, they keep 51% and run the business as before.
On the face of it, the arithmetic doesn't add up. How can one half be worth $15 million and the other half only $5 million? Because of added debt. To create the leverage, as in most LBOs, the buyer pledges the company's assets to help finance the deal. CVP, for example, may put up only $5 million of its own, borrowing the remaining $10 million to make the up-front payment to the sellers. Since the business going forward is saddled with additional debt -- some of its subordinate, at Lord knows what interest rates, to debt already on the books -- its profitability is strained and its future rendered more risky. Therefore the entity in which the old owner now owns 51% is worth considerably less than before.
Who could resist such a deal? For one, an owner who didn't want to stay around and run the business, of course. For another, an owner who feels safer having that last $5 million in hand. What with its new cash-flow problems changing the financial face of the business, this owner calculates that the 51% might be worth less several years down the pike when the VC firm makes its exit than, say, if he simply put the $5 million into Treasury bills.
Nursing its minority rights, a VC firm requires that the package include terms by which it can elect to become liquid again a few years hence, presuming that by then the debt will have been paid down significantly, and the company will be thriving nicely. Among other options, the company can either be brought public, be sold to another company, or be bought back by the original owners responding to a buy-sell agreement. (Under a typical buy-sell agreement, if one party brings in an offer, the other party either has to accept the offer or match it.) Alternatively, the VC firm could elect to stay in longer. "If we like the business," says Glastris, "we'll help it grow through acquisitions, making additional investments ourselves."
To protect their vulnerable standings, since the venture firms do not participate day to day, they dictate restrictions and downside standards -- how much cash the owners can spend on plant and equipment, for example, or a profitability ratio that, if not met, allows the VC firm to elect the majority of the board of directors. "We're doing a venture deal, not a buyout," CT&S reminds sellers. But since a VC firm can't really afford to offend owner/managers, they are mostly left to their own devices. "The covenants are loose," CVP's Kirtley insists. "They are there to protect only against radical changes that would irreparably damage us, such as the declaration of a big dividend. We trust their business sense, or we wouldn't have made the investment."
Thanks to the 1986 Tax Reform Act, the deals don't come without their complications. How items such as the up-front cash and the majority shareholdings are entered in the books will determine the owner's and the corporation's tax liabilities. Any transaction warrants close scrutiny by both an attorney and an accountant.
Still, any deal in which owners of small businesses no longer have to sell everything plus the watchdog to come out ahead of a venture capitalist is worth considering. Indeed, in today's markets, the amount of money an owner can take out of his or her business and still own it is on the rise. And venture capital's hold on even a 49% stake is slipping. Some firms already are talking lesser percentages.
VC firms are quicker to meet owners' asking prices as well. Since the leverage is written down over several years, having to come up with a few million dollars more won't make much of a difference to a venture capitalist in the long run. But to the seller, it's a villa on the Riviera that can be visited by Concorde on weekends.