Growing a business can be good for your wealth. Last year, one-fifth of Inc 500 CEOs had an estimated worth of more than $7.5 million. But other data points tell a more troubling story. Many successful entrepreneurs have their wealth tied up largely in one place: the business.
There are rational explanations for the imbalance. For the more fortunate, there has simply been no need to tap their companies -- equity. For others, the growth of the business has been their best possible investment -- particularly in the last two years. But a great many other entrepreneurs who've wanted some liquidity from their businesses haven't done so primarily for fear of having to relinquish the reins or being hustled into an early public offering.
It doesn't have to be that way. In fact, selling some stock now can be the best way to get a "second bite of the apple" later -- the opportunity for a much bigger payout when the company reaches a final "liquidity event" such as a public offering or a strategic sale or merger.
Now is a good time to reexamine the question of what's on your personal balance sheet, because some of the drivers for liquidity are more pressing than ever. And right now, there is abundant private equity funding -- more than $100 billion -- available to help fund liquidity moves.
Say you co-own a growing business that's on a solid footing: decent revenue growth, a comfortable stable of customers, steady cash flow, and reliable increases in earnings. You and your cofounders put up most of the founding equity (28% of last year's Inc. 500 CEOs raised seed money from cofounders), and you've drawn salaries for most of the company's life.
By now, it's likely that at least one founder wants more payback. Perhaps it's the need to fund college tuition -- costs of four-year public schools are up nearly 10% since last year, according to The College Board -- or to help with elder care. It could be to purchase a second home, or finance another business. Or it might be simply to offset poor performance in other asset classes.
Now let's say that, based on conversations with a personal financial advisor, one founder wants to sell out completely, and another wants to reduce her stake by 40%. The moves may be stymied if other owners fear a consequent loss of control. Even when there's agreement to sell, it's often hard for founders to be objective about issues of valuation, contribution, and motivation. Many a business has been torn apart and many a friendship has collapsed when partners cannot reconcile over those core issues.
The right equity partnership can deflect such debates, providing dispassionate third-party analysis of a company's value, arranging for recapitalization deals that get the necessary liquidity for owners who want to sell a portion of their equity, and demonstrating to those owners that they'll benefit later from all that happens subsequently to increase the value of the business.
Most entrepreneurs have a clear sense of their business's potential, but they often struggle to identify the best ways to achieve it. Many have learned on the job, and they're looking for help with upgrading their management teams, with which business processes will work best, with identifying core competencies, and much else. By selling a stake in the company -- usually at least 15% -- to a private equity partner, they get access not only to capital but to the equity firm's strategic counsel and strong networks of contacts built over many years of similar deals. The right kind of equity partner will offer "hands-off support" it is not in its interests to de-motivate the existing management team by dabbling in day-to-day operations.
That was the case at EMED Co. The maker of industrial signs -- they display warnings such as "Slippery When Wet" -- had been growing strongly for nearly two decades. But by the late 1990s, EMED's two founders were keen to convert their stakes into assets to support their retirements. An additional motivation: since the business had been throwing off substantial free cash, the founders -- ownership positions were not tax-efficient.
The founders knew EMED could grow faster. But the company lacked the systems that would make customer interactions more efficient. So when the two men began to look for a partner that could get the liquidity they wanted, they sought a firm that could also provide expertise, contacts, and resources -- without taking over.
In 1999, EMED's founders agreed to a $60 million recapitalization arranged by private equity firm Summit Partners. The recap secured their retirements and left them with a 15% stake in EMED's future. The move also enabled EMED to step up the pace. With a Summit partner on the board, EMED's founders sought the equity firm's help to find an experienced leader to succeed them; Summit's network led them to Tom Fay, a veteran marketer, who became president in August 2001. With guidance from Summit and the rest of the board, Fay used part of the refinancing to overhaul many of EMED's core processes, hiring a management team experienced in customer acquisition, customer retention, product development, and creative design. The company soon identified and expanded relations with its best customers, brought on new customers, and set up a telemarketing operation. Today, EMED is expected to achieve double-digit growth over the next several years -- more than double its earlier growth rate.
Recap deals are not for every situation. They are ineffective if a business is burning through cash. But for many entrepreneurs, recaps offer the opportunity to get some liquidity while remaining in charge of the businesses they have built so carefully. That way, they are in prime position to help make their remaining stakes in the business work much more effectively.
Here are the 10 questions that growth-company owners must ask about creating founders' liquidity:
- What are my options for achieving liquidity at this point?
- What's my obligation if I want to get this deal done? Will I be pushed toward an IPO?
- What is a recapitalization, and how does it work?
- How much leverage will the partners employ if I give up 60% of the equity? 25% of the equity?
- Describe your experience with recapitalizations to date.
- How have those companies fared since?
- What methods are you using to value my company?
- How can you help us if my partners and I disagree on the value of my stake?
- How long will it take before I receive cash liquidity from you?
- What conditions must I meet?