When an opportunity for growth or a general need for liquidity arises, various capital options exist to help private and family business owners achieve their objectives. Such owners could be looking to finance an acquisition, expand production, buy out a minority shareholder, or perhaps, fund a dividend or distribution. When the liquidity required for such events extends beyond the reach of cash-on-hand, traditional bank loans, or senior debt, owners have turned to additional and larger pools of capital by issuing majority equity. However, with majority equity comes ceding majority ownership (and control) to third parties. For those companies not interested in giving up control of their business, another option—minority equity—offers owners the ability to receive additional liquidity, while keeping both hands on the wheel.
The types of capital available
Private, middle-market companies seeking liquidity often turn to traditional sources along the capital structure from cheapest to most expensive, depending on the company’s debt capacity, the amount of capital that is required, and the objective at hand. Beyond cash-on-hand, owners can contemplate the following types of capital, and should understand the advantages and inherent risks of each:
- Asset-based loans — These traditional senior debt loan options come in two flavors. The first is a “loan to value” note secured by specific plants/facilities or equipment based on appraisal. The second is formula driven and based on metrics, such as working capital and receivables. These loans have the advantage of being relatively less expensive in terms of cost of capital but are limited in terms of the amount of capital that can be raised by the assets they are based on.
- Cash-flow based traditional bank loans — Another type of senior debt are loans on offer by local, regional and national banks that provide negotiated amounts of capital secured by a blanket lien on the business. These loans have the advantage of offering potentially more capital than an asset-based loan, but come with more risk to the business in the event of financial difficulty.
"Mezzanine is the last stop along the capital structure where owners can raise large amounts of liquidity without selling a stake in their company."
- Mezzanine or subordinated debt — As the name implies, this type of financing sits in between senior debt and equity in the capital structure. This type of capital is typically unsecured and subordinate in terms of payback priority to any senior asset-based or bank loan debt on the books. Mezzanine is more expensive to borrow than senior debt, but it is also more patient; it is less expensive than equity. Mezzanine is the last stop along the capital structure where owners can raise large amounts of liquidity without selling a stake in their company.
- Preferred equity or stock — For those companies that require capital and are open to involvement from an outside investor, selling an equity share in the company is an option. Such a transaction is typically completed by a private equity fund or institutional investor, and capital is exchanged for equity. The selling owners are generally expected to keep at least some equity in the company. Preferred equity, specifically, has a higher “first out” position than common stock with a preferred dividend attached to it.
- Common equity or stock — Like preferred equity, common equity also involves selling an equity share of the business and is typically funded by a private equity fund or institutional investor. However, it has a slightly higher return requirement than preferred equity and a “last out” position, but often requires a control position.
"Minority equity may require board representation or observation rights from the lender, but it’s minority position allows the business owners to ultimately maintain control."
If you’re selling equity, you are either selling minority equity (minority control) or majority equity (majority control). Minority equity has similar return expectations as majority equity, but does not require business owners to forgo control of their company. It is typically provided by institutional investors; very few private equity funds are willing to take a minority position. Minority equity may require board representation or observation rights from the lender, but it’s minority position allows the business owners to ultimately maintain control.
Minority equity offers business owners a way to complement and extend the liquidity from traditional senior debt resources. Often structured as preferred equity in conjunction with mezzanine debt, this combination can be used to finance a minority recapitalization, or “minority buyout”, an alternative means of raising capital to generate liquidity. Both preferred equity and mezzanine debt are more patient than senior debt and less expensive than common equity. If owners need to achieve liquidity beyond their senior debt capacity, a minority recapitalization comprised of preferred equity and/or mezzanine debt is generally recommended, as it will leave some “headroom” in their capital structure to provide flexibility for opportunities for future growth or unforeseen events.
A closer look at minority recapitalizations
Companies that are, typically, attractive candidates for a minority recapitalization include those with experienced management teams who are looking to leverage their already strong and defensible business model with a source of patient, long-term capital. As such, financing from a minority recapitalization is often used to:
- Provide shareholder liquidity—Capital can be used for a shareholder to reduce or sell all of his/her ownership stake, while the remaining, (presumably active) shareholders can consolidate and maximize their ownership as well as benefit from future growth down the road.
"A minority recapitalization can help smooth and minimize the time it takes for the handover."
- Facilitate a buyout—When owners decide to step back or away completely to transition the company to a management or employee ownership structure. A minority recapitalization can help smooth and minimize the time it takes for the handover.
- Fund future growth—Growth, achieved organically or through acquisitions requires capital, and fast growing companies can often outpace their ability to borrow through their usual channels. A minority recapitalization can help extend a company’s borrowing ability for sustained growth.
- Refinance older debt—Liquidity can be used to pay down older, higher cost debt, alleviating strain on the balance sheet or to better position a company for an outright sale in the future.
- Issue a dividend— For owners looking to take some equity exposure off the table, they can achieve liquidity through a dividend while leaving a portion of their equity in place for another liquidity event in the future, when hopefully, the business has expanded and is trading at even higher valuations.
Minority Recapitalization Example
Polar Beverages: A family that grows together
Capital is the lifeblood of every business. And for some, that lifeblood comes carbonated. Ten years ago, Polar Beverages was looking for a way to transition the business from fourth to fifth generation ownership. That meant simultaneously buying out minority shareholders and refinancing some senior debt, which would require a good deal of capital. The remaining family owners were not interested in selling or giving up control of the business, which has been in the Crowley family since 1882. They turned to Prudential Private Capital for solutions to help them rebuild their capital structure, facilitate the buyout and help Polar grow under the new generation.
Prudential Private Capital worked closely with Polar’s senior family owners to complete a minority recapitalization to help them rebuild their capital structure and facilitate the buyout. Prudential Capital was also awarded a board seat and observer rights. A decade later, Polar continues to grow, and the relationship between Polar and Prudential Capital remains strong.
“We've had such a good relationship with Prudential Capital that we're delighted to have them on the board,” said Ralph Crowley, Jr., President and CEO of Polar Beverages. “Some board members are value added, and we look at Prudential Capital that way.”
Polar repaid the mezzanine financing in full (from earnings) in less than six years, and continues to have a strong relationship with Prudential Private Capital.