Capital / Cash Management

Cashing in without cashing out: Dividend-levered recapitalizations

dividend levered recaps

How can a dividend-levered recapitalization help your business? Let’s picture this scenario: You own and run a successful company.  You feel strongly that your company will do well, grow and increase in value.  The business is run by you and you don’t want or need any partners. The company is worth a lot.  It represents 60-90% of your net worth. 

Even though your company is doing well and has rosy prospects, there is always the possibility that things will go wrong and your business will falter. Having the majority of your wealth tied to a single asset creates great risk. So, you wonder, “How do I mitigate that risk while continuing to own and run my company?

What’s a dividend-levered recapitalization?

An efficient way to mitigate your risk of wealth concentration is to do a dividend-levered recapitalization.  This embraces the same financial engineering used by private-equity firms.  The difference is that you can:

  • Maintain your existing ownership position.
  • Take almost as much capital out of your company as you would in a PE deal.
  • Keep management control and continuity.
  • Avoid the fees PE firms charge and the disruption they can create.

For example, take a look at how a levered recap could mitigate your risk of wealth concentration in this scenario:

  • Your company has EBITDA of $5 million
  • The company borrows $20 million – 4x EBITDA – on a non-recourse basis
  • $5 million remains with the business for working capital
  • $14 million is paid out to you as a dividend, with about $1 million paid in fees and expenses to the various parties to the transaction
  • Your cost of capital in today’s market will be 6-7% above LIBOR
  • The multiple of EBITDA and interest rates available improve as EBITDA grows

The $14 million you take as a dividend will generally have significant tax advantages versus receiving annual profit sharing at ordinary income rates.  Therefore, you and your family have greater financial security if anything should happen to your business.

Isn’t the risk to the business increased?

The answer is no, not really. 

Management hasn’t changed and the company has adequate working capital to continue to grow and thrive.  Moreover, after taking the dividend out of your company, debt is quickly amortized — not so fast as to eliminate growth investments, but fast enough to “de-lever” your company rapidly.

A dividend recap is a risk-mitigation strategy for balancing the wealth between your company and personal holdings.

In the example below, the assumption is that your company’s EBITDA will grow at 10% annually and that you will want to balance debt amortization with growth investments and continued cash distributions to shareholders.

 
Year 1
Year 2
Year 3
Company EBITDA
$5.0 million
$5.5 million
$6.0 million
Existing Debt
$20.0 million
$19.0 million
$16 million
Amortization – Scheduled
$1.0 million (5%)
$1.0 million (5%)
$1.0 million (5%)
Remaining EBITDA
$4.0 million
$4.6 million
$5.2 million
Amortization – ECF Sweep (see note below)
NA
$2.0 million (~50% After Tax Cash Flow)
$2.2 million (~50% After Tax Cash Flow)
Ending Debt
$19.0 million
$16.0 million
$12.8 million
Ending Total Leverage
3.80x
2.90x
2.13x

This example demonstrates that by year 2 after the dividend, shareholders can again begin to take distributions from the company, and that the ratio of debt to EBITDA reduces from 4x EBITDA to 2.9x at the end of year 2, and 2.13x at the end of year 3.  Please remember that 1x EBITDA is your working capital line.

2.9x EBITDA – 2.13x EBITDA do not represent a high-leverage ratio that should create risk to your business. 

In years 2 and 3 after required debt amortization, you have the option to apply the second 50% of after-tax cash flow to distributions for shareholders, further balancing your wealth portfolio.  You may also apply those funds to growth initiatives.

Or, try this

Alternatively, you can apply those funds to faster debt amortization.  If you take this tack, ending debt at the end of year 2 will be $14 mil – 2.55x EBITDA.  At the end of year 3, ending debt will be $10.6 million which is 1.77x EBITDA — a conservative level.

It is important to reiterate that a dividend recap is a risk-mitigation strategy for balancing the wealth between your company and personal holdings.  The borrowings described above are non-recourse to you.  Should something go wrong in your business, you and your family have (in this example) $14 million more held outside your business to mitigate risk to your personal wealth.

Excess cash flow

Cash payment of Excess Cash Flow (ECF) sweep amortization occurs after the yearly audit is completed. ECF is a highly negotiated term of any credit agreement, and is generally defined as EBITDA less the following:

  • Capital expenditures for the period
  • Cash taxes
  • Principal payments
  • Cash interest expense
  • Cash management fees
  • Restricted distributions for each year

This article covers a lot of ground quickly and may leave you with more questions than answers. If you do have questions, please contact Mark Taffet at mtaffet@mastadvisors.com.

Related articles

What’s better: Cash flow or asset-based borrowing?

Merger and acquisition trends in 2019: 10 steps to optimize your valuation

1,400 CEOs reveal their biggest obstacles to innovation: Here’s how to solve them

Category: Capital / Cash Management

Tags:  , ,

Mark Taffet About the Author: Mark Taffet

Mark Taffet is CEO of Mast Advisors, Inc., an M&A and strategic advisory firm focused on maximizing value for middle market companies. Taffet provides capital raising services through an affiliation with SPP Capital Partners, an investme…

Learn More

Leave a Reply

Your email address will not be published. Required fields are marked *