Many business owners are faced with the possibility that the largest asset they own in their retirement portfolio is their privately owned business.  Many business owners have expressed a desire to pull value from their existing businesses as a planning strategy to deliver some liquidity and diversification to themselves in lieu of selling a controlling interest in the business.  By doing a dividend recapitalization, the owners receive the benefit of a sale of the business without actually selling the business.

A dividend recapitalization is achieved when a company incurs new debt from an outside third party (usually a private equity fund) in order to pay a special dividend to the owners of the company.  In a typical recapitalization transaction, the company borrows funds from an outside third party and is required to make quarterly payments over a period of years (typically 5-6 years) at which time the entire balance of the loan is due and payable.  The company uses the loan proceeds to pay a dividend to its owners in the amount of the net proceeds received in connection with the loan.  The business owners have thereby diversified their personal portfolios (they now have cash to use toward retirement planning) and they still own their business.

In a typical recapitalization transaction, there are prepayment penalties included during the early years of the loan.  The lender typically wants a guaranteed rate of return on its investment (loan) and a prepayment penalty allows the lender to accomplish this goal.  However, you may be able to negotiate a provision that would allow you to make prepayments from internally generated funds without penalty.  The lender will also likely request warrants that are convertible into stock of the company (usually a right to convert into approximately 5% ownership in the company).

As an example, suppose a private equity fund agrees to make a loan to your company in the amount of $15,000,000 based upon the value of your business for a recapitalization.  As a result of the dividend recapitalization transaction, the company is in a position to make a special distribution of $15,000,000 (less the payment of all fees to counsel, CPAs and brokers) to the owners.

In order to receive funds in connection with the recapitalization, it is typical that the lender will require all of the owners to pledge their ownership interests in the company as security for the repayment of the debt obligations incurred by the company.  The lender will hold all of the original stock and/or unit certificates in order to evidence the pledge of the interests.

We anticipate that you (like most business owners) have questions regarding the dividend recapitalization transaction.  The following is a list of some questions that we normally receive from clients regarding a potential dividend recapitalization and our responses to such questions:

What happens to the money (distributions) an owner receives in connection with the recapitalization in the event the company defaults in its repayment obligations and fails to cure the default within the required time frames? 

  • Typically, the owners who receive distributions are required to guarantee the repayment obligations of the company. However, we have been able to negotiate the elimination of personal guarantees in these types of transactions. If the personal guarantees are eliminated, an owner will be entitled to keep all of the money they received in connection with the recapitalization. The trade-off for eliminating these personal guarantees is usually allowing the lender to foreclose on the ownership interests and take control of the company in the event there is a payment default by the company that is not cured. The end result is essentially the sale of the business in the event of a default for the loan amount.

What happens in the event the company defaults in its repayment obligations and fails to cure the default within the required time frames? 

  • The lender can elect to proceed against any and all security for the loan to secure repayment of the debt. All assets of the borrowing company will typically be pledged as security for the loan. In addition, the lender would typically also have the right to take ownership of the stock and/or units pursuant to the Assignment and would have the right to vote those shares/units in accordance with the Proxy. Typically the lender will elect one or the other, not both. However, the lender could elect a combination of the rights.

Is there a limitation as to what lender could receive in the event there is a default? 

  • Yes. For example, assume the company defaults at a time when the remaining balance on the debt (plus any costs and fees) is $2,500,000. The lender would be entitled to foreclose on either the assets of the company or the stock/membership interests (or any combination thereof) to reach the value of the remaining outstanding balance due to lender (plus any costs and fees). Also, for purposes of this example assume the value of the company at the time of the default is $5,000,000. Under this scenario, the lender would only be entitled to receive fifty percent (50%) of the assets of the company or fifty percent (50%) of the stock/membership interests pledged in the company. The lender is limited in terms of receiving fair value for what is owed and no more. In other words, the lender may not be “unjustly enriched” and receive more than it is entitled to.

What is the worst case scenario? 

  • Using the above example, the worst case scenario would be for the company to default during the first year of the loan or default when the value of the company is less than the amount owed to lender. It is likely that the lender would take over the company at that point (foreclose on the ownership interests and/or the assets). However, if negotiated properly, the owner(s) of the business would all be allowed to keep the money they received in connection with the recapitalization ($9,500,000) while the lender takes over the company. Thus, the worst case scenario is that the owners sold the company for $10,500,000 (with owners receiving $9,500,000 of the net proceeds after payment of fees).

If you are considering ways in which to pull value from your existing business, please be sure to consult with your legal and tax advisor on the various methods that may range from a dividend recapitalization to the sale of your business.  If your ultimate goal is continue to run the business, we believe that a dividend recapitalization is a method that you should consider.