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Too Much of a Good Thing?

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When Extracting Equity from Your Business Makes Sense.

Share current LOB: CommercialCorporateInstitutional

One of the difficult challenges for owners of mid-sized businesses lies in unlocking and extracting the often sizeable equity that they’ve built-up over the years. It’s not that the process in and of itself is complex, but rather that the entrenched mindset of “the needs of the business always come first” can be exceedingly hard for many owners to surmount. Nevertheless, there are a variety of situations where taking equity out of the firm simply makes sense – two of the more commonly seen are the desire to diversify a highly concentrated equity position in a low-leveraged, successful firm, and the need to buy out the interest of a partner or shareholder who’s looking to exit the business.

While there are a multitude of potential strategies that can help achieve this end, the particular approach or approaches best suited to a business’s specific needs will depend greatly on a host of factors including business structure, degree of leverage, EBITDA and book value. Most important, however, is determining how much a business owner can afford to take out of the business from both a credit and risk perspective. Your SunTrust Relationship Manager can assist you in assessing your current business situation and exploring the pros and cons of the various avenues available to you.

Dividend recapitalization

A common situation is successful entrepreneurs who have reached a point in their career where they’re starting to think about ways to monetize some of their considerable equity in the business, but are not yet ready to retire and not willing to relinquish control of the business. Take a typical example of a single-owner firm with very little leverage, an EBITDA of $5MM annually and a book value of $20MM. Over the years, in an effort to ensure that the business retains enough cash to fund future growth, the owner has been exceedingly judicious in refraining from taking too much equity out of the company. As a result, while the business has flourished, the owner’s personal wealth picture has lagged behind.

In sitting down and reviewing the business, we’re often able to show this type of owner a simple way to take a large chunk of cash out of the business through a dividend recapitalization process. In the case above, the owner could extract $15MM in equity, without creating excessive leverage or leaving the business cash poor. For example, the owner might take out $5MM in cash and secure a 7-year term loan for $10MM. The business’ $5MM annual cash flow would more than payback the loan, and the owner could invest the $15MM.

Partial buyouts

Even more commonly, we are approached by multiple-owner partnerships where one or more partners are seeking to buy out another. Predicated on the financial health of the business, these are normally straight-forward transactions that can be facilitated with relative ease. But there are a myriad of financing tactics that can make up some or all of the buyout package including cash, deferred compensation arrangements, extension of benefits until age 65, a company-financed vehicle, etc.

In many instances, however, the partner being bought out may prefer to not be paid over time and/or be tied to the business going forward. In these instances, a partial buyout using a combination of cash and debt financing may be advisable. Consider a $21MM business wholly-owned by three equal partners. Whether due to death or retirement, the company needs to buy back the stock from one of the partners (a $7MM transaction). A typical partial buyout might consist of $2MM in cash combined with a 5-year term loan for the remaining $5MM.

Keep in mind that in the case of a deceased partner, you may be dealing with the partner’s spouse, children or estate. And the future well-being of your business may be the furthest thing from their mind. It’s why we constantly stress the importance of having an executed partner buy-sell agreement in place that clearly articulates the disposition of equity in the event of one or more of your deaths.

Buy/Sell Agreements Afford You Peace of Mind

In addition to facilitating the orderly transfer of your business to new owner(s), buy/sell agreements:

  • Provide your heirs with a buyer for your business interests
  • Provide the cash to buy out the interest of a deceased partner
  • Help establish the value of the business for estate tax purposes
  • Prevent the forced sale of your business at a reduced price to an unwanted buyer
  • Set a fair market price that lets you pre-plan estate and tax obligations

 

Any withdrawal of equity from your firm may have significant tax implications and therefore should only be undertaken in consultation with your tax attorney. But for owners who either choose to or need to explore their options, your SunTrust Relationship Manager can help you with approaches you may want to consider based on the structure of your entity and your specific equity needs.

This content is general in nature and does not constitute legal, tax, accounting, financial or investment advice. You are encouraged to consult with competent legal, tax, accounting, financial or investment professionals based on your specific circumstances. We do not make any warranties as to accuracy or completeness of this information, do not endorse any third-party companies, products, or services described here, and take no liability for your use of this information.