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The Half Exit

When most founders think of an exit, they think of the giant company swooping in and writing an enormous check to buy all of their shares. However, the more likely exit for a lot of owners is something that looks more like half an exit. It’s called a “majority re-capitalization” or “majority re-cap” and there are pros and cons.

First, let’s deal with the definition: a majority re-capitalization is where you sell more than half (hence the term “majority”) of your shares to an investor and “roll” the rest of your shares into a new entity the acquirer sets up to own your business. You become a minority shareholder in your former business.  This week, we’re publishing an interview with Lloyed Lobo who co-founded Boast, a software application designed to simplify the process of applying for R&D tax credits.  After bootstrapping their first few years, Lloyed and his partner sold the majority of the business in 2020 to Radian Capital for $23 million.  They got to take most of the money for themselves but had to leave a little bit (“low single-digit millions”) in the company to fund their growth. They rolled the rest of their equity (about 40% between them) into a new legal structure Radian Capital set up to own Boast.

These offers are common for smaller businesses because savvy private equity groups see an opportunity: buy a controlling interest in a company using a mixture of equity and debt, increase its value over time, and then sell it for a higher multiple down the road.

Let’s use a hypothetical example to simplify the math. Imagine a private equity company that values a business generating $1 million in EBITDA at $5 million (5 x EBITDA). They acquired 60% of the business for $3 million. The $3 million is made up of  $1.5 million of their cash and $1.5 million of bank debt. 

With the help of the founder, the private equity group has operated the business for seven years and uses their business savvy, connections, and capital to turn the business into a juggernaut churning out $3 million in EBITDA.  The business is larger now and attracts the attention of a strategic acquirer who pays 8 times EBITDA for the company because it’s larger and the private equity group knows how to negotiate hard. 

The ROI for everyone involved is impressive: the private equity group put $1.5 million of their cash to work and ended up with 60% of a business worth $24 million. Their take is $14.4 million — almost a 10-bagger on their original $1.5 of cash invested. The founder who rolled 40% of her shares also made out like a bandit. Her 40% became worth $9.6 million — triple what she got in the original transaction.

That’s the theory, but the reality of a majority re-capitalization is more nuanced and includes some pros and cons.

Pros of a Majority Re-capitalization

Take Some Chips Off the Table

Unlike a VC who invests in your company to fund its growth and expects you to leave most of their cash in your business, when a private equity group does a majority re-capitalization you can usually take most (or all) of the money and put it in your jeans (called a secondary). You diversify your personal balance sheet and keep some skin in the game.

Keep Your Job

This may be a pro or con depending on how you feel about your job, but in most private equity majority re-caps, they want the founder to stay on and operate the businesses they invest in. You get to cash out some of your shares and keep your day job.

In 2017, Randy Woods sold his digital agency Non-Linear Creations to the private equity firm Valtech. Today, Woods remains with Valtech happily talking to potential sellers from around the world.

Two Bites

As in the hypothetical example above, most private equity groups are run by savvy, experienced operators who are good at increasing the value of your business. They have an eye for efficiency and often bring experience from multiple industries to your company. They are typically seasoned negotiators which means they drive a hard bargain when it comes to selling the second tranche of your equity.  Therefore, your company may grow in value under their ownership and it’s possible that your minority slice of equity becomes more valuable than your original exit where you sold the majority of your shares.  Private equity groups refer to this as a “second bite of the apple”.

Sarah Dusek had built Under Canvas to $3 million in EBITDA when she decided to sell a majority stake to the private equity group, KSL Capital. She retained 25% of her equity and continued in her role as CEO. When she eventually stepped down, Under Canvas had a valuation exceeding $100 million.

Cons of a Majority Re-capitalization

At Their Mercy

You become a minority shareholder in a company you no longer control. This means the private equity group will decide when/if they want to sell your business. So if you’re counting on that second chunk of cash to do something you’ve always dreamed of, you may have to wait a while — unless you negotiated a “put option”. A put option entitles you to sell your remaining shares to the acquirer at a pre-determined valuation, but they are hard to get from most acquirers.

Listen to Tyler Smith as he used a put option to limit his downside when he sold SkySlope to Fidelity National for $80 million.

You May Not Like Their Changes

A private equity group will usually invest in your business if they see a way to improve it. That means they will likely make changes to your company you hadn’t thought of, or may not agree with. For a proud founder, that can feel like open heart surgery without the anesthetic.

Hear why 90% of Sherry Deutschmann’s employees left after a private equity firm acquired LetterLogic and gutted its bonus plan.

Your Apple May Rot

Although most private equity groups are savvy, some are not. They may underestimate or discount the delicate alchemy that is your company and screw it up, leaving you with little or nothing for the second half of your shares.

Listen to Ryan Moran as he describes losing a 7-figure slice of his company when he sold to private equity and they brought in a new CEO.

Narrower Margin of Error

Remember that most private equity acquisitions are financed by borrowing some of the money. Your business will need to pay that money back — harder these days with higher interest rates —  so you’ll have a narrower margin of error to manage your business under the burden of that debt. Suffer a few lean months, and life could get nasty, very quickly.

You May Get Fired

Once you become a minority shareholder, you no longer control things and it’s possible — depending on your agreement — that you could be fired from your own company. In Lloyed’s case, he struggled to get used to life under new leadership. In his own words, he became an “insufferable” employee so eventually Lloyed and Radian came to the conclusion he was probably not the best person to run Boast anymore.

Can We Buy You a Coffee?

We’re conducting a “Built to Sell” Reader & Listener survey. It takes about 3 minutes to complete. We’ll send you a Starbucks gift card as a thank you for taking a few minutes. We’ll share the results here in the coming weeks. Please 3 minutes and answer our reader survey.

📣 Quote of the Week

“It was a 30-day close but we were a bootstrapped company with not many buttoned-up systems so it ended up being a sixty – seventy-day close”.

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–  Lloyed detailing the headaches that came with not being prepared for due diligence.

Make due diligence smoother with VidGuide. Start your free 30-day trial now.

📈 Deals

  • Cornell Dubilier, with over $135 million in annual revenue and more than 35,000 customers, will be acquired by Knowles for $263 million (almost 2 times revenue). The provider of micro-acoustic microphones and speakers said Monday that the all-cash deal would add Cornell Dubilier’s array of film, electrolytic, and mica capacitors, which are used in industrial electrification applications, to its product portfolio. The acquisition deal comprises a $140 million immediate cash payment and a $123 million interest-free seller note, with $50 million maturing in one year and the balance in two years. Adding Cornell Dubilier’s industrial-grade capacitors to its offerings, Knowles estimates the deal’s total fair value at $250 million.
  • Swvl Holdings Corp sold its subsidiary Urbvan Mobility Ltd, an App-based transit mobility network that connects inner-city commuters by providing a safe, and efficient commute to Kolors Inc, a leading Latin American transport provider, for around 12 times revenue, totaling $12 million. The sale included an upfront payment of $9.5 million in cash and a deferred payment of $2.5 million to be made over one year.  At around $1 million in turnover, Urbvan made up 4% of Swvl’s IFRS revenues as of September 2022.

If you know a founder who has successfully exited their business and has valuable insights to share, we encourage you to nominate them. 

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