For CEOs, the culmination of years of dedication and strategic growth often leads to contemplating the best exit strategy for the company. Whether driven by personal aspirations, market conditions or the desire to unlock value for stakeholders, understanding the various exit options is crucial for a smooth transition.
This article delves into three prominent exit strategies: dividend recapitalization, private equity investment, and sale of the company. In some cases, employee stock ownership plans (ESOPs) are considered, however these are far less common. Each path presents unique advantages and challenges that CEOs must carefully consider.
Each CEO's circumstances are unique, and the best path forward depends on a variety of factors. Engaging the right legal advisor is essential to help you navigate these complexities, decide the best course of action, and implement it effectively.
Dividend Recapitalization: Balancing Liquidity And Control
Dividend recapitalization involves the company taking out a term loan and using the proceeds to issue a special dividend to owners. This strategy allows founders to retain complete ownership while accessing liquidity.
Pros:
• Ownership Retention: Founders maintain 100% equity, preserving voting rights and future upside potential.
• Control: No power is transferred to external investors; founders are only bound by typical loan covenants.
• Modest Liquidity: Provides immediate cash, enabling founders to diversify personal finances without relinquishing control.
• Flexible Financing: In low-interest environments, investing the dividend can yield returns surpassing the loan's interest rate. Additionally, debt can be refinanced to extend repayment terms.
• No Restrictive Covenants: Avoids non-compete or similar restrictions often associated with other exit strategies.
Cons:
• Limited Liquidity: Usually offers less immediate cash compared to other options.
• Debt Obligations: The loan must be repaid, adding leverage to the balance sheet and potentially impacting creditworthiness.
• Guaranty: Often the founder or majority shareholder must provide a guaranty for the loan repayment.
• Cash Flow Impact: Debt servicing diverts cash that could be used for annual dividends or growth initiatives.
• Interest Rate Risk: Variable loan rates could increase debt costs unexpectedly.
Private Equity Investment: Partnering For Growth And Partial Liquidity
Private equity investment entails issuing a new class of preferred equity to a third-party investment firm. This could involve selling a minority or majority stake, providing both growth capital and partial liquidity to founders.
Pros:
• Non-Repayable Capital: Unlike loans, equity investments don't require repayment.
• Partial Liquidity: Selling a minority interest allows founders to take some "chips off the table."
• Second Bite at the Apple: Retained equity can be sold later, often at a higher valuation.
• Expertise and Resources: Private equity firms offer valuable advice, industry connections, and financing for acquisitions and growth.
• Growth Focus: These firms typically prioritize company growth, aligning with the founders' expansion goals.
Cons:
• Preferred Returns: Similar to loan interest, preferred returns must be paid to investors.
• Retained Equity Dilution: Even after preferred returns are paid, investors retain their equity stake, sharing future upside.
• Operational Control: Investors may impose significant reporting requirements and board representation, potentially influencing company decisions.
• Exit Pressure: Private equity firms aim for a return on investment within a specific timeframe, often leading to pressure to sell or achieve liquidity within the firm's secondary investment period.
• Management Changes: If performance falters, investors may replace existing management to protect their investment.
Sale Of The Company: Achieving Full Liquidity And Transition
Selling the company, either through an equity sale or asset sale, transfers ownership to a third party. This strategy can cater to financial buyers (e.g., private equity firms and family offices) or strategic buyers (operating businesses).
Pros:
• Full Liquidity: Provides immediate and complete financial exit for founders.
• Aligned Interests: Buyers hold the same equity class as founders, fostering aligned goals.
• No Preferred Returns: Eliminates the need to pay preferred returns.
• Operational Synergies: Strategic buyers often enhance the company's capabilities through economies of scale, revenue growth, and cost reduction.
• Expert Guidance: Buyers can offer expertise, advice and financial resources for further growth.
Cons:
• Earnouts: Sometimes a material portion of the consideration for the sale is structured as an “earnout” where the post-closing achievement of certain financial or operational metrics is required in order to get the money.
• Reporting and Control: Significant reporting requirements and buyer representation on the board may limit founders' autonomy.
• Cultural Shifts: Transitioning control can be emotionally challenging, especially if the buyer's decisions differ from the founders' vision.
• Employee Impact: Buyers may lay off redundant employees, affecting company culture and morale.
• Indemnity Obligations: Founders need to provide representations, warranties, and indemnities as part of the purchase agreement.
Conclusion
Choosing the right exit strategy requires CEOs to weigh the pros and cons of each option against their personal goals, company performance and market conditions. Dividend recapitalization offers control and modest liquidity, while private equity investment provides growth capital and partial liquidity with investor support. Selling the company ensures full liquidity and operational synergies but involves significant transition challenges. By understanding these strategies, CEOs can make informed decisions that align with their long-term vision and ensure a successful transition for their company. While understanding the primary exit strategies is a good baseline, it is best to engage the right legal advisor to choose the optimal path.
Andrew Apfelberg, a partner at Greenberg Glusker LLP, is a corporate and finance attorney for middle-market companies throughout the United States.