Those who have run successful companies for a number of years, either as CEOs or founders, will inevitably face the question: When and how do they bow out? They might have personal aspirations to do something else, or they might think that the market conditions have made it the right time for them to leave or at least sell most of their interest in the company. Maybe they want to monetize their life’s work but keep running the company. Maybe it’s a CEO who’s been running the company alongside its founder and wants to do something else. They might want to unlock value for their company’s stakeholders by selling their shares or recapitalizing the company—or helping it go public.
But for a smooth transition, they’ll need to understand the various exit options.
This article delves into three of the most common methods for entrepreneurs ready to sell out: dividend recapitalization, private equity investment, and the sale of their company. (Sometimes, CEOs or founders will turn a company over to their employees through employee stock ownership plans, or ESOPs, though that’s less common.)
The right path depends on various factors, but by engaging the right legal advisor, your client can navigate the complexities and implement the plan 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 shareholders. If the CEO is not the founder of the company, this strategy allows him or her to unload shares while letting other shareholders, perhaps the company’s founders, retain complete ownership while accessing liquidity.
There are pros and cons to this approach.
Among the pros is ownership retention. The founders of the company (if the CEO is not among them) can maintain 100% of the equity in the company, preserving voting rights and future upside potential.
This method also allows the owners of the company to keep control, since no power is transferred to external investors. The founders are bound only by typical loan covenants.
Dividend capitalization also offers the company some liquidity, giving it immediate cash and enabling the CEO who’s leaving to diversify their personal finances without losing their shares in the company, which they might want to hold onto after they leave.
In low-interest-rate environments, shareholders can invest the dividend, yielding returns that surpass the loan’s interest rate. Additionally, the debt can be refinanced to extend repayment terms.
But the dividend capitalization strategy has disadvantages, too: One is that it offers less liquidity than an outright sale of shares would. It also saddles the company with debt—a loan that must be repaid—adding leverage to the balance sheet and perhaps even affecting the company’s creditworthiness. And the departing founder or majority shareholder has to provide a guaranty for the loan repayment.
The debt service for this structure, meanwhile, diverts cash that could be used for the company’s annual dividends or growth initiatives, and if the loans are variable, that could later increase debt costs.
Private Equity Partners
The second strategy for exiting founders/CEOs is to turn to outside investment from a private equity firm, which entails issuing a new class of preferred equity for these third-party partners. The structure usually involves selling a minority or majority stake, and in return the company gets both growth capital and partial liquidity for the company founders.
The pros of this scheme include an influx of capital that, unlike the loans, doesn’t require repayment. The partial liquidity companies get from this strategy also allows the founders to take “chips off the table.” Meanwhile, the equity they hold onto can be sold later—often at a higher valuation—which offers them a second bite at the apple.
Beyond those advantages, the companies will now also benefit from the expertise and resources that private equity firms offer, including their valuable advice, industry connections and financing for acquisitions and growth. PE firms typically prioritize a company’s growth, which will likely align with the founders’ goals for expanding.
Yet this approach, too, has disadvantages. The private equity firm is going to require that preferred returns be paid to investors, which can be similar to loan interest. The equity that’s retained will be diluted, though the investors with the retained equity will share future upside.
Another disadvantage is that the company’s founders and original shareholders lose total operational control. The new investors may impose significant reporting requirements and board representation, which can sway company decisions.
Private equity firms also have their own exit agenda—they’re aiming for a return on investment within a specific time frame, often leading to pressure to sell or achieve liquidity within their secondary investment period. And if the company’s performance falters, the private equity partner might demand management changes to protect its investment.
Company Sale
The last strategy is the outright sale of the company to a third party, either through an equity or asset sale. This approach allows someone who’s built a business to unlock its full liquidity and gives them an immediate and complete financial exit. In this case, the interests of the buyers and shareholders are aligned, since they hold the same equity class. There’s no need to pay preferred returns.
A strategic buyer would often improve on the company’s capabilities, offering it economies of scale, revenue growth and cost reduction.
On the downside, these deals often come with earn-out requirements, where certain financial or operations targets must be met by the company after the transaction for the seller to get the higher price.
The reporting and control requirements are also going to change, and the buyer’s representation on the board will limit the autonomy of shareholders or founders who remain at the company. These changes will also likely lead to cultural shifts, especially if the buyer’s decisions differ from the founders’ vision, and that can be an emotional transition. Buyers might lay off redundant employees, which would further affect the company’s culture and morale.
On top of these disadvantages are the founders’ indemnity obligations, where they must provide representations, warranties and indemnities as part of the purchase agreement.
The Right Choice
Departing founders and CEOs have to weigh these pros and cons against their personal goals, the company’s performance and market conditions. Dividend recapitalization will let them perhaps keep control of their company and win them some modest liquidity, while a private equity investment would give them growth capital and partial liquidity with investor support. If they sold the company outright, it would ensure they get full liquidity and operational synergies, though it would involve significant transition challenges.
By understanding these strategies, the founder/CEO can make an informed decision that aligns with their long-term vision and ensures 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.