Recapitalization — the process of changing a company’s capital structure through the issuance of new debt or equity securities — is a popular way to fund acquisitions, growth strategies, partner buyouts and distributions. 

“The successful execution of a business recapitalization relies on a clearly defined investment objective, realistic expectations and a solid operating plan,” says Kevin Coyne, founder and CEO of Canal Holdings LLC, a Cleveland-based junior capital firm serving the lower middle market.

Smart Business Dealmakers spoke with Coyne about the essential components of an effective recapitalization strategy.

Define objectives, set expectations
When considering recapitalization transactions, it is imperative that potential new partners understand the business owner’s true objectives, Coyne says.

“The success of a recap will depend on how well the involved parties communicate, understand and support both the operating objectives of the business and how the new capital structure supports those objectives,” he says.

The two biggest constraints on a business owner are cash and time. The first step in considering a recap strategy should be educational — gaining an understanding of the types of capital available, the cost of that capital and the level of operational support that comes along with the capital.

“Many owners underestimate that the cost of capital includes both monetary/hard costs in terms of interest rates and ownership percentages, but also includes soft items such as performance covenants and reporting requirements,” Coyne says. “An educated owner will be able to identify the right terms and the right partner to meet the needs of their business.”

A key component to identifying the right partner is to understand the amount of support a new investor will provide to help advance the business. A recapitalization partner should have the resources and relationships to assist with operating issues, personnel challenges, senior lender relationships and sales strategies, among other issues.

“We’re operators at Canal,” Coyne says. “Our partners have bought, built and sold many businesses. We think like owners; we act like owners. Preparing for planned — and unplanned — outcomes is a very important part of how we operate.” 

The second, and possibly concurrent, step is to clearly define the company’s goals and objectives and how new capital will help achieve those goals. Establishing a robust and flexible plan early in the process will help attract the right investor and contribute to an efficient transaction process.

Gather intelligence

The third step is to gather market intelligence. Often, many recap conversations begin with a company’s existing senior lender, accounting firm or attorney.  Owners need to determine quickly if additional capital from the senior lender is going to be the right fit for the business objectives at hand.

“The senior lender may not be comfortable advancing the necessary capital, or they may not be willing to provide the operational support the company needs,” Coyne says. “If the company’s capital or support needs are greater than a senior lender can provide, owners may then look to traditional private equity to fill the capital need.”

If a private equity firm is looking for too much ownership or control over what’s going to happen in the business after the recapitalization, then traditional private equity may not be the right fit either for an owner who wants to continue to effectuate growth and reap a majority of the rewards of their hard work.

“Canal’s investments lead with a debt component and may include a minority equity stake, providing a nice hybrid of what many owners are looking for in a recap transaction,” Coyne says.

The right structure for the right purpose
“No two transactions are ever alike,” Coyne says. “Every financing that takes place is an individually negotiated transaction that should create a stronger balance sheet post-transaction and make sense to all parties involved.”

Companies with a strong balance sheet are prepared to support current operations, maximize financial performance, survive economic downturns, and be positioned to thrive when the economy gets going again. While debt is typically a less expensive source of financing, owners should be cautious and avoid borrowing too much. 

“Debt will benefit the company, and its owners, when times are good,” Coyne says. “But overleveraging can be dangerous when the company, or economy, stalls. Equity financing may be less risky from an owner’s perspective as there are no current payment obligations and the investor has the ability to be a little more patient, but the trade-off is usually giving up more control and the creation of higher return expectations for investors.” 

Stay focused on the business

As much time as owners spend on the recap strategy itself, they should also think about life inside the business after the deal gets done.

“Changing the capital structure of a business is a major event that will change a company’s capabilities and quite possibly the management responsibilities,” Coyne says. “It’s important to keep senior managers focused on their primary sales, production, shipping and collection responsibilities during the process.” 

Even if your existing bank provides the financing, it’s a new relationship with new performance expectations.

“The business owner needs to be ready on the other side of the transaction,” Coyne says. “The profile of the business has now changed and you have to make sure that you can stay focused on operating the business. Make sure the change is providing for the positive outcome you sought and that you’re ready to operate the business to meet your new objectives with the new foundation you’ve created by doing the recap.”