While dividend recapitalization can be an effective way to create liquidity, it’s not for everyone — or for every type of business, says M&A adviser Andrew Dickow. There are certain industries that just don’t match up well with a dividend recap formula.
“A lot of times, it’s very hard to get great terms on a business that is in business services, which is typically very light on assets,” says Dickow, managing director at Greenwich Capital Group. “When you’re getting a lender, they are not just lending on your cash flow. If you’re a $10 million EBITDA business and you’re looking to raise $30 million, the bank wants to look at your historical track record to see that you’ve delivered year-over-year growth and consistency in your financials to prove you’ll be able to service the debt. More importantly to the bank, if things go awry, how do they recoup their investment?”
The primary method of doing so, of course, is through your asset base. If your company has minimal assets, that’s a concern for the bank.
Smart Business Dealmakers talked with Dickow about the keys to effective recapitalization strategy.
What’s your status?
The first step to a successful recap strategy is understanding the financial health of your business.
“Do you have a clear understanding of your capital structure?” Dickow asks. “What order are your financial statements in? Do you have reviewed financial statements by a third party? Do you have audited financial statements? Are you putting together you own in-house finance team?”
Banks are going to pick apart all these areas, and more, to get a sense of where your business is at financially.
“They’re doing a deep dive into not only the book value of your assets, but if there has been any recent appraised value of your assets, including your real estate,” Dickow says. “They are also looking at the health of your accounts receivable. Your business should be in a very healthy state producing excess cash flow. If you look at all the traditional covenants — debt to EBITDA, debt to equity, your fixed charge coverage — you should be evaluating those items. If you’re not in a good spot on those, you shouldn’t be doing it.”
If you are a services business and you’re trying to force a dividend recap, you could end up with really bad financial terms.
“You might have a higher interest rate, more aggressive amortization and other things like warrants when you’re going to alternative lenders,” Dickow says. “You might get the money you want today, but you’ve really put your company in a challenging spot with bad terms because no one is willing to lend against your cash flow versus your asset base.”
Know the consequences
The opportunity to create liquidity can be very appealing, but it doesn’t come without consequences.
“One of the symptoms of a leveraged recapitalization is it forces the company to have more discipline,” Dickow says. “Your debt structure and your capital structure has changed. You have significant debt service that you have to ensure you can manage. This often forces management, operations, supply chain, marketing, sales, everybody to be more thoughtful and think about the business in a different way than they were before because there is less room for error.”
Thus, there is value in creating a sense of urgency and a more disciplined environment in your business because of that reduced wiggle room.
“If you have no debt and you have a bad month and a very healthy balance sheet, you can get through it,” Dickow says. “When you don’t have that, it changes things. You create this undue burden and you have a blip in the road and things can get really sour, really fast. You can lose everything if you breach a covenant. Even though you took some liquidity off the table upfront, you could lose everything. You could lose your entire business.”
Plan for everything
The key with any significant financial strategy, whether it’s a dividend recap or something else, is to think through all the scenarios.
“Outline what your personal objectives are,” Dickow says. “If you’re exploring a leveraged recap or any kind of strategic option other than continuing to run your business as is, what is the goal? If the goal is to have a liquidity event and pull money out of the business for personal use to diversify your risk and be able to take that liquidity and put it in different industries, put some away for a rainy day, have alternative investments, that’s one consideration. If you’re taking money out so it can be reinvested back in the business and you also want to have the business for another three to five years, drive it for growth and explore your options then, that’s another option.
“A great place to get started is to engage an adviser who has experience in exploring strategic options. A dividend recapitalization is one of those options that can provide liquidity for a business. They can walk you through the implications and the pros and cons of what will change about your business.”
Related story: Is a dividend recap right for you?