Corporate Finance Guides
Guide to Equity Release (Cash-Outs)
Guide to Management Buy-outs (‘MBOs’)
Raising Development Capital
The Sale Process
The Descision To Sell
GUIDE TO EQUITY RELEASE (OR ‘CASH-OUTS’)
The concept of a cash out encompasses several different types of transactions. The common theme is that the shareholders are unlocking some of the capital value of the business by extracting liquidity (cash) whilst retaining a majority ownership of the business. In some cases a cash out can represent a partial exit for some or all of the existing shareholders, or a full exit for some but not all of the existing shareholders. A cash out can involve a private equity fund taking a minority stake in the business, together with additional bank debt. In some cases, the cash out may be funded entirely by additional bank debt.
It is important that cash outs are always structured in a tax efficient manner, and that the cash out is structured so as to meet the shareholders’ objectives.
Here are some examples of different forms of cash out:
Company A has been established for a number of years, is profitable and is growing rapidly. The shareholders who work in the business, are in their mid forties and remain enthusiastic to continue to work in the business. The current value of the business is approximately £10m, and, realistically this will grow to approximately £20 within the next four to five years as profits increase. The shareholders are well remunerated but would like to extract some liquidity whilst retaining majority ownership of the business.
In this situation, a private equity fund could take a stake of 30% in the company for £3m, payable to the existing shareholders, with the existing shareholders continuing to manage the business with a reduced shareholding of 70%.
In, say four years time, both the private equity fund and the founders could sell to a trade purchaser for, say £20m, thereby providing a very satisfactory investment return for the private equity fund, and a further £14m of proceeds for the founders.
Company B has three shareholders who work in the business, one of the shareholders is considerably older than the other two, and is approaching retirement age. The business is worth approximately £15m, the shareholding who is reaching retirement age has a 20% stake in the business.
In this situation, a package of funding comprising some private equity and bank debt could be raised to acquire the retiring shareholder’s stake for £3m. Assuming this is financed in equal portions of private equity and debt, the private equity fund will take a 10% stake in the business, and the company will service and repay the £1.5m of new debt. This provides an eloquent exit for the retiring shareholder and improves the combined shareholding of the other two shareholders from 80% to 90%.
Company C has four shareholders, and is about to embark on an expansion phase. One of the shareholders wishes to leave the business for personal reasons, and his/her shares are worth £8m. The funding requirement for the company’s growth plans amounts to a further £6m. The company therefore raises a total of £14m to buy out the shareholder who is leaving, and to finance the company’s expansion plans. This finance would normally be sourced from a combination of private equity and bank debt. The private equity investor will take a minority stake in the business, normally a smaller percentage than that currently held by the leaving shareholder.
Shareholders’ and funders’ objectives
In each of the above three examples it is clear that:
The shareholders’ requirements and objectives in each case have been met; both the shareholders who are staying and the shareholders who are leaving.
The businesses are able to sustain and service the new funding taken on for the cash out. This is important – if a company is not profitable or the profits are declining, a cash out becomes much less attractive to the incoming private equity and debt providers.
The incoming private equity investors and banks will only invest/lend if they are comfortable that the non-selling shareholders/managers are capable of continuing to run the business successfully, i.e. if the business is too heavily dependent on a selling shareholder, or the funders are concerned that a partial sale of shares will cause management to lose focus or motivation (because the proceeds make them too financially comfortable), then they will not find the proposition attractive.
Therefore, for a cash out to work, it must be attractive to the three constituent parts, namely the incoming funders, the selling or partial-selling shareholders and the remaining shareholders. Fundamental to the success of any cash out is the underlying performance of the business which typically must be profitable with good further growth prospects.
For further explanation, please contact:
Jeremy Cole, Partner, Cole Associates Corporate Finance LLP