If you are struggling to repay debts or keep shareholders happy, you may have considered selling your company a few times. Why not pass the worries on to someone else and start in a new field with a clean slate? The truth is that few business owners feel real enthusiasm at selling off their businesses. Yet, the factors that prompt the thoughts to sell remain. To resolve these issues, more business owners are relying on dividend recapitalization.
The term describes the business practice of using debt to pay special dividend distributions to shareholders. They do so in place of using the company’s earnings. The practice has a substantial impact on the company’s financial makeup because it increases debt and reduces equity financing.
At first glance, it may not seem like the best use of debt, but companies generally have good reasons for choosing this route. When managed correctly, the benefits are worth the risks. Unfortunately, the stakes are high, and proper mitigation plans are necessary.
Why Should Businesses Consider Dividend Recapitalization?
One of the most common reasons companies use dividend recaps is to buy back shares. As long as the business continues to pay its debts on time, creditors have no say in business operations. On the other hand, business shareholders have voting rights and may attempt to steer the business in the opposite direction of what owners originally envisioned.
Debt financing also helps companies free up cash without losing ownership of the business, unlike a public offering. Debt provides the opportunity for businesses to re-position ownership, incentivize employees, and set the framework for growth and expansion. Here are some specific uses that make this possible:
Reinvesting Profits
When companies accept capital in the form of shares, paying dividends is a significant expense on the balance sheet. This can leave very little money for the company to proceed with plans for expansion or improvement. Financing can provide cash flow while still keeping shareholders happy.
Exiting an Investment
Private equity firms sometimes use debt financing in place of conventional exit strategies. Known as leveraged dividend recapitalization, this practice helps firms recoup their investments. Companies that choose this route must manage affairs carefully to reduce legal and financial risks.
Recovering Investments
Recaps allow investors the unique situation of having their cake and eating it too. These companies get to recoup the dollar values of their initial investments without giving up the stakes they bought. They can then use returns from the investment to help repay the loan at a later date.
What Are Some of the Risks Involved?
As with any loan, the most significant risk is defaulting, particularly within the first year of taking out the loan. The company may also find itself with an underwater loan, where the amount borrowed far exceeds the company’s total value. In either of these cases, the lender can seize the company to repay the debt. In some cases, business owners successfully negotiate with lenders to keep the business, but there is no guarantee of this.
Another big risk stems from potential allegations of fraud and other illegal activities. If the company goes bankrupt and cannot repay its loans, creditors may point to its recapitalization strategy as a sign of fraud. This happened during the 2004 KB Toys, Inc. bankruptcy. The company recapitalized in 2002 and used the money to pay more than $120 million in dividends and executive bonuses. This money then reportedly made its way back into the company’s pockets that acquired it two years prior.
When it then filed for bankruptcy in 2004, creditors claimed this move contributed to the company’s financial failure. Creditors alleged that this was a clear breach of the managers’ fiduciary duties.
What Can Companies Do To Reduce Recap Risks?
There is no risk-free business or risk-free debt. There is always a risk of defaulting on a loan and potentially upsetting creditors in the process. Even the strongest and biggest companies can begin to struggle during economic downturns or after changes in local or federal laws. Still, business owners can reduce the inherent risks by studying their businesses carefully to determine eligibility.
The best candidates for dividend recap meet the following criteria:
- Has a predictable level of monthly cash flow with few seasonal dips
- Has a consistent and robust history of revenue growth
- Holds lower debt levels than competitors
- Possesses debt with more competitive terms than competitors
Partnering with a financial institution that may be more willing to negotiate should a default occur. Traditional banks are often among the least flexible options. At LQD Business Finance, we take pride in being a different type of lender. Contact LQD Business Finance to learn more about dividend recap options we can facilitate. Our team can help you review your business finances so that you can make the most suitable decision.
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