Founder and Shareholder Liquidity Alternatives During “Inflationary & Stagflation” Environments

As we enter, the Biden administration's inflationary and possible stagflation-driven environment for small businesses and embark on our organizational and personal financial planning for late 2022 and into 2023. Quite possibly if the first half of 2022 has not met expectations there is no better time to understand the market dynamics as they relate to the “Financing Options for Small Business” founders and shareholders to liquidate some or all their equity holding or wealth transfer.

Introduction

Having been a Founder, Shareholder, Investor, and Operator for nearly a dozen technology-enabled service and outsourcing business models over the past 21+ years now; Ephor makes it a priority to evaluate and take an “inventory” of the current financing markets that enable shareholders and equity participants to understand their current and near-term liquidity options.

Options for Small Business Founders

This is particularly important due to the fact the current market for service business models IPO’s, is almost non-existent and is exclusively oriented to only the” best business models” in the sector.

It is clear and known that this limited “public” liquidity option will be reserved for only the top 1% of the business models, and larger more critical mass-oriented organizations. Therefore, Ephor in our fiduciary role, we provide the following alternatives, reviews, and commentary, to guide your near-term “Personal” financial planning and liquidity options. 

Consistent with what we experienced in past “recessionary, difficult economic times and political disruption” over the past 40 years, as small business owners and shareholders our options will be generally limited to “traditional and conservative” sources of capital in that the “aggressive capital providers” (“non-legacy capital providers”) generally “Go to the Bench” until ‘investment and ROI conditions improve, especially during inflationary and politically uncertain times.

Therefore, Ephor’s objective with this correspondence and guidance document is to provide you with a high-level overview, educational, and conceptual analysis to guide you through your initial thoughts on Re-financing, Financing & your Equity Exit alternatives, from the “non-traditional” small business capital sources, in the near-term from late 2022 thru early 2024.  

The Mezzanine Financing Alternative

Overview & Definition:

The word “mezzanine,” utilized in the financial engineering arena, describes a layer of financing that “sits” between classical asset-based or senior bank debt financing, and the equity component of the company’s balance sheet.  Often, there is a debt component that is tied to an equity component that generally represents a small minority equity interest.

Operational Statistics:

This alternative best fits organizations that generally have a minimum of 3-5% annual revenue growth rates established and business models that have illustrated scalability. As a result, EBITDA profiles that illustrate annual EBITDA growth rates of ~7% EBITDA or greater. Minimum EBITDA levels are generally $1M to $1.25M, on a trailing twelve-month basis (TTM).

Terms: 

Debt component interest rates are generally in the low teens with an equity component of 5%-15% of the company's equity. The duration of the investment is generally 3-4 years. For the “best business models,” this is a very common “bridge” capital structure. 

Governance Requirements & Considerations:

Generally, a formal governance process is required that includes a Board of Directors with the financial sponsor having 1 seat and/or observer rights. However, it is quite common for an Executive Chairman (Board of One concept) to be required in place of a formal board construct. A “minority interest” investment, generally with minimal day-to-day effect, is inserted into the business model and current management.

Shareholder Considerations:

This alternative generally provides wealth transfer through the combination of debt and equity and therefore is very “equity efficient”. Likewise, this instrument provides a meaningful wealth transfer amount that can be ~3-3.5 times trailing 12-month EBITDA performance. Therefore, it is very attractive in satisfying very near-term liquidity objectives, while maintaining a significant equity position for long-term wealth creation objectives. In layman terms, this is a “second bite at the apple” concept.

Potential Sponsors:

• Mezzanine providers: There are approximately 12-20 quality “mezz shops” in North America that are Useful Capital and have invested in technology-enabled and outsourcing-oriented business models.

• SBICs are another active participant in the sector. Generally, there are at least 1-3 such providers in every region of North America.

• Family Wealth Offices have recently entered the “mezz” structure market and are becoming more prevalent, more flexible, and are more “Patient Capital.”

The Minority Recapitalization Alternative

Overview & Definition:

A minority “recap” of a company is defined as 49% or less of the company’s equity and voting rights that are tendered for wealth transfer objectives. This is a very common and often executed alternative for organizations that have illustrated repeatable revenue growth postures while presenting consistent and increasing recurring EBITDA performance. Generally, the wealth transfer aspect of a “minority recap” is combined with an infusion of growth capital and/or part of an acquisition financing event. However, it is also common as an exclusive wealth transfer transaction. The most relevant benefits of this alternative are that current ownership/equity maintains governance control and, in layman terms, a great “second bite at the apple.” Bridge.

Terms:

Generally, 18% to 49% of the company's ownership shares and voting rights are tendered or sold. In general, the shareholder agreement includes most customary minority shareholder rights (generally determined at the state level), which are negotiated as part of the transaction structure. Generally, the participant's financial sponsors provide a 3-year to 5-year duration as their investment time frame.

Governance Requirements & Considerations: 

A formal governance process is generally required through a formal Board of Directors, with the minority financial sponsor having 1-2 seats of a 5-person board or a minority number of seats, which may also include one observer seat as well. Please note, however, that Ephor has participated in Executive Chairman or Board of One concepts that have proven to be quite successfully utilized in this alternative, with the results being a balanced stakeholder approach. 

Shareholder Considerations:

This alternative generally provides a substantive wealth transfer portion that can provide an enterprise value of 5-7 times trailing twelve-month EBITDA, combined with maintaining control and the attractive “second bite at the apple.” This alternative is most attractive to existing shareholders that have investment or wealth transfer objectives that are required in both the very near-term combined with longer-term objectives tied to the company's performance. 

Potential Sponsors:  For this alternative, financial sponsors include:

• Private Equity shops that specialize in “minority recaps” of technology-enabled service or outsourcing business models, and other “minority buyout-oriented” Private Equity groups that have experienced success in the sector. As such, they are Useful Capital. Ephor currently monitors 8-10 of such providers that have established track records in the sector.

• Again, Family Wealth Offices have, over the past 2-4 years, entered the market, illustrating a more “Patient Capital’ and flexible term approach.

Alternative Asset providers have recently entered this alternative and will become more prevalent in the near-term, dependent upon near-term interest rate demeanor.

The Majority Recapitalization Alternative

Overview & Definition:

The “majority recap” alternative occurs when the shareholders tender greater than 51% of the entity's shareholder interest and voting rights. However, most commonly, greater than 70% is averaged value tendered. This alternative is quite common where the company business model is proven, scalable and has provided historically sustainable revenue and EBITDA growth rates, and where the founders or shareholders are “aged” as such, a liquidity event is “a financial life changing event”.

Operational Statistics:

This alternative best fits organizations that generally have institutional worthy revenue growth rates and consistent and predictable EBITDA performance. EBITDA hurdle rates are generally greater than $2.5M. Barriers to a “majority recap” can include significant customer concentration issues, lack of illustrated operational scalability, a management team that is not proven, or does not include a “bankable” experienced proven “sector executive” involved in the business, or a past governance process that would not enable the business to pass the stringent due diligence requirements of a majority change of control transaction.

Terms:

In general, normal equity tendered amounts range between 70% to 90+% of the company's ownership shares and voting rights. The resulting shareholder agreement includes most customary majority shareholder rights, and majority control voting considerations, which are negotiated as part of the transaction structure. Investment time frames are generally 4-6 years.

Governance Requirements & Considerations:

A formal Board of Directors will be required that generally includes 5 members (though 7-seat boards are not uncommon) where the majority of the seats, 3 in a 5-member board, are appointed by the “controlling” shareholder group, with the founding shareholders generally having 1 seat. The remaining seat most generally goes to a knowledgeable sector or industry executive as a board “outsider.”

Shareholder Considerations:

This alternative generally includes a “substantive” wealth transfer amount that can provide an enterprise value of 5-10 times trailing twelve-month EBITDA (TTM basis).

However, loss of control and no significant “second bite of the apple” are the trade-offs in this wealth transfer alternative. This alternative is most attractive to existing shareholders that are aging, or need to diversify their personal investments, or feel that current management simply does not have the skills or know-how to take the business model to the next level. 

Potential Sponsors: For this alternative, financial sponsors include:

• Private Equity shops that specialize in “majority recaps” of technology-enabled service or outsourcing business models, and other “buyout-oriented” Private Equity groups that have experienced success in the business services sector. There are ~35 “Useful Capital” Majority Buyout PE providers in the business services sector in North America, that Ephor monitors or have worked with.

• Again, Family Wealth Offices have, over the past 2-4 years, entered the market and illustrated a more “Patient Capital,” flexible term approach, and are rapidly becoming “Useful Capital” providers. Family offices are Ephor “partner of choice in Buyout situations”

In summary, at Ephor, we have been participants, co-investors, and advisors to Founders, CEO Entrepreneurs, and shareholders in the business services sector for 21+ now.

We have utilized, studied, and have been a participant in all the alternatives (and a few others as well) presented above at various stages of our activities with our client companies and investments.

Therefore, we have learned a lot, done a lot, and like many, have made our share of mistakes: as a result of all that learning, we have created significant wealth for ourselves and our clients.

In summary Ephor’s guidance to you includes:

• Each of you should carefully evaluate your specific liquidity needs against these alternatives

• You should decide when your timing is right, and for when the markets and the company’s “timing is right”

• You should seek outside assistance in the final evaluation and execution of a chosen alternative. The selling and the timing of your equity liquidity activities is potentially the most important and relevant personal financial decision of your life.

As a concluding remark our Strategic Practice Lead, Garry E. Meier often states in his “Keynote" addresses that:   ​

For additional information please see our Useful Capital & Private Equity as an Exit Option by selecting below or feel free to contact us to discuss your specific situation at your convenience. In any event, please view us as a strategic resource