Minority Equity Transaction: A Liquidity Strategy for Reducing Debt

June 26 2020 | 3 Min Read Time

Michael Poole

E: mpoole@pcecompanies.com

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A minority transaction offers you as a business owner a solution for reducing debt while maintaining control. This helps if your company is facing cash flow issues and drowning in debt. Principal and interest payments that used to be easily covered by annual cash flows are becoming more difficult to service. You can cut costs in other areas of the business, but your debt obligations are unavoidable. A minority equity sale can solve the cash flow problem without having to sell the entire business.

When Debt Becomes Too Much

Debt is neither inherently good nor bad. Many companies use debt to finance operations and generate enough cash annually to service the principal and interest payments. You can achieve the optimal balance of equity and debt and boost returns to equity holders under the right economic conditions. Many private equity firms’ core investment strategy is focused on using leverage to increase equity returns.

However, unfavorable economic conditions can shift debt from a favorable financing option to an obligation driving your business into bankruptcy. Your company is in dire need of cash when annual cash flow decreases below your annual debt service obligations. It is essential that you manage your debt and annual cash flows, especially during recessionary periods.

Capital Financing Options

Under ordinary circumstances, you will use debt to fund your company’s operations and use the cash generated to service your debt. You would use the cash remaining after debt payments for capital expenditures or distribute it to equity holders as dividends. However, if your company faces cash flow issues, it means something unusual is impacting operations, like decreased sales or customers delaying payment of invoices. If the cash flow issue becomes so severe that your company can no longer service its debt obligations, you must seek alternative funding solutions:

Capital Raise – Debt

Companies in need of cash can borrow it. If your company’s debt issue stems from interest rates higher than the current market, it may be possible to replace your debt with new loans, like refinancing a home when interest rates are low. However, the option of replacing senior debt will most likely be unavailable if your business faces cash flow issues.

Capital Raise – Equity

Selling equity is always an option for increasing liquidity. The downside is that you give up ownership of the business and possibly control. A minority sale resolves this issue because it allows you to retain control of your business while generating the liquidity to solve your debt issue.

Minority Sale – Equity and Mezzanine Debt

Selling a minority stake in your business is a great strategy for recapitalizing debt. You maintain control of the business while generating cash to reduce the debt burden. These transactions are often structured with non-controlling equity and mezzanine debt. The mezzanine debt sits higher in the capital structure than equity and provides the investor some cash flows annually.

How a Minority Transaction Works

For overleveraged companies, the goal of a minority equity sale is to replace debt with equity. You can use the cash proceeds generated from a minority equity sale to pay down current debt. The minority investor will take a non-controlling equity stake in your business. The process typically involves these steps:

Review current debt – Review current debt balances and their covenants. Contact your banker to discuss your options on delaying payments or revising terms.
Analyze cash flows and determine a level of sustainable debt – An efficient minority sale will generate enough cash to reduce your debt to a sustainable level. A sustainable level of debt is calculated by analyzing expected future cash flow and determining the level of debt the company can afford to service annually.
Perform minority valuation of equity – This is the target price to sell a noncontrolling share of ownership. A minority valuation will include discounts for minority interest to compensate a minority investor for the risk of being a non-controlling shareholder.
Determine optimal transaction structure – Determine what percentage of ownership would generate the cash needed to pay down your debt to sustainable levels. Ensure the investment is a non-controlling stake. A minority sale will likely include mezzanine debt financing, so it is important to analyze different transaction structure scenarios.
Use the cash proceeds from the sale to pay off debt – Apply the cash received at close to the targeted debt. It is essential to find a buyer that will pay cash at closing for the transaction. Earn-outs and other contingency payments will not suit your current cash needs.

Who Are the Investors?

Strategic buyers are less likely to make minority investments. Strategic buyers often look for companies they can merge operations with, which is not possible with a minority, noncontrolling stake. A more likely candidate for your minority sale is a financial buyer such as a private equity group. These firms currently hold a fair amount of dry powder (uninvested cash) they are looking to deploy. Many private equity groups have expanded their focus and are looking for minority investment opportunities.

Why Mezzanine Debt Often Supports Minority Transactions

Minority transactions are often supported with mezzanine debt when the goal is to recapitalize debt and retain shareholder control. Mezzanine debt is also known as subordinated debt, or junior debt, since it sits below senior debt but above equity. Mezzanine financing is riskier than senior debt but cheaper than equity. Mezzanine lenders often require equity participation rights, so mezzanine debt is often considered a debt-equity hybrid. Minority transactions often include mezzanine financing to reduce equity dilution and keep control with the selling shareholders.

Finding the right investor and structure for a minority sale can be challenging. It is critical to have an investment banker advise on the process to ensure the selling shareholders maintain control. PCE Investment Bankers is experienced at structuring minority transactions and has relationships with many financial buyers that make minority investments. Contact us today to learn more.