One common element of a divorce is the need for one spouse to buy out the other spouse’s interest in a business. Many times this business interest is simply exchanged for other assets, such as real estate. In other words, the primary operator of the business may simply give the other spouse an interest in an amount of commonly owned real estate equal in value to the interest in the business. This exchange may be acceptable; but what happens if the business if much more valuable than the real estate and other community assets? In that instance a simple even-up exchange is not possible, and outside financing will likely be necessary to make the business interest buy-out possible.
Financing the Buy-Out of the Business
In terms of financing the buy-out of a divorced spouse’s interest, the nature and size of the business is a key factor. Buy-outs of interests in small businesses (typically under $5 million in sales) and most professional service businesses (such as an accounting, law or medical practice) can be facilitated by a traditional bank loan, a Small Business Administration (SBA) loan, a seller note or some combination of these methods. Since the outright sales of entire such businesses are typically very highly structured, with a modest amount (one-third or less) paid upfront and the rest in a seller note or earn-out, the buy-outs of partial interests in these business are similarly structured. The sales and partner buyouts of professional services firms (where the owner or primary partner is the key operator and therefore represents most of the value of the business) also typically involve deferred payment schemes to mitigate the risk of a significant loss in value after the transaction.
For larger businesses, however, partner buy-outs often require outside capital investment sourced through private equity firms and mezzanine debt funds. The same can apply when one spouse needs to buy out the other’s interest. Private equity firms raise money from institutional investors (banks, insurance companies, pension funds, endowments, etc.), which is managed by a group of investment professionals who invest the money in private companies. This pool of money is called a “fund” (equity fund). Mezzanine debt, also known as subordinated debt, is invested in debt securities in private companies instead of equity. This pool of money from the debt financing is called subordinated debt, more precisely a mezzanine debt fund or sub-debt fund.
In a situation where a $75 million consumer products manufacturing and distribution company is owned 50/50 by a husband and wife, it is rare that there would there be $75 million or more worth of real estate to facilitate a non-cash swap of the assets in the divorce. Any business with at least $10 million in sales, solid growth potential, a strong management team, a sustainable competitive advantage and strong profitability, would qualify for investment from institutional investors using equity funds or mezzanine debt funds.
The preferred source of funding should always be the cheapest. Therefore the acquiring partner (in a divorce, the operating spouse) should always first exhaust all secured bank financing options. Next, the acquirer should evaluate raising private equity funds versus subordinated sub-debt or mezzanine debt financing. A business with very strong, stable and predictable cash flow would be a good candidate for debt financing. However, the acquiring partner would have to be comfortable with this additional leverage. Subordinated debt financing is much more expensive than bank debt since subordinated debt (a) does not require any personal guaranty from the owners, (b) is contractually in a second lien position behind the senior bank debt in the event of default, (c) is term debt (not revolving debt) with a five-year maturity, and (d) allows an interest-only period of at least three years if not four or five.
A New Partner
Private equity firms differ by industry focus, target company size, geographic focus and importantly by whether or not they require control. While most private equity firms require an ownership interest in the business of greater than 50%, many firms are comfortable owning less than 50%. Few firms, however, will require a 100% ownership. The vast majority of private equity firms would want to partner with the acquiring/operating spouse, strongly preferring to keep the acquiring/operating spouse as the operator of the business. They also typically would want for that spouse to maintain a significant minority position in the company (at least 20%) if not a controlling position.
Neither private equity nor subordinated debt (mezzanine) investors are looking to immediately take over everyday management while slashing expenses to the bone. Most institutional investors are able to leverage their investment experience in similar companies to add, not just capital, but also real strategic value and guidance to the business going forward. Investors will want a formal board of directors established, and they can often help execute strategic growth initiatives by tapping such resources in the industry as potential vendors, customers and C-level executives.
Each Situation is Unique
Each buy-out situation needs to be evaluated according to its unique requirements. A customized approach to financing the buy-out can be implemented by an investment banker in coordination with the client’s other advisors including attorneys, accountants, and wealth managers.
About the Author
David Bonrouhi is co-founder and Managing Director of Calabasas Capital, a boutique investment banking firm that provides sell-side and buy-side merger and acquisition advisory services and private equity and debt capital-raising service to lower middle market privately held companies. Calabasas Capital works in a broad range of manufacturing, distribution and services industries and has specific expertise in working in the areas of food and restaurants, other consumer products and services, and business services. David has 18 years of experience in investment banking and private equity at Calabasas Capital, Merrill Lynch and UnionBanCal Equities. David is a CPA (nonactive) and he holds securities licenses with Fallbrook Capital. David has an MBA from UCLA’s Anderson School and two Accounting degrees from Miami of Ohio. He is a member of the California Restaurant Association and the Anderson Private Equity Alumni Association and is on the board of a local chapter of the Association for Corporate Growth.
Disclaimer: This should not be considered in any way an offer to buy or sell a security. This is for informational purposes only. Buying or selling a security involves substantial risk. Investment may be worth more or less than the original investment. Calabasas Capital is a division of Fallbrook Capital Securities Corp. Securities offered through Fallbrook Capital Securities Corp. Member FINRA/SIPC.