A partial exit might be best for some owners

They’re creating partial liquidity, and taking advantage of the current window of opportunity. Why to do one and what to watch out for? Read on.

A recent example of a successful partial exit involved Comm-Works Inc. Comm-Works is a Twin Cities- based telecommunications equipment and installations company.

Todd Eberhart and Al Lampe founded Comm-Works and had realized growth. In order to continue to grow the business, expand into new markets, and have greater access to capital, they recently completed a partial exit transaction where Morgenthaler Partners, a Cleveland based investment group, and two lending partners purchased a significant interest in Comm-Works.

The partial exit allowed the owners to obtain cash while retaining a significant interest in the entity. Moreover, Morgenthaler had two similar companies on the East Coast, which were combined to form a larger overall enterprise that is now under the direction of Eberhart and Lampe.

“The transaction was a really good fit to accomplish both personal goals and to continue to expand and grow the business,” Lampe says.

Motivations driving these transactions are varied. Some owners see partial exits as a great way to diversify their financial holdings, since many privately held business owners have most of their wealth tied up in the business.

Other owners see it as a way to significantly expand the business and access to capital if the partial exit involves a partner who is otherwise engaged in the same line of business or has a bigger checkbook or borrowing capacity.

Partial exits also function as a way for majority owners to have an exit or liquidity event without a sale of the entire business. This can be particularly attractive for family-owned businesses, where the senior generation needs to harvest some liquidity for retirement but wants to have continued ownership by the junior family members.

How partials work
Although there is not one specific structure for partial exit, most partial exit transactions involve having equity or lending partners infuse money into the business with one or more owners cashing in all or a portion of ownership.

The key benefit is that the owner is able to take money off the table without personally guaranteeing its repayment. The cost comes with a reduced ownership percentage and a bank or group of investors as new partners in the business.

At its most basic, owners may work with a lending partner to infuse funds into the company to provide a total or partial liquidity event for one or more owners.  Of course, the lender usually looks for additional advantages, such as warrants to acquire a portion of the potential growth of the company as an equity participant.

In a more complicated transaction, a new equity partner may infuse money into the company in exchange for an ownership interes. That new partner may then work with lenders to infuse even more money into the business to fund the partial exit of one or more existing owners.

The transactions may also occur as part of an overall acquisition transaction that leaves the current owners with both liquidity and a significant stake in the acquired company.

Two negotiations
In general, partial exit transactions involve two distinct negotiations. The first aspect is related to the price and terms of the liquidity event. This is primarily driven based on the value of the business, the amount of liquidity that the particular owner is seeking, and a negotiation with the third parties who are putting in the cash.

The second aspect concerns the rights and limits on the retained ownership. This can vary greatly and usually depends on what percentage of equity is retained and, in particular, depends on whether the historical owners maintain a controlling interest in the company.

If the historic owners have been reduced to a minority interest, the owners will need to negotiate a series of rights to protect their minority interest position. For example, the minority owners typically negotiate the right to have a designee sit on the board of directors to make sure that they have seats at the table where decisions will be made.

Protection of the historic owners may include putting rights on a termination of employment or other specified events, so that the historic owners do not end up with an illiquid equity interest.

In addition, it is common for the minority owners to negotiate rights known as tag-along rights or come-along rights. These rights generally allow the minority owner to piggyback on any exit transactions by the majority owner.

Beware, however, that a common trade-off for getting such rights is that the majority owner will require rights known as drag-along rights or bring-along rights, which would allow the majority owner to force the minority owners to sell their interest in the event that a potential buyer wants to acquire 100 percent of the company.

Oversight happens
Keep in mind that there will often be structural changes. For example, the entrepreneur may now find that he or she is under the review and oversight of the outside investor. This may be particularly true if the partial exit involves complex lending arrangements that include complicated provisions, financial ratios and reporting requirements. Such items may cause an overall feeling that things are not as simple as they had been prior to the partial exit.

Bottom line: A partial exit can be a very attractive transaction that can meet a variety of needs. All it takes is a willingness to have a new equity or lending partner in the business.