In certain circumstances, cashing out of your business without selling it makes a lot of sense from a strategic and financial standpoint. When would this make sense? The most likely circumstance is that you happen to operate in a very litigious industry and you have concerns some predatory defendant might come after you for your business. This is more common than you’d think.
If you have built a successful business and you worry that your business may be sued or be dying and you could lose the value of the enterprise, then this strategy may be for you. The strategy is called “equity stripping.”
The term equity stripping always gave us a pretty negative impression…kind of like a “junk bond”. But there are times where this type of advanced business planning is advantageous.
So what is equity stripping? At the heart of it, equity stripping is going to the bank, taking out a loan collateralized by equipment, receivables, inventory, etc. and then paying yourself a dividend to strip the “equity/cash” out of your business. Taking out debt which could lead to the loss of those collateralized assets seems like a pretty bad idea under most circumstances because you could lose them to the bank! But if there is real risk you could lose them and the value of your business to a lawsuit or obsolescence then this makes sense.
This happens all the time in the public markets. In fact, private equity firms have built their entire industry around this model. In the private equity vernacular, this is also referred to as a “leveraged recap.”
If you have “stripped the equity” out of the business the predatory “defendant” or creditors can no longer come after you for those assets…instead the bank has the claim on them.
The bank will require you to have adequate cash flows to execute this strategy. But this is a pretty slick way of effectively cashing out of your business without having to sell the company.
Does this make sense in most cases? No of course not. But does it make sense when you’ve built a highly valuable business in a highly litigious industry and most of your business value is locked up in your assets? Absolutely it does.
Many billion dollar companies do this regularly when backed by the right management teams and business models. Why not take advantage of this if it makes sense on a smaller scale?
Please reach out to us with additional questions.
All the best,
Your Fortis Capital Management Team