You will meet many business owners who are proud to say that they do not owe any money. For many start-ups, it’s an important milestone to be debt free. When you start building your business, you take on debt to help pay your bills and keep your business afloat. Becoming debt free as a business owner is an important milestone. However, once you have a successful cash-flowing business, it might not be the best long-term strategy for wealth creation.
Family offices are very strategic in using leverage financing and debt to maximize their return on assets and investments. Especially in a low-interest rate environment, typically, they are borrowing at a much lower interest rate than they are earning from their investments. For example, they could be borrowing at 3% and reinvesting the borrowed capital to make an 8% return, the spread on their leverage is 5%. Depending on the jurisdiction, the cost of borrowing a loan for an investment is tax deductible.
An operating company is responsible for the day-to-day management of the business. It is often the subsidiary of the holding company.
Using leverage to unlock equity in an operating/family business you own is sometimes referred to as partial or leveraged recapitalization. In this case, the operating company would take on debt to possibly repay shareholder loans, issue dividends or redeem shares.
You can unlock equity and maintain your ownership with a leveraged recapitalization strategy. For example, if you owned 100% of the company before the leveraged recap, you would own 100% afterwards.
Assume a manufacturing business has $10m in EBITDA. EBITDA is a widely used measure of core corporate profitability and stands for earnings before interest, taxes, depreciation, and amortization (EBITDA). This company has no debt and no unique software or intellectual property.
In this example, let’s assume this business sells for 5x multiple. That means the business would sell for $50M.
Suppose the owner sold the business and paid approximately 25% (depending on their jurisdiction and tax planning) tax on the sale of the business, leaving them with approximately $37.5M. This is usually paid out over a few years and is often contingent on the company meeting key performance metrics over those next few years.
After a sale, the business owner needs to find new investment opportunities to re-invest that capital.
Now let’s take that same example and talk about leveraged recapitalization. With $10m of EBITDA, we could likely leverage that company at 3.5x, giving the owner access to $35m in the company. This money can be reinvested into the company to expand and make other investments or acquisitions. The funds can also be used to repay shareholder loans, issue dividends or redeem shares. In the end, by using leveraged recapitalization, the owner still owns 100% of the company.
(Note: Any dividends paid out to shareholders or redemption of shares will be subjected to taxes applicable in your jurisdiction, in some jurisdictions with appropriate tax planning, these taxes can be minimized)
It’s important to understand where you can find leverage in your business. Here are some places to start looking when assessing your Balance Sheet and P&L:
Interest rates for this type of debt are usually between 15%-30%.
Real estate lending is generally referred to as a mortgage. If you own a home, you are familiar with real estate lending. If you own an investment property, you can use a mortgage to finance it and increase your return on your investment.
Let’s assume you are purchasing a real estate property for $200,000, earning $20,000 in annual income from this property.
A loan on your public equity portfolio is referred to as a margin loan. A margin loan allows you to borrow against the value of securities you own. Usually, you can borrow up to 50% — 60% of the total value of your security.
There are certain benefits to using leverage for particular investors. For example, if most of your investments are concentrated on stock, i.e., you recently experienced an IPO or have received a significant amount of stock options in a public company. You may want to diversify your portfolio without selling shares and triggering taxes.
Typically, it’s straightforward to get one of these loans approved; there is typically no formal credit approval required. The disadvantage is you could be exposed to a margin call, whereby your lender requests additional funds if the assets fall below the account’s required minimum value.
You can leverage your insurance asset if you own a Whole or Universal Life insurance policy. This is usually referred to as a policy loan. Family offices use life insurance as an investment class and usually maximize leverage on insurance policies.
Whole Life Insurance Policies earn dividends each year and build cash value which is guaranteed to grow over time, similar to a GIC. Universal Life also grows in cash value over time. As a result, you can sometimes leverage up to 100% of a policy’s cash value.
Disclaimer: This blog is for informative purposes only and should not replace the professional advice of tax, legal, financial, or investment advisors. The opinions expressed here are merely observations of industry trends and should not be taken as stock or sector recommendations.