The Founder’s Guide to a Successful Recapitalization in 2024

Recapitalizations can be a startup founder’s best friend, especially as they march toward an IPO. In a recapitalization, a startup restructures its current capital stack through a combination of debt and equity, often to stabilize the company’s operations, defend against a hostile takeover, or prevent bankruptcy. The ultimate goal is to improve the company's debt-to-equity ratio to reach its “optimal capital structure”. In this guide, we break down recapitalizations—exploring how they work, why startups use them, and how they’re typically structured. Ready? Let’s dive in!

What a recapitalization is (and isn’t)

Recapitalization in the context of a startup, is like rebalancing your 401k or investment portfolio. With rebalancing, the goal is to optimize the underlying assets in a portfolio to achieve better returns, reduce risk, or better align it with your financial goals. Whereas with recapitalizations, the goal is to improve your company’s debt-to-equity to prepare to go public, to make the company more attractive for an investment or acquisition, or to reduce its debt burden. The term “recapitalization” does not refer to a specific form of financing, rather it's more of a strategy that a startup pursues.

How recapitalizations work

To explain how recapitalizations work, we’ve opted for an analogy (sorry, not sorry).

If you imagine a startup as a house, then its capital structure is like the foundation and structure of that house. The house is built with a combination of capital from the founders and investors (equity) and loans from the bank (debt). When the homeowners (founders) decide they want to improve or expand their house, they would undertake a recapitalization. Outlined below are some of the common scenarios in which a startup may want to pursue a recapitalization.

• Home Expansion (Revenue Growth): The homeowners decide they want to add a new room, renovate the kitchen, or make other improvements. To do this, they need more money. This is similar to a startup wanting to expand its operations internationally, launch a new product, or pursue a strategic growth initiative.
• Refinancing (Capital Mix): The homeowners decide that they want to refinance their loan because rates are better, or they want to access some of the equity they’ve built in the home. This is like a startup adjusting the mix of equity and debt in its capital stack.
• HELOC for Remodeling (Debt): The homeowners decide that they want to renovate their home and take out an additional loan from the bank using their equity as collateral. This loan is like the convertible debt component of recapitalization.
• Home Sale (Acquisition): The homeowners decide to sell their home and want to pay off the outstanding balance of their HELOC to prepare for the sale. This is like a startup satisfying its outstanding debt before pursuing an acquisition from another company to make it more attractive to the acquiring entity.

The other common use cases of recapitalizations

• Drive up stock price: In this scenario, the goal is to prevent a decline in the stock price or raise the stock price by repurchasing its shares to push the stock price up. Note: this scenario only applies to a company that is publicly listed on a stock exchange. 
• Prevent a hostile takeover: This isn’t technically a recapitalization strategy, it's more of a defensive strategy. Essentially the company either purchases more of its shares from investors, restructures the shares of stock to give different voting rights, or issues more shares to dilute the ownership
• percentage of all shareholders.
• Prevent bankruptcy: Simply put, excess debt can kill a startup. In this scenario, the goal is to pay off some portion of the outstanding debt balance by raising funds from investors.
• Recover from bankruptcy: Startups that file for bankruptcy often restructure their debt and equity to survive and recover from the bankruptcy process.

The three types of recapitalizations (and one bonus type): leveraged recapitalizations, equity recapitalizations, and leveraged buyouts

• Leveraged Recapitalization: the startup takes on additional debt to increase its equity position. This is most frequently used to drive up the stock price or prevent a further slide in the stock price. 
• Leveraged Buyout: this typically applies only when a startup is being acquired. Essentially the acquiring party takes on additional debt to cover the acquisition costs. It provides the cash to the company being acquired, so it can pay off its existing debt and purchase the equity positions of its investors. For more information, check out the founder’s guide to leveraged buyouts.
• Equity Recapitalization: In an equity recapitalization, a company issues new equity shares to raise funds to pay off its existing debt. 
• Bonus: Nationalization: This happens when a government entity acquires a controlling interest in a company. This most recently occured in 2007-08 when the government bailed out over 1000 companies including the automotive manufacturers (GM & Chrysler), and several large banks (Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo).

The common types of financing used in a recapitalization

• Equity Financing: This is the traditional venture capital we all know and love—investors purchase an ownership stake in the company. For more information, check out the ultimate guide to equity financing.
• Structured Equity Financing: Startups combine convertible notes, preferred stock, and SAFEs—to create a tailored capital solution. For more information, check out the ultimate guide to structured equity financing.
• Convertible Notes: Startups issue convertible debt, allowing creditors to convert their debt into equity under predetermined conditions. For more information, check out the ultimate guide to convertible notes.
• Unitranche Debt Financing: Startups combine senior and subordinated debt into one debt instrument to raise a substantial amount of capital. For more information, check out the ultimate guide to unitranche debt.
• Mezzanine Financing: Startups combine elements of debt and equity. For more information, check out the ultimate guide to mezzanine financing.
• Retained Earnings: This is less relevant to startups, essentially a company uses the profits it generates from its day-to-day operations to repurchase its stock.
• Special-Purpose Vehicles (SPVs): Companies may establish SPVs for specific financing purposes in a recapitalization to isolate and manage financial risks.

The less common types of financing in recapitalizations

• Tender Offer: Tender offers happen when a company offers to buy back the outstanding shares of another company that they intend to acquire.
• Debt-for-Equity Swap: This occurs when a startup exchanges its debt for equity. Unlike convertible notes, the conversion event is typically not outlined in the initial agreement and is negotiated at a later time. 
• Employee Stock Option Plans (ESOPs): Most startups issue equity to their early employees as part of their compensation plans (ISOs & NSOs). Later-stage startups (and publicly traded companies) typically provide RSUs or discounted shares to their employees.

Wrap-up - undertaking a recapitalization in 2024

If you’re looking to optimize your capital stack, a recapitalization may be the right strategy to pursue. Recapitalizations are useful for fueling periods of growth, financing an acquisition, driving up your share price, preventing a hostile takeover, preventing bankruptcy and even recovering from bankruptcy. While structuring a recapitalization may be complex, the underlying financing vehicles used to accomplish it are not.

If you’d like an extra set of eyes (and hands) to kick off a recapitalization, or if you’re interested in financing to fuel your recapitalization efforts, we’d love to help—get in touch with us!