By Lloyd Compton, MRSB Group
In succession of a business, the most suitable buyer may not always be a financial buyer or a strategic buyer. In some cases, the buyer best able to continue the success and growth strategies of the business may be someone already working in the business. Existing Management are intimately familiar with the business’ operations, its employees, its customers and its suppliers and may be best positioned with new ideas for growth or improvement. In these circumstances, a Management Buyout may be the quickest and easiest succession strategy.
What Is a Management Buyout (MBO)?
A management buyout (MBO) involves the purchase of a business by its existing management team, usually through external financing or a combination of external and vendor financing. In most cases, the management team takes full control and ownership of the business as the former owners exit. However, partial buyouts and phased buyouts are also possible.
The most common reasons for an MBO are:
- Some or all of the company owners wish to exit the business and crystallize their equity
- A parent company wishes to divest itself of a subsidiary or business division
- The company is in distress or has gone into receivership, but still has potential
- The management team perceives greater opportunities under their ownership than the current ownership
MBOs are particularly useful for small to medium-sized businesses, especially in the transfer of family businesses to the next generation. They can also be used to take public companies private.
The management team typically pools personal resources to provide capital for the MBO while arranging debt financing, often through an external lender. Vendor financing is often a significant component of the MBO financing package. The amount of vendor financing for an MBO is usually proportionately higher than in a traditional open market sale.
An MBO is a good option for a company that lacks a clear succession plan, as it creates a smooth transition to those who know the business and are best positioned to ensure its future success. Selling to management also reduces the risk of exposing confidential information to competitors or the public and ensures a knowledgeable buyer with a high level of commitment to the company.
What Is the Normal MBO Process?
Preparing an MBO involves several steps, beginning with the management team establishing a strong track record and a business plan for the company’s future. Both buyers and sellers must assess the opportunities and risks before entering the MBO process, as follows:
- The management team must either be invited to the process by the current owners or directly approach the current owners to let them know they are interested in the succession of the business.
- The current owners and management team must determine the price of the transaction. Often this involves the current owners setting a price, with the assistance of an independent Chartered Business Valuator (CBV), and the management team obtaining independent advice on whether the price reflects fair market value. Independent valuations can help to remove some emotion from the negotiations and are often mandatory for obtaining outside debt financing. Due diligence on the company’s financial and legal status is an essential part of the MBO process.
- The parties must negotiate the deal structure and terms. This process involves the management team and aims to meet the objectives of both parties determine the legal and financial requirements and limitations.
- Management team members must determine how much of their personal resources they can invest in the MBO, how much traditional debt financing they can obtain, whether they can secure alternative or mezzanine financing, and how much vendor financing they will request or require. Meanwhile, the seller must consider how much vendor financing they are prepared to accept and at what repayment terms, including amortization period, interest rate, and security.
- The participants and their legal teams should develop a memorandum of understanding (MOU) outlining key elements such as price, structure (asset versus share purchase), included and excluded assets of the transaction, and the terms of the proposed deal, such as payment terms, vendor financing, repayment period, and future employment of the current owner. The MOU is shared with the legal teams for drafting the Agreement of Purchase and Sale and with the lenders to begin the financing process.
- The parties must finalize legal agreements and complete due diligence, ensuring their legal teams, accounting representatives, and lenders have the information they need. They must also finalize the definitive sales agreement, loan agreement, employment contracts and non-compete agreements, promissory notes, and security agreements.
- Close the deal and transition the company. Post-acquisition is an important period in the MBO process. Thoughtful and effective communication with staff, customers, and suppliers is important and must be done as soon after the closing date as possible. In some cases, key staff may be informed prior to closing if their assistance is required in the due diligence process. To ensure a smooth transition, and to increase the likelihood of collecting a vendor note or earnout, the former owner often stays on for a period of three months to one year under an employment contract with the new owner(s).
How Do MBOs Typically Get Financed?
There are several forms of financing that are most common in MBOs.
Traditional Debt Financing
Traditional debt financing typically involves one of the following options:
- Chartered bank cash flow lending, based on the company’s historical and projected cash flow and growth potential
- Chartered bank asset lending, based on the strength and value of the target company’s tangible asset backing
- Non-bank cash flow lending, based on the company’s historical and projected cash flow, growth potential, and tangible asset backing
- Home equity lines of credit, or borrowing against the value of the buyers’ homes
Seller financing is a popular source of MBO funding and often involves a term loan amortized over a period of years following the buyout. Sellers tend to finance 10- 25% of the total MBO value as part of a funding package. Seller financing is a delayed payout for the business and is a good indicator of the seller’s confidence in the buyout process and the future prospects for the business under the new ownership. Management teams typically have less liquid capital than strategic or financial buyers so sellers must be prepared to accept a higher vendor note to get the deal done with management.
Mezzanine financing combines the features of debt and equity financing. Mezzanine debt typically ranks below senior debt (such as traditional bank debt) in priority, but above equity and may take several forms, including preferred or common equity, subordinated debt or convertible debt (convertible to equity).
Management teams use mezzanine financing when seeking more flexible repayment terms. In return, mezzanine investors have a say in corporate direction and often develop repayment schedules in concert with the company’s cash flow.
What Are the Benefits of an MBO?
Compared to a sale on the open market, an MBO can offer advantages to both the buyer and seller. The most obvious is the smooth transition from one owner to the next. Because the buyers in an MBO are already associated with the company, their continued presence can be reassuring to existing customers, vendors, and employees. An MBO implies minimal disruption and a continuation of business as usual, even though the new owners might have different ideas on how to run the business.
Management buyers are less concerned about “skeletons in the closet” because, in all likelihood, they put them there.
An MBO protects sensitive and proprietary information. In an open market transaction, potential buyers will need to see the company’s internal workings. Advantageous processes and potentially damaging information may be revealed. This can leave the business vulnerable to less scrupulous competitors acting under the pretense of potential buyers.
The management buyout team will usually be familiar with the company’s financial and corporate health. This can reduce due diligence and speed up the time to closing.
Lastly, an MBO offers the seller the opportunity to find the company “a good home.” This can be important with a family business where there is a strong emotional attachment. This also helps to reduce “seller’s remorse,” making for a smoother closing and transition.
What Are the Risks and Challenges of an MBO?
In an MBO, the company’s potential for future success relies on the expertise and commitment of existing management. In situations where a company is being sold due to distress or poor performance, lenders may question the role of the management team in that performance. If lenders determine that the buyout team was complicit in the business’s decline, it may present a roadblock to financing.
Even if the company is healthy and being sold from a position of strength, the skills and experience of the buyout team can be an issue for lenders if they question management’s ability to transition from employees to owners. The transition from a managerial to an entrepreneurial position can be challenging. This may create stresses that negatively affect the growth of the business. Lenders may also question whether there exists personal goodwill with the current owner that will not easily transition with the business or to the new owners.
The management buyout team will be required to invest in the acquisition; management buyers do not often have significant savings or access to capital. Team members without sufficient liquid capital may be forced to leverage the equity in their homes or retirement savings. Employees are often unaccustomed to taking on this level of financial risk.
Conflict of interest may arise if a management team wishes to bid for a business being marketed to independent third parties. In an MBO, management sits on two sides of the transaction with differing goals: the buyer and seller. Management owes a fiduciary duty to corporate shareholders and must work for the good of the corporate enterprise. As part of its fiduciary obligation, management must refrain from self-dealing and ignore its self-interest when it diverges from shareholders’ interests. Should the management team not be successful in their negotiations to acquire the business, it could damage the relationship and diminish the business’s value and future success. Vendors should consider the likelihood of a successful MBO outcome before inviting a management team to be party to an open market transaction.
In addition, the seller may not get an optimal price from an MBO. The transaction lacks the competitive tension associated with being exposed to the market and potentially multiple strategic buyers. MBOs usually transact at fair market value or lower, and the selling price is often based on an independent valuation.
Vendors must determine if an MBO is right for their specific situation, based on the risks and benefits described above, especially when the MBO may have a negative impact on the selling price if it is not an open market transaction.