Business Owners have more choices than ever before about how to transition out of their business.
But many do not take advantage of those choices by not considering them or not preparing for them. When a business owner has grown their company over many years, they need to consider all their options and identify those that realistically give them the outcome they desire. Then set the company’s strategic plan around those choices. Choices range from a third-party transaction (which can mean either private equity or a strategic purchaser) to wind up the operations. In between, there are many other opportunities including allowing management to buy a controlling position of the company (MBO), which is a great opportunity for many business owners to ensure legacy, continuity and security for their employees. It’s not without its complications. So, let’s look at the benefits and the challenges.
First – The Jargon
It’s worth starting with some jargon busting. You’ll hear a lot about the role of private equity funds (“PE”) in MBO’s. This is very common. PE funds are organisations where investors with common aims pool resources to enable the acquisition of assets (companies, property etc.) in multiple ventures without a single investor taking all the risks. PE funds and lenders look to invest in strong management teams who are primed to take over the reins of successful organisations. As with any transfer of ownership, as a business is always more attractive with the right team.
Senior debt is one of the cheapest sources of capital and includes bank loans, overdrafts, or lease/asset financing. Lenders get interest and capital repayments over a defined period. If repayments are missed the lender can, depending on the terms of the loan, take control of and sell certain assets owned by the company. Lenders are not, generally, shareholders of the business.
Mezzanine Debt is bridge finance that fills the gap between the purchase price, the equity and the senior debt (often called secured debt) It is prioritised behind senior debt from repayment purposes because it is most commonly unsecured. Mezzanine debt is a higher risk for the lender and therefore pays a higher level of interest AND may be converted into equity under certain conditions.
Equity is the shares in a business that comes with the benefits of ownership. It also represents the highest level of risk as if things go wrong the shareholders are literally last in the queue to get the residual value from the business therefore it is also the most expensive source of capital. There are different levels of equity with varying levels of control and risk. See later in this article for more details.
Vendors take back is a method used by buyers to bridge any gap between the sale price and available finance. Typically, is takes the form of annualized payments over subsequent years after the transaction closes. It’s deferred payment and means the seller is taking part in the future risks of the business.
Leverage is the amount of debt held compares to the price being paid for the acquisition. You may even hear an MBO described as a “leveraged” MBO. This simply means that the MBO has been funded by some form of debt.
WHAT IS AN MBO? (The Important Questions)
What does a successful buy‐out looks like? Should you consider one? What are the most common challenges? How do you avoid them?
In PWC’s white paper, Anatomy of a Management Buy-Out, they define it as:
“A management buy‐out is the acquisition of a business by its core management team, usually (but not always) in coordination with an external party such as a credited lender or PE fund. The size of the buy‐out can range considerably depending on the size and complexities of the business, but one aspect that all MBOs have in common is the core management team taking an equity stake in the business. Depending on the intentions of the current shareholder base, the buy‐out will represent a controlling acquisition stake in the business, if not a full 100% acquisition.”
I couldn’t have put better myself.
The opportunity of an MBO usually comes out of the business owner starting to think about retirement and where there is no family succession in place. The business and its team are often thought of as “family” and the. Owner is motivated by looking after their employees and giving the current management team both the motivation and opportunity to grow the business into the future.
The management team buy‐out the company with some of their own capital, ensuring they have “skin in the game” enough to ensure they are tied into the business future success. In short, the management team transfer from employees to business owners.
Here’s where one of the complications can arise. Business owners selling want a fair price for their years of effort and risk, while buyers want to purchase the business at a fair price to generate future value. Add in the 3rd dynamic of PE or lenders and there is a balance to be struck. All buying parties (whether PE, 3rd party lenders or anyone else) look to recover their investment from future success. Competing interests can make MBOs are more complex processes. Clarity of communication and overall expectations at the beginning of the process is essential to a successful transaction.
Is a management buyout the right route for YOU?
If you are a business owner with no family succession plan in place then an MBO is a great way of planning your own exit from the day to day, then from control and finally from ownership. 100% of business owners leave their business. Often it is because of unplanned activities i.e., something happens to you or your family that changes everything. Often it is the ability of the business owner to continue working in the business. Part of preparing for an MBO is simply good succession planning for yourself. Getting out of the day-to-day makes your business worth more. Getting your senior management team working autonomously and able to confidently make decisions adds value – and means you are more exit ready.
MBO’s work where:
- The business owner wants to reward a loyal and talented management team and see their business create greater future value.
- The idea of selling to a competitor or “outside” buyer is unattractive to the business owner.
- A sale transaction can be shortened because the management has industry knowledge and can operate autonomously.
- A sale to a 3rd party might result in the loss of the key people.
- The business is very specialist and niche (therefore needs specific industry knowledge to continue).
An MBO won’t work where:
- A business owner who is not prepared to sell or transition out of absolute control
- A business owner who states “I am never leaving/selling my business”
- The seller wants the highest possible price
- There’s no management team with the talent and autonomy to take the business further
Key Success Factors for a Successful MBO
There are some key factors that are needed before going down the MBO route:
- Quality Functional Management Team with balanced leadership and industry skills. The team must be able to develop strategic business planning and decision making which shows how they are going to grow the business to enable return on the investment.
- A Business generating positive cash flows and healthy profits. An MBO invariably involves different levels of debt, all of which needs to be repaid in both capital and interest. The business must evidence that the debt is manageable as well as investment in the growth of the business.
- A Business (and owner) that is Sale Ready. This isn’t an overnight decision and the business owners must be sale ready which often means a significant mindset shift of the business owner, even if there has been a management team in place for a while. This means understanding the due diligence process and being prepared for it.
- A source of capital and, often, external expertise. This is usually lead by a PE fund that backs their investment up with additional lending.
- Alignment of the management team to the growth potential of the business and “what’s in it for them” in relation to the risks they are taking.
- A selling business owner who recognises the value that the management team add to the business.
Sale Readiness and Due Diligence in an MBO
The better prepared a business is for the due diligence process, the easier the transaction will be regardless of what kind of sales the business is going through. If you are not prepared you are going to experience a world of pain – and risk failure of the deal. The object of commercial due diligence is to ensure that there is reduce the risk to the investors by giving them a complete understanding of the current state and future potential of the business. Key due diligence elements include:
Commercial due diligence:
- Full details of the products, customers, markets and all stakeholders
- The strategic plan, showing alignment with the seller and management
- Demonstrable understanding of the business by the management team
- A thorough understanding of the current and future markets for the business by the management team – and their strategic plan for addressing growth
- Evidence of assumptions, market positioning and growth opportunities.
Legal Due Diligence:
- Every contract, commitment or asset detail and associated paperwork you can think of
- Full records evidenced
- Financial Due Diligence:
- Detailed past financial reports and evidence of high standards of internal controls and processes
- Future financial plans and forecasts
- A robust defence of the risks associated with forecasts, including investment capital required
The Right Partner for a Business Owner
Just because a PE fund is interested in helping your Management Team buy your business, doesn’t mean that they are the best options. Not all PE funds are equal. As a Seller, you need to do your own due diligence on the potential “buyer”. I never recommend doing this on your own. If you’ve never sold a business before, get expert help. Make sure that the. “buyer” has the financial resources to complete the buy‐out and any future growth investment that is going to be needed. You might also want to make sure the buyer has the right sector expertise to support your management team with increasing shareholder value.
PE funds that are well capitalised and well educated in the industry sector are better equipped to support strategic plans in specific sectors.
The Deal Structure
Selling your business means finding a buyer with the resources to buy it. This includes the purchase price AND the transaction fees as well as having the capacity to fund future growth. With PE supported MBO’s this often involves debt instruments. It may even involve funding from the seller (see jargon re vendor take back).
One of the key success factors is the businesses’ ability to support different methods of financing from the positive cashflow generated from its operations. There will always be an upper limit on the sale price requiring early valuation of the business to set expectations. PE will always come with an expected exit timeline. PE funds always ask, “How and when can I expect to crystalise my return on investment?” Balancing this with the seller’s requirement to get a fair price for the business they built creates an internal tension between the Buy-Out team is essential to the success of the transaction.
Management must understand the deal structure and the burden of debt they are taking on. Understanding their own equity position and what risks they are taking will colour their view of how they run the business. Too much debt and the business will feel heavy. More equity dilutes their own “investment” in the business when the next “exit” happens. It’s a fine balance for both management and the funders/investors.
The deal structure and price will be a matter of judgment. Sellers have a lower attitude towards risk compared to buyers – and buyers’ risks are invariably the ones that get addressed in the sale process.
Most commonly buy‐outs are financed through a combination of senior debt (loan instruments) and equity (shareholders owning shares). Other sources include mezzanine debt, deferred consideration (such as vendor takebacks)
The cheapest source is senior debt, which is usually secured (back up by) personal guarantees or liens on assets. The most expensive sources are equity and mezzanine debt which is not secured or is subservient to other debt instruments. Finding a fair price means that management can grow the business and benefit from the upside without feeling crippled by serving the cashflow needs of a heavy and unrealistic debt burden.
With a strong management team, senior debt lenders are betting on the growth of the company. They usually secure the debt on the assets of the business as well as taking personal guarantees from the management team. This leads to higher levels of leverage on the business.
When putting together an appropriate structure, important considerations relate to Cash flow. It is most important that the buy‐out team has a detailed understanding of projected cash flows not just profit. Cash is needed for capital expenditure, growth funding and working capital, as well as restructuring costs if required. The timing and predictability of the cashflows relies on the predictability of future orders. The more predictable the timing and quantity of the cash flows, the more likely a company can raise and service debt at a lower cost (and with lower levels of security required).
Nothing cripples’ businesses more than struggling with cash flow; having a burden of debt that cannot be easily serviced by the business has killed off a lot of high-profile businesses, even though the business has been profitable. Making sure that all parties in the MBO understand both the structure of the business AND what they are all trying to achieve means you are more likely to put together a buy-out structure that works for everyone.
If the management team haven’t worked in a leveraged (debt) environment, they may need some education. There is often a temptation to look at quick repayments of debt which is one way a business with growth opportunities can be stymied. 4 factors need to be understood:
- The interest rate (and timing of interest payments);
- The repayment profile (timing of capital repayments);
- The security required (business and personal); and
- The financial covenants (what condition will make this loan be called in early).
It’s also important not to forget tax and the impact of both business and personal for all parties. The seller may have done extensive personal tax planning without considering the impact of personal tax on the management team. Alignment of all parties should be considered to ensure there are no unexpected negative tax impacts. I am not suggesting that the tax tail wags the whole dog but I have seen, on more than one occasion, a deal fall apart or significantly delayed because of the personal tax circumstances of the management team.
In the same way that all debt is the same, neither is equity. A deal is structured to balance equity and debt according to the risk appetite of the buy-out team. If the management team are not aware of the different levels of equity, they need to be educated – as early as possible. Most will be aware of ordinary shares, which are where the management team usually sit. Preferred shares are also commonly used in buyouts and are like debt in that they can be “redeemed” and attract a fixed interest rate for a specified period. Preferred shares are paid out before the ordinary shares when a future sale occurs. Preferred shares set out the intention of the PE funds providing equity capital.
It is important that the management team understand the structure of the deal, what they are “putting in” and risking, what they need to do to realise their financial rewards and what control they have. Many a management team have ended up working in a more challenging environment than they expected because they had the wrong funding partner, a poorly structured deal for them and a lack of control.
The selling business owner may be required to provide some of the bridging finance. This ends up being very similar to an earn-out without the business owner being required to work in the business. They are simply carrying some of the risks into the future. As a seller, it’s important to understand what your personal boundaries are and get clear on the structure of the deal as early in the buy-out process as possible.
The Pitfalls Business Owners need to Look Out For
All sale processes have their pitfalls and challenges – often in communication and expectations. Here are some of the top ones for management buy-outs:
- Thinking it’s the only option and not looking at other options. There is sometimes a kind of business owners myopia around MBO’s without investigating other ways of rewarding a loyal management team with better outcomes for everyone.
- Lack of alignment of all parties. It’s always going to be a balance and everyone’s perspective needs to be aligned to avoid disastrous outcomes
- Adverse behaviour from the management team once they realise the opportunity (management greed) – this includes manipulating numbers to downgrade value and holding the business owner to ransom with walkout threats
- Lack of management ability or desire to take on the burden/risk of a buyout
- Lack of communication and preparation for the business, the management team and the business owner to be sale ready
- Lack of clear leadership. A management team that is currently managed by the business owner often means there isn’t an immediate “leader” in waiting
Any sale process is complex and demanding for all parties. In an MBO the business owner selling finds themselves pitted against their own management team in a negotiation for the seller’s future financial security. Psychologically that’s a tough situation for all. Getting clear on the boundaries and process as early as possible means there are no misunderstandings later in the process when significant expenses and time have been invested. Starting the journey without clarity can result in an unrecoverable situation with potentially significant damage to the value of the business.
As a business owner are you still interested in an MBO?
With good planning and preparation, an MBO can be a great way for the business to thrive into the future and give the selling business owner the value they’ve worked so hard for AND a legacy to be proud of. It’s something to think about, especially as there is a pile of underutilised PE funding out there looking for a good home. The key thing is to explore the options and make sure this is the one that is right for you and your business.
When you have the key ingredients for success, this is a great route to take for business owners and all the stakeholders. If you don’t currently have the right people in place then this isn’t the journey for you right now – but it could be in the future. Getting an idea of your current valuation and business saleability is a good first step. And it’s easier than you think – it takes one quick call.
Are you ready to sell? Click here to contact Christine by email alternatively you can book a call with the Business Mentor of the Year 2020, author and speaker. Who helps business founders get their businesses exit ready so they can enjoy a happier, richer future. She saves them THOUSANDS and increases the value of their businesses by MILLIONS.