Important Information About Management Buy-Outs (MBOs)
Sometimes privately-held company owners envision transitioning ownership and management responsibility to experienced employees.
It is considered a reward for the good managers who helped build the owners’ success, and a comfort, knowing that the company will be in good hands, the culture perpetuated, and that they won’t have to undertake a formal sale process. It’s especially logical that the exiting owner would envision this option when the managers are also family members.
Despite owners’ best intentions, the first problem to solve is that employees seldom have the money to buy out the owner, and often not even enough to provide a significant down payment for financing.
MBOs can work wonderfully – or horribly. There are many important considerations, and it’s best to seek knowledgeable third-party counsel before launching internal management discussions on the topic.
As strategic advisors, we will guide the entire process, from analysis through raising debt and/or equity financing, and maybe even help supplement the management team. Departing owners want the peace of mind of knowing that the transaction meets their personal financial needs, and the new management will succeed – especially when owners finance part of the transaction or retain a portion of equity.
This article briefly contrasts the two primary transaction structures, financing options, lists prerequisites for a successful MBO, then describes the pros and cons of ownership transition by this mechanism.
While employee management would take a prevalent role in an Employee Stock Ownership Plan (ESOP) too, that is an altogether different ownership transition structure that should not be confused with a MBO. I have written about ESOPs previously in a separate article .
There are two prevalent management transfer MBO deal structures in the lower middle market. The first and most commonly used is an equity-sponsored buyout. The second structure, a leveraged buy-out (LBO), is less commonly used unless the acquiring managers have significant cash to inject into the deal, since it may transfer disproportionate upside opportunity to the Buyer, while leaving the Seller to shoulder the risk as before, but without the upside.
Both structures may involve Seller financial participation through a number of mechanisms. Depending on deal structure, the Seller may consider that participation desirable or not; it may present a favorable opportunity, or a basket of discomforting risk. As the saying goes, “the devil’s in the details.”
Many management teams – whether related family members or not – partner with a private equity group to complete a transfer. The structure is not only more financially conservative than the LBO option, it dramatically increases the likelihood that the acquiring management will succeed, and it dramatically reduces risk for the selling owner.
In this scenario, Management has tremendous resources of the private equity sponsor, in management skill, experience managing rapid growth proficiently, industry experience and contacts, so they have greater tools with which to succeed. Of course, since the equity sponsor will be investing in Management, they must have faith that they can do the job without “hand-holding.”
This structure can be quite lucrative for the acquiring management, but they usually must be willing to give up a controlling equity position (ultimately yielding a “smaller piece of a bigger pie?”).
Certain companies may qualify for a “growth equity” investment however, in which the equity sponsor remains a minority shareholder. This situation is less common, and would apply to high-growth companies in which the acquiring management team had a proven track record of having managed that growth proficiently, with nominal dependence upon the departing shareholder(s). Equity sponsors only take a minority position when they are very confident in the team that will be running the company post-transaction.
The Sponsor-equity contribution to the capital structure tends to be 20-40%, with banks/asset-based lenders financing most or all of the rest. Acquiring Management may or may not have to contribute capital (though deal terms are more favorable if they do), and the structure is designed for them to “earn” equity for performance over time.
A variation on this deal structure would be a “recap,” when the original owner remains a minority owner, with the intention of converting a significant ownership stake to liquid cash now. Thus, a recap is different from an outright sale of the company.
A recap is an ideal solution for an owner who wishes to sell a portion of his or her company for liquidity or estate planning purposes, while retaining significant equity ownership to participate in the company’s upside and earn a second “payday” down the road (typically about five years).
- Recaps are commonly used when:
The original owner wants to achieve personal liquidity, but without sacrificing operating control of the company that he or she has painstakingly grown. The original owner(s) remain in charge of managing the new growth plan, forged in conjunction with the new equity partners. This option tends not to be used by owners of advanced age.
- The original owner wants to transition operating authority to qualified management, which may or may not include family members (the MBO), but wants to retain some equity in order to participate in the growth opportunity. New Management will be responsible for executing the growth plan.
The new partner is a private equity firm that shares the business owner’s culture and vision for the future of the business. Establishing the right fit is important. Investment bankers field daily inquiries from private equity groups, so are in the best position to guide this alignment.
As partners, these private equity funds are able to bring strategic opportunities to the company that were not previously available, can provide strategic, industry-specific management experience, capital for growth and other acquisitions, and assist the company to its next level of growth. A recap offers a business owner many potential benefits (such as removing any personal guarantees on company loans which may exist, among others).
Leveraged Buyout (LBO)
Acquiring Management may or may not put equity capital. If they contribute at least 10% of the transaction value as cash, they’re more likely to secure institutional debt financing.
If not, the Owner is more likely to have to finance a substantial portion of the transaction, along with outside debt provider(s). There may be the requirement for a personal loan guarantee, but if the acquiring management does not have the cash for the deal, the bank will look to the Seller to provide it.
Borrowed funds account for most of the purchase price, with the tangible assets of the firm used as collateral. A fairly typical structure would be banks/other asset-based lenders provide 50-60% of the financing, with the Seller financing the rest, possibly in conjunction with a mezzanine capital provider. These can be heavily indebted, high risk capital structures. Everything must go right after the sale, as there’s little room for failure to meet the business plan. There’s extended risk for the Seller, too.
Prerequisites for a Successful MBO Transaction
- Employee management team has the personal drive to be entrepreneurs, not employees. People often talk a good game, but as the process unfolds, it is common for discomfort to set in.
- Employee spouses must be enthusiastic about the process, too. Selling entrepreneurs know the sacrifices involved in owning a business, such as the higher demands on their time, wealth concentration that no financial advisor would recommend, lack of wealth liquidity, personal liability and guarantees, stress, and so forth. Employees and their families must understand and accept this, and sometimes an initial financial investment is necessary, too. This may mean uncomfortable changes to family budgeting, work hours and other time priorities, such as weekends and vacation planning.
- Lower level employees must have at least as much respect and affinity for Acquiring Management as Selling Management
- Employee management must be fully qualified and capable of running the business independently right away – no “mulligans.” If it is not readily apparent that this condition is met, the MBO exit is not a viable option. That said, there may be management gaps that must be filled, but those must be identified and budgeted for the post-sale period before outside investors or lenders are contacted.
- Acquiring Management must be fully committed to growing the company substantially, not maintaining the status quo – unless the company is already growing robustly, in which case this would bode well for securing investor/lender support for the transaction
- Unless the Seller funds the entire transaction with no outside investors or lenders and doesn’t require it – not advisable! – a solid business plan for growth must be in place, with targets, pro forma and any resource gaps identified and quantified
Advantages to a MBO Transaction
- Seller comfort with selling to a known buyer, whose motives are fully understood
- Least disruptive to the company’s operation, community and trade relationships, assuming that the above prerequisites hold; if otherwise, it would be most disruptive
- May be reduced risk of external confidentiality breach unfavorably affecting market position. That said, most breaches occur from within the company, as investment bankers are trained to manage the process to reduce that risk.
- When the acquiring management team is “right,” and the Equity Sponsor fit is good, these can be wonderful ways for Sellers to transition out, and for acquiring Management to make a substantial sum of money in about five years
Disadvantages to a MBO Transaction
- Probably will not bring the highest sale amount to the Seller. If the Shareholders’ objective is price maximization, this is not the optimal approach.
- If the Seller is not ready to step aside completely, personal conflicts can erupt as parties struggle for control. This potential tension can be managed, but only proactively with clear responsibility and authority delineation, and time-enforced handoffs.
- The inherently conflicting Seller/Buyer objectives for price maximization and minimization, respectively, may present short and/or long term relationship tensions. An investment banker managing the transaction process must be sensitive to this and manage it accordingly, providing a buffer between the two parties.
- These are high risk transactions which fail to close at a much higher rate than other transaction types. It presents greater risk of months of time invested, only to have to pursue another sale option later.
- Once the discussions with internal management begin, other options such as a straight 3rd party sale may be tainted
- Employees have “hidden power” in MBOs or Employee Stock Ownership Plans (ESOPs), as the Sellers’ power is dependent upon employees continuing to perform at 100%. The sensitivity is particularly acute if the Seller is financing a substantial part of the transaction, as is often the case with the LBO option or ESOPs.
- If negotiations sour, or don’t work out for other reasons, the risk of management turnover and confidentiality breach increases substantially, as does diminished productivity, especially if lower level employees are told of the situation, too.
In any case, the entire process should be managed by a third party. Sometimes attorneys will handle part of it, but do not address all the aspects described, such as establishing value and bringing equity-sponsors and debt providers to the transaction. Typically, investment bankers handle it from end-to-end, alongside attorneys specialized in business sale and investment transactions to represent the Seller. Acquiring Management will typically hire their own legal counsel.
McGavock Dickinson (Dick) Bransford is a Managing Director in San Francisco with Mid-Market Securities, LLC, an investment bank headquartered at 11 East 44th Street, 19th Floor, New York, New York 10017. Member FINRA/SIPC. He can be contacted at (415) 294-0002 or mdb @ mid-marketsecurities.com.
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