Management buyouts (MBOs) are an invaluable tool for business owners (Vendors) and management teams (Buyers) to plan and secure the future of their businesses.
The MBO process allows an incumbent management team to purchase the existing business operations from the Vendor and continue to operate the company for the foreseeable future.
The Buyers will then directly benefit from the future success of the company and have the autonomy to direct the business as they see fit while the Vendor will receive fair consideration for their shareholding and can agree a harmonious exit of the business, safe in the knowledge that the company has been left in the hands of an experienced and trusted team.
However, before the ownership changes hands both parties will need to address each other’s objectives and concerns. Transactions of this kind are ordinarily dependent both parties being able compromise and gain assurance around key factors, these include
- Buyer’s risk appetite for owning the business.
- Buyer’s ability to raise the necessary finance.
- Buyer’s level of comfort with the businesses performance and forecasts to ensure a return on investment.
- Vendors may be concerned about the future of the business and would want to understand the long term business plan.
- Vendors will likely wish to maximise the consideration received while Buyers will have the opposite objective.
Assuming that all of these considerations are discussed and agreements are reached during the negotiation stage, the question is “how can management raise funds to complete the purchase?”
Sources of Finance
Management Equity
The “easiest” method of funding an MBO, from the transaction perspective, is through the Buyer’s own finances and funding 100% of the consideration privately. However, the total level of consideration required to complete most MBOs is likely to be far in excess of what the Buyers may have available.
As a result, the lending market has recognised the need for third party funding. Banks and private equity funds (PE) have satisfied this requirement by providing lending facilities in the form of debt or in return for equity in the target business.
It is worth noting that all MBOs will require some management equity to be invested even when primarily funded by other facilities. The amount invested does not have to be significant in terms of the transaction’s overall value, but all the Buyers need to contribute a substantial level of funds in relation to their own finances. This is vital to give banks, PE’s and Vendor’s comfort that management believe in the business and are committed to making it successful as they now have personal money at risk.
Debt Financing – Term Loans
One of the most common means of raising capital to support an MBO comes in the form of term loans from third parties (typically referred to as Leveraged Buyouts). These loans can be borrowed against the future performance or the assets of the business and will typically be issued over a fixed term with fixed repayments that the business is liable to pay.
During the transaction a range of institutions (Lenders) will be approached for funding. When determining if a loan facility can be granted, Lenders will consider the historic performance of the business, assess the feasibility of the P&L and cash flow projections and review the asset value of the company.
For businesses which have historically demonstrated consistent earnings before interest, tax, depreciation and amortisation (EBITDA) and strong cash flows, an unsecured or secured term loan may be available. Unsecured loans carry the highest risks for the Lenders and are less common than secured loans but to obtain either requires careful planning and presentation of the company’s financial data.
If a Lender considers the EBITDA and/or cash flow to be outside of their risk profile, then they may consider an Asset Based Lending approach instead. Asset based lending is loan facility that is secured against the assets of the business. Lenders will consider all forms of assets from fixed assets to stock and even trade debtors when considering what they are willing to offer. By securing a loan in this fashion the risk profile reduces for the Lender and they may be able to provide access to other facilities which can be drawn on to fund working capital.
Deferred Consideration and Earnouts
Deferred consideration and earnouts are simply asking the Vendor to delay receiving some of the money they are owed from the MBO to a pre-determined date in the future. The key difference between the two options is that an Earnout is tied to the performance of the business following the transaction while deferred consideration is a known fixed amount.
The rationale behind deferring the consideration is to allow time for the business, under new management, to generate additional cash which can then be used to settle the deferment rather than taking on higher levels of debt or sharing equity with a third party.
This arrangement increases the risk for the Vendor and will need to be negotiated carefully.
Vendor Financing
Best described as a halfway house between deferred consideration and debt financing. In some instances, a Vendor may be willing to forego a large upfront payment and instead opt to take a nominal amount of consideration initially. The remainder of the consideration will be financed through a loan note from the business to the Vendor. This loan, similar to debt financing, will be repaid to the Vendor over the life of the loan.
Private Equity Investment
PE firms also fund MBOs through a combination of debt and equity (typically referred to as Private Equity Management Buyouts). PEs will perform similar assessments to a debt lender but will often take an equity stake alongside the Buyers in addition to requiring interest on their loaned amount.
This arrangement allows PEs to be involved in the business’ day-to-day activities (if they so choose) and then benefit from the future growth of the business similar to management. Once the value of the business reaches the PE’s target level, they will look to sell their shareholding.
There are benefits of PE investment for the Buyers also.
- The repayments made are less than debt financing as the debt portion if less than full debt financing and allows more free cash for investment.
- PE funds bring knowledge and contacts which can support business growth.
- PE funds may be willing to allow a further MBO on their shareholding providing Buyers with the opportunity to acquire 100% ownership when the business is in a stronger position.
If you are management team considering an MBO or a Business owner looking to sell a business, please do not hesitate to contact Philip Olagunju (philip@pemcf.com) or Lake Falconer (lake@pemcf.com) who will be happy to support you.