Management Buyout Finance
Everything You Need To Know
A management buyout is a well-established route for senior business employees to become true entrepreneurs, taking control of the business and reaping the rewards of all their hard work - but doing so requires considerable capital.
To explain how a management buyout works and detail how to obtain management buyout finance, we’ve compiled this in-depth guide.
What is a Management Buyout (MBO) and Management Buyout Finance?
A management buyout (MBO) is when the management team of a company purchases the business from its current owners.
In doing so, they transform themselves from employees to directors, able to make greater decisions about the company’s future and lead the business in the direction they believe is best.
The experience of the management team gives them the perfect knowledge to become its directors, bringing years of combined expertise to propel the business to a new level without ties to previous owners or stakeholders.
A Brief Explanation of Leveraged Buyouts (LBO)
Management buyouts are typically a form of leveraged buyout (LBO).
A leveraged buyout is any purchase of a company that uses debt capital to finance the operation, so if the management team requires external capital to help fund the buyout, the MBO is also an LBO.
Not all leveraged buyouts however, are MBOs. Leveraged buyouts include company purchases from private equity firms, employee takeovers with an employee ownership trust (EOT), or a previously unrelated external third party buyout.
Why Undertake a Management Buyout?
There are multiple reasons why the management team may look to acquire management buyout finance to enact an MBO. These include:
1. The current owner is looking to exit
Probably the most common reason for an MBO is simply that the current owner no longer wishes to own and run the business. This may be for retirement reasons or a pre-conceived exit strategy that has been in place since the birth of the company.
With many MBOs, the current owner has spent many months and even years considering this exit strategy and will have groomed the management team with a view to a manager buyout. They may even have laid the groundwork for obtaining considerable management buyout finance.
However, perhaps the current owner has not considered this avenue, and has instead looked to an outside third-party to sell the business to, or are looking to a public valuation. In these cases, the management team may not desire that outcome and may come forward with the case for an MBO instead.
2. The parent company is looking to remove a division or subsidiary
Often a larger parent company has been financing a division that no longer forms part of the long-term plan and may look to divest itself of that part of the company.
In this instance, the management team of the subsidiary may see an opportunity to branch away from the parent holding to become a completely separate enterprise in their control; an MBO and management buyout finance offers a path to that end.
Equally, the parent company may openly offer the opportunity for an MBO having considered the management team to take over in a similar way to an owner’s exit strategy described earlier.
3. The company is in trouble but may be saved
Many MBOs occur when the company is close to or enters, administration.
Here, the management team still see considerable potential in the business and believes that under their control it will regain viability. With the business in distress, its valuation may be small enough that the level of management buyout financing required is lower, and the opportunity is simply too good to pass up.
In these MBO situations, the risks are obviously somewhat greater than when the company is performing strongly, but the rewards are also potentially much larger.
4. The management team believe they can do better
Here, the management team simply think that without the shackles of the current owners, the business would flourish.
In this instance, it may be that they approach the owner with an MBO proposal somewhat out of the blue, but often, such unsolicited offers are accepted by a current owner who feels relief at the opportunity to exit and take on other opportunities themselves.
MBOs, MBIs, and BIMBOs
An MBO is not the only variant of a management team takeover of a business. When external expertise is brought in to strengthen the company purchase, it is seen as either a management buy-in (MBI) or joint MBI and MBO, known as a buy-in management buyout (BIMBO).
Management buy-in (MBI)
For an MBI, the management team that takes over the company is entirely external. Here, the team have seen opportunity in a business that is not one where they are currently employed, and will replace any existing management team with themselves.
In many cases, an MBI team will clash with a potential internal MBO team, causing competition for the business purchase. This can be good for the owners, as the value of the company will consequently increase.
Buy-in management buyout (BIMBO)
This is a combination MBO and MBI, merging the two management teams to form an overall new ownership and leadership structure. It occurs either when the internal management team, perhaps considering a pure MBO, partners with outside expertise; or when an incoming MBI group see value in retaining existing management and presents the idea of a BIMBO to those employees.
The Process of a Management Buyout - How It Works
While each MBO follows its own path and there is a lot of individuality with each purchase, a similar overall pattern does govern the process:
1. Seizing the opportunity and solidifying the management team
Finding that there is an opportunity for a management buyout is the first link in the chain.
It may be that this is an open discussion between the current owner and the prospective takeover participants, or it may be a more discrete conversation between members of the management team.
It is essential when considering an MBO that each member of the team is clear regarding their abilities, investment level, and expectations. A collaboration between all management team members cannot take place if there is not one uniform view.
2. Undertaking due diligence
Due diligence refers to the process of reaching an honest understanding of the business, its viability, and ultimately its value.
An extremely optimistic viewpoint may lead to an over-enthusiastic and ultimately unrealistic vision of the business and the future, while pessimistic team members (who often consider themselves ‘realistic’) can hamper the opportunity. Importantly, a logical balance must be struck where the company is assessed and understood in the most truthful ways.
During this time, the business plan comes into focus. This document, which details the entire MBO project, should detail the key points and conclusions of the due diligence stage.
The process of due diligence is a significant amount of work and is essential before any final application for management buyout finance.
3. The business valuation
With due diligence having been undertaken by both the prospective purchasers and the outgoing owners, a business valuation can be reached.
Valuing a business is a complicated process with many variables that cannot be accurately defined. Ultimately, there are no clear mathematical formulas that will reach an exact figure, however, a final valuation that is agreed on by all parties is needed and will be calculated by the end of the process.
4. The special-purpose vehicle (SPV)
A special-purpose vehicle (SPV) is created as a holding company to undertake all financial and legal arrangements during the buyout process. This holding company, called the NewCo business, is used as the acquisition vehicle to purchase the company.
5. Obtaining management buyout finance
With the valuation agreed, the NewCo can officially approach lenders and other financiers with the MBO proposal to raise the capital required for the purchase.
It is not enough to simply generate enough funds to meet the business asking price, however, as the newly owned company will also need cash flow to run and maintain its business activities, including coverage for any existing business debt.
It is essential to obtain enough MBO finance to keep the business running smoothly until day-to-day operations are in place and income is assured.
6. Legals, exchange, and completion
With the financing available, the process quickly moves to the legalities of finalising the buyout. Warranties are signed, contracts are agreed, and the business ownership changes hands.
Management Buyout Finance - A Lender’s Perspective
From the lender’s point of view, management buyout finance is an opportunity to form a fruitful business relationship with a potentially valuable long-term company.
However, like any business debt financing, proper due diligence and evaluation of the risks involved are undertaken.
Management buyout financing requires a considerable amount of this work and decisions are not made without proper analysis. Thus, getting management buyout finance is a process that may take many weeks, even months, and should be given due levels of care by all involved.
The experience of the team members and their understanding of the company’s history and potential for the future is not underestimated by lenders and means that management buyout finance is often easier to acquire than similar levels of MBI or general LBO financing.
MBOs and Multiple Level Financing
Unlike more minor undertakings, management buyout finance is rarely a single financial product, but is instead comprised of multiple levels of finance.
Main business loan
The primary source for finance for most MBOs is a primary business loan, sometimes known as senior debt.
This is structured in a traditional debt finance way, with funds provided for both the company purchase and an additional amount for business cash flow and operations.
Payments will be made, usually monthly, by the business over the length of the term, during which time they will generate interest.
If it is an unsecured business loan, then the new directors (members of the management team) will generally be required to provide a personal guarantee, making them personally liable for the debt repayments in the case of the business failing to meet its debt commitments.
An alternative would be an asset-based secured loan, tied to one or more business assets as collateral for the debt. An asset-based loan would be appropriate when the company owns significant assets that are able to be leveraged, but as these assets will also form part of the valuation of the company, it is logical that their value will not meet (nor exceed) the total required for the buyout, thus the need for additional financing.
In some cases, non-tangible business assets, such as accounts receivable, may be able to form some measure of collateral depending on the finance terms.
Financing the management buyout with an asset-based business loan will also be difficult in cases where the business is in financial difficulties or liquidation. In those cases, directors’ guarantees on an unsecured loan is almost always the preferred option.
Full consideration of all factors should be undertaken by the management team before agreeing to personal guarantees and taking out a primary business loan. Complete confidence should be held in the company’s ability to make regular loan repayments.
Secondary business loans
Secondary loans, sometimes referred to as “mezzanine finance” or “subordinate debt”, are additional business loans with other lenders that are considered lower rank than a primary business loan.
This ranking means that the risk for the lender is considerably greater than that of a primary business loan and as such, fees and interest rates are often higher than that of other loans. Loan terms are also often shorter, with the expectation that loan exit strategies exist to shift away from secondary loans.
It is important to note that assets leveraged as collateral in the primary business loan cannot typically be utilised in this way for any subordinate debt.
Private equity finance
Outside of debt finance, many MBOs are achieved through private equity financing, where a private individual or company is provided with shares in the business in exchange for additional capital.
In many cases, it may be that the equity finance comes directly from members of the management team, injecting further personal funds in exchange for a greater stake in the business, but there is also the opportunity for additional third-party investment, whether from individuals or private equity firms.
Collaborating with third parties for equity finance should be undertaken with due caution in a management buyout. While it is a commonplace strategy, it can weaken the overall strategy of the management team regarding decision-making and business direction, effectively undoing much of the reason for the MBO in the first place.
UK Tax Considerations with Management Buyouts
It is important to enlist the services of a professional tax accountant when undertaking a management buyout. There are several tax implications that are easy to overlook when considering the MBO. These include (but are not limited to):
- Capital gains tax - More applicable to the current owner when selling the business, capital gains tax is owed to HMRC based on the profit made when selling an asset.
- Earn-out payments - Shareholders may receive earn-out payments based on the future success of the company that is subject to income tax and will likely want to structure these payments to limit future tax liabilities.
- Stamp duty - In some cases, stamp duty may be payable.
- Interest tax deductions on the business loan - Understanding the tax deductions available for the interest due on the primary and secondary business loans will help the business cash flow.
- Exit options - Consideration should be made for any exit strategies and income tax compliance for members of the management team looking to a future exit.
Pros and Cons of Management Buyouts
Generally, management buyouts are considered an excellent opportunity for a business looking to change ownership, however, there are some downsides as well that should be considered to form a full understanding of MBOs.
The Benefits of MBOs
1. Management experience and a smooth transition
Perhaps the greatest benefit is also the most obvious - with an MBO, there is often no immediate change in the day-to-day running of the business. The management structure can remain the same and projects already in progress can continue unabated.
This is especially advantageous for employees, who are less likely to feel that jobs are at risk and will gain from the additional feeling of security provided by the management team's faith and investment in the business.
Similarly, clients who are in the know will retain confidence in the company and are more likely to continue with their relationship.
2. A clear future plan based on knowledge and experience
When management changes in a company it often heralds sweeping changes that can be disruptive despite the best intentions.
Viewing a company and its processes from the outside is not the same as having worked closely inside the business, and external management, such as those coming in from an MBI, are less likely to have a comprehensive understanding of the business's finer nuances.
The management team undertaking an MBO will have a plan for the future that no doubt involves some changes in direction, but it comes from a solid foundation of experience.
3. Business confidentiality and stability
The sale of a business can cause some instability, especially if news of the changes becomes a rumour prior to any official announcement. This can have a knock-on on effect with customer trust and employee loyalty, as well as a greater public perception of the business.
When the acquisition of a company is undertaken within the walls, there is a substantially smaller likelihood of cracks in business confidentiality.
4. Retaining employee skills and talent
The smooth transition and ongoing stability of an MBO means that employees are far less likely to take the opportunity to look to move their careers elsewhere. Compared to other business acquisitions, MBOs are far more likely to retain those employees whose skills and talents have been cultivated and are important going forward.
5. Understanding the vision
For the owners, letting go of their company that may have been built from very humble beginnings can be difficult. It is made considerably easier if those who are being passed the torch are already known and established. Many business owners exiting their companies feel more confident in an MBO, making the process simpler and easier for all.
6. A smoother sale
One final advantage to most MBOs is the speed and confidence in the sale process. While due diligence is no less important with a management buyout than other forms of business sale, much is already known and can be quickly and easily compiled from within. Management buyout finance lenders are able to make decisions with more confidence, and the overall process can often be quicker and easier.
Related: Business loans to buy a business
The Disadvantages of MBOs
1. Lack of competition leads to a cheaper sale price
MBOs often mean there are no competing bids from interested third parties. For the current owners, this means accepting the offer from the incumbent management team without counteroffers to drive up the price.
2. External bids can ruin MBO plans
Larger industry corporations have access to greater funds than management buyout finance may offer, meaning that should the owners look outside for alternative offers, the MBO team may find themselves outbid with little recourse to additional capital.
3. Management buyout finance can be difficult to obtain
There are so many factors that must be assessed when management moves to acquire finance, that they may find obtaining the desired level of management buyout finance harder than expected.
Individual credit reports, lender’s team assessments, business plan quality and more may all have an impact on the level of financing available.
4. Management team agreement is essential
While the management team may all be good at working together, staying on the same page while working on an MBO can put a strain on relationships - especially when management buyout finance requirements ask for personal guarantees on loans.
Each member of the management team will have external considerations, such as family commitments and personal finance history, that may impact the plans and can derail the MBO in some cases.
5. Investor involvement may be somewhat undesired
Private equity finance is often a component of the overall MBO finance and comes with another set of influential voices. If the management team and their investors are not in alignment with their vision, it can cause difficulties both at the initial stage of acquisition, and also later on with the running of the business.
Obtaining Management Buyout Finance
Clifton Private Finance are here to help you with management buyout finance. Our experienced team will work with you throughout the process, assisting from the early stages of due diligence through to the successful application of funds.
We can help with primary and secondary business loans, as well as advise on equity finance options.
For a consultation on MBO finance, give us a call at Clifton Private Finance today.