By Jarrett Davidson , March 21, 2016
Takeaway: MBOs are risky, but can be mutually rewarding when these three key areas of focus are done right.
An increasingly popular transaction is occurring as a result of baby boomers retiring: the management buyout (MBO). As baby boomers age and finally retire, their executive or senior management employees aspire to own the business. This type of transaction is appealing to both parties and is one of the riskiest and most difficult transactions to close.
Management-led deals often result in a stalemate between outgoing owner and incoming owners/management. It seems like an easy goal to achieve, right? Owners want to sell to employees who want to buy, so how hard could it be?
Based on what my firm has done and observed in the marketplace, there are two fundamental flaws that cause the stalemate. First, neither party has ever done a transaction like this, which leads to deal fatigue. Deal fatigue is a syndrome that occurs when both camps tire of the negotiating and fact-finding. Ultimately, they feel and say, “I just can’t keep doing this anymore!” Second, each party sets up camp (lawyers, accountants, advisors, egos) on either side of the transaction, leading to conflict that potentially involves either the management team quitting or being fired. Either scenario is bad for the owner and usually bad for the managers.
The business value must be fair to the owner and fair to the incoming buyers. The value should be fair market, which means it can be appropriately financed with an appropriate capital structure and should be acceptable to the vendor. If the price is higher than fair market, the buyers may be unable to finance it (so the deal dies) and/or the business will suffer down the road as it struggles to repay the loan (so the business dies). If the price is lower than market, the vendor will not accept it (so the deal dies).
While valuation may be agreed to and at fair market, the buyer’s ability to finance in a MBO is often a challenge. The fact is that most managers lack the liquid cash to be able to put enough of a down stroke in equity to result in an acceptable level of debt. As a simple example, imagine a $10 million enterprise value business that could support $5 million in debt financing. The management team needs $5 million in equity to do the deal. This is the challenge. Here is why: Imagine a well-paid manager who is used to getting a regular monthly paycheck relatively risk free for 10 years. That paycheck now will only come if he remortgages his house, sells his investments, and borrows money from family and his wife’s family to come up with as much as he can to put in as equity. He may very well come up with the $5 million, but guess who is now questioning the viability of the business? His spouse, his parents, spouse’s parents, etc. Believe me, these are not easy hills to climb. My wife is awesome and has supported my entrepreneurial adventures since day one, but we come from an entrepreneurial-rooted upbringing. Not all families are the same. Fortunately, there are solutions.
- First is the obvious vendor take back loan. The vendor loans money to the managers to buy him/her out. In the $10 million example, the vendor could loan the managers $2.5 million of the $5 million, but would have to be subordinate (so it can be treated as equity, not debt) to the senior bank debt of $5 million. The manager now comes up with $2.5 million of his own cash instead of $5 million. This arrangement brings its own challenges of who’s in control, what do they have control over, etc. (See below.)
- Second is the increasing pool of private equity (PE) investors, large and small. In Canada and the U.S., there are numerous funds that are interested in succession transaction and are very willing to buy alongside managers in these transactions. Deals usually start at $10 million and go up. This often eliminates the need for a vendor loan and helps management with ongoing executive support from the PE firm.
#3 Roles and Control
If a MBO is done without the vendor loaning the managers any money, the deal can be smooth and straightforward. “I will pay you fairly; you will leave in a few months.”
If there is a vendor loan, expect the vendor to want to have plenty of say in the new owner’s decisions. Rightfully so. If the vendor is loaning management roughly the same amount of equity ($2.5 million in the above example) as the management is investing, the owner will need to ensure that management can’t make dumb decisions or high-risk bets. This will come in the form of negative covenants in the promissory note and the purchase agreement. In addition to the normal restrictions on capital structure changes, there will be operational restrictions, dollar limits to capital expenditures and more. Expect it until management has paid their debts in full.
In some cases, the vendor and the manager will want, or require, the vendor to continue working. In this case, be clear upfront about what the vendor’s role and job is and what management’s role and job is. If management can slide right into the role of president, the vendor may be an advisor for a specified time frame. If management isn’t capable or prepared to do that yet, management may want the vendor as president for a while until management is trained and ready to assume that role and its responsibilities. There may be milestones based on time frames, loan repayment or performance to shift control from the vendor to manager.