In the spirit of the Go Beyond Way, this article introduces to the idea of the Collaborative Management Buyout, in which the Management Team and the Business Owner(s) acknowledge the contributions of the other party to the past, present, and future success of the business and work to avoid the errors of attitude and practice that often turn the process adversarial.
A management buyout (MBO) is a type of business acquisition in which the managers of a company purchase the business from the current owners or parent company. Certified exit planning advisors (CEPA) usually work on the sell-side, representing and interests of the business owner. CEPAs, especially if they have experience as M&A Advisors, can work effectively on behalf of the management team seeking to buy the business from the current owner(s).
Professional ethics require CEPAs to make their best efforts on behalf of the party who has engaged their services. Nonetheless, through training and experience working closely with other advisors, CEPAs are well-practiced in the art of collaboration. The key is being seen by all stakeholders as “the honest broker” and helping the parties avoid devolving into zero-sum gamesmanship. We do this for family transitions, why not for MBOs as well.
Management buyouts can be structured in various ways
Few management teams have the financial resources to buy the target company outright. They need external financing to facilitate the purchase and are often interested in leveraging some of the assets of the target company.
Leveraged buyouts are often seen solutions for acquiring larger businesses. However, the concept can also be used to acquire smaller businesses. Nonetheless, financing options for smaller deals usually are limited.
Small opportunities usually don’t have access to private equity because those firms generally prefer larger deals. Smaller MBO deals also don’t have access to mezzanine financing or the ability to issue bonds. In most cases, to accomplish the deal, they must seek sources of alternative financing.
Why would small businesses use a leveraged buyout?
The owner sells the company to the management team to facilitate a liquidity event at fair market value and equity participation to management.
From a buyer’s perspective, there is one main reason to use a leveraged buyout: well-executed buyouts can provide the opportunity for an excellent return on equity. If the deal is well structured, the business should generate enough cash flow to cover all regular business expenses in addition to the debt service from the buyout.
It’s the age-old concept of using leverage. Use a small amount of equity and borrow the rest. If the deal works out as planned, you stand to make great returns.
The seller’s perspective is a little different. A leveraged buyout provides a vehicle to sell the business. The hard truth is that finding a buyer for a small business can be difficult and time consuming. In some cases, the owner may not have many options and will have to be flexible to accommodate a buyout by the management team.
Purchase financing vs. operational financing
Most small business leveraged buyouts are funded using two categories of financing. The first category is the funding used to acquire the business. This funding gives the buyer “ownership” and the ability to operate the business.
The second category of funding is operational financing. This type of financing provides the working capital needed to execute the business plan and grow the business. Operational funding is often a critical piece of a successful buyout.
The CEPA, using his professional network of bankers, private investors, insurance brokers, attorneys, and other professionals, can usually assist the management team in meeting potential sources of funding.
Funding the purchase
The type of funding that is available to purchase the company is based on the size, brand recognition, assets, and cash flow of the company. Smaller companies or turnaround situations usually have fewer options. However, it is possible to finance the buyout of a small company if the management team is willing to use alternative financing. Such options include:
- Seller financing (deferred consideration): One of the most important types of funding you can get is seller financing. Given that sellers have a vested interest in making the sale, you may be able to convince them to extend a loan that is amortized over a period of years. Getting seller financing also provides the buyer with some comfort, as it implies that the seller expects the business to have enough money in the coming years to satisfy the debt.
- Buyer’s own funds: The buyer needs to contribute a portion of the purchase price from their own funds to handle the equity component. As a result, they may need to tap into their savings, sell investments, access retirement funds, or take a home equity loan on their house. It’s not unusual for buyers to use all or most of their assets to make the business purchase.
- Assumption of debt: Another way to pay for part (or all) of the business is to assume existing loans. In some extreme turnaround cases, the only payment that buyers make is the assumption of business debt. The advantage to the seller in this case is that they can sell their distressed business without incurring personal liabilities due to prior loan guarantees.
- Equipment financing: Sometimes, the buyer may be able to finance part of the purchase price by financing the company’s existing equipment. This method can work if the company owns the equipment free and clear – and if the equipment has equity that can be financed.
- Bank loans: In principle,buyers can get a business loan to purchase a business, and the SBA supports that. The reality is that getting a bank loan to purchase a business is difficult due to the qualification requirements. Getting a bank loan for a leveraged buyout of a small business may be next to impossible because a leveraged buyout puts little equity in the deal to maximize the return on equity. Banks and SBA lenders, on the other hand, want buyers to maximize their equity investment before they provide a loan.
- Private equity: In some cases, the management team may be able to secure financing through a private equity firm. However, private equity firms prefer scale and tend to invest in larger transactions. Their investment may consist of buying shares and/or providing additional funding such as loans and asset-based financing.
Private equity firms usually want a liquidity event after 3 to 6 years. They look to exit the transaction in that time frame, allowing them to realize their gains. Consequently, their funding programs often include stipulations of how the company is to be run and what objectives must be met. The CEPA can help the management team/new owners to apply The Value Acceleration Methodology to meet the private equity firm’s objectives and develop strategies for future of the business.
Remember that the private equity firm is looking to maximize its short-term rate of return – often at the expense of future opportunities. Therefore, management teams must be careful to align themselves with the right funding partners.
Financing business operations
In most cases, the buyer also needs financing to help run the business after the purchase. The objective of this type of financing is to provide funds and working capital to run the business. This type of funding puts you in a better position to execute the business plan and grow. Options for this type of financing include:
- Business loans and lines of credit:One of the best products to help finance operations is a commercial line of credit. These lines give you the most flexibility at the best price. They are also very difficult to get– especially for small businesses whose assets are already leveraged. Lines of credit require substantial collateral and are also subject to strict lending covenants. Lastly, they are not an option for business owners with bad or “less-than-ideal” credit.
- Factoring:Factoring is a financing option for small businesses that sell to commercial or government clients. Businesses must often sell their products/services on net-30 to net-60 terms. As such, they must wait up to eight weeks to get paid. Few companies can afford to wait that long for payment. Invoice factoring enables businesses to finance their accounts receivable. This option provides them with funds to pay suppliers, make payroll, and cover other business expenses.
- Purchase order financing: Purchase order (PO) financing helps companies that re-sell third-party goods. Alternatively, it can be used to finance companies that outsource their manufacturing. Purchase order financing helps cover supplier expenses, thereby allowing the business to take on larger purchase orders. Note that this solution cannot be used by companies that do their own in-house manufacturing.
- Asset based financing: Asset based financing is an umbrella solution that allows companies to finance multiple asset types. The line allows companies to finance receivables, equipment, inventory, and, in some cases, real estate. Asset based loans are considered intermediate products for companies that have outgrown factoring/PO financing but can’t qualify for a line of credit yet.
- Vendor credit: One last source of financing that should not be overlooked is your own vendors. Vendors may be more willing to extend terms to your business than they were to the prior owner. Negotiating better payment terms, such as going from net-30 to net-45, or even net-60, can dramatically improve your cash flow. Learn how to get and increase your supplier credit.
One obvious financing risk is that the buyer can over-leverage the whole transaction. This scenario leaves the business unprepared to handle unexpected issues – which are likely to happen. This situation can create financial problems from the start, which are very hard to fix. The CEPA helps the management team develop contingency plans and take actions to protect the enterprise value of the business.
Another risk related to over-leveraging is the use of operational financing to cover part of the initial purchase cost. For example, a company could factor all outstanding receivables at purchase time and then uses those funds to pay the seller. This approach leaves the company with minimal working capital, since most invoice payments for the next 30 to 60 days have already been used to pay the seller. You may then be forced to delay supplier payments or payroll. In many cases it puts the company into a financial tailspin from which it never recovers.
The business value must be fair to the owner and fair to the incoming buyers. Using the inside information available to the management team, by a variety of methods the CEPA provides the same Enterprise Value Assessment (EVA) that he would before for a seller. Buyer and seller will be operating from similar starting points. Using the fair market value rubric would improve chances the purchase could be appropriately financed with an appropriate capital structure and should be acceptable to the seller. 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 seller 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 an MBO is often a challenge. Most management teams lack the liquid cash to be able to put enough of an equity investment 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 likely would be challenging. 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. This is not an easy situation. Fortunately, there are other options.
- First, the Seller could loan money to the management team to buy him/her out. In the $10 million example, the seller could loan the managers $2.5 million of the $5 million but his loan would have to be subordinate (so it can be treated as equity, not debt) to the senior bank debt of $5 million. The management team now puts in $2.5 million of his own cash instead of $5 million. This arrangement creates challenges of who’s in control, what do they have control over, etc. (See below.)
- Second, private equity investors could close the gap. large and small. There are numerous funds that are interested in succession transactions 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 seller loan and helps management with ongoing executive support from the PE firm.
#3 Roles and Control
If an MBO is done without the seller loaning the management team any money, the deal can be smooth and straightforward.
If there is a seller loan, likely the seller will to want to have a high degree of input to the new owner’s decisions. To protect his interests, especially in the above example, with negative covenants in the promissory note and the purchase agreement. In addition to the normal restrictions on capital structure changes, there may also be operational restrictions, dollar limits to capital expenditures and more. To limit these restrictions, take as little money from the seller as possible and pay off the debt as soon as possible.
In some cases, the seller and the management team may agree that the seller should continue working. In this case, the agreement must be explicit about the seller’s role and job description and the roles of the management team. If key managers can effectively assume such roles of CEO and president, the seller may be retained an advisor for a specified period. If key managers are not ready to do that yet, management may want the seller to remain as president for a while until management is trained and ready to assume that role and its responsibilities. Shifting control from the seller to the management team may be based on milestones, loan repayment, or other performance metrics.
Be careful not to become-over leveraged
One of the greatest challenges for leveraged buyouts is making sure that the business is not over-leveraged. If it is, your company will have little room for error – which leaves you open to financial problems. If things don’t go according to plan, the company could easily enter a financial tailspin.
One common way to over-leverage the buyout is to use operational financing to fund the company purchase. This scenario happens if the management buyout team decides to leverage their accounts receivable and inventory to cover part of the purchase price.
Leveraging these assets to buy the company leaves the management team with little cash to operate. Basically, you are using short-term future payments (due in the next 90 days or less) to pay for the purchase. This strategy leaves you with little working capital to operate. It also affects your ability to make payroll, pay suppliers, and, ultimately, run the business.
The CEPA Becomes the Value Advisor
During the process of supporting the Management Team during the MBO, the CEPA has become familiar with the key managers, their strengths and challenges, and all aspects of the business. He also has intimate knowledge of the new users’ advisory team of attorneys, accountants, bankers, financial planners, and other professional. In fact, he probably had a hand in introducing them to the management team.
The CEPA knows what needs to be done to protect and build the enterprise value under the new owners. When the CEPA did the first EVA, he probably developed a prioritized action plan, whether he shared it with the management team or not. He is poised to help the new owners launch a program of advanced value acceleration. This intimate knowledge positions the CEPA to move seamlessly into the role of Value Advisor to the new regime.
Think of the Value Advisor as the quarterback of the stakeholder team. “Just like on a football field, none of the other players on the offense “report” to the quarterback. But when the quarterback calls the play, everyone on that field has a role and a job to do. The better they synchronize their efforts, the more effective they will be,” writes Christopher Snider in Walking to Destiny: 11 Actions an Owner MUST Take to Rapidly Grow Value & Unlock Wealth. As new owners, the management team doesn’t have the time to do the quarterback’s job. Other ways to think about the Value Advisor include as a project manager and a teacher, helping you identify, protect, build, harvest, and manage the value of your business. It doesn’t matter how long the management team plans to own the company, every day they will make decisions that impact their eventual exit from the business. Who better to work with them than the CEPA to helped them achieve a collaborative management buyout.