Frequently Asked Questions About Management Buyouts
Is my company a Management Buyout candidate?
Managers often confuse two critical, but very different, questions when thinking about a Management Buyout:
- Do we want to own our own company? and,
- Can we put the deal together & raise the money?
Before worrying about putting a deal together, it’s important that you first answer the question “Do I want to own my own company?”
Some managers long for the opportunity to be their own bosses while others like the “safety” of being an employee and have no desire to risk their money.
While the idea of being an owner is very attractive and the financial gains can be potentially huge, you must be fully aware of the risks, as well as the opportunities, of a Management Buyout before you start. Some of the key questions you need to ask yourselves include:
- Do I believe in the future of our company?
- Do I respect and trust my fellow managers?
- Do we have a leader in the group?
- Am I prepared to put some money at risk (say one year’s compensation)?
- Am I prepared to commit to the company going forward for a period of time?
- Are we prepared to take full responsibility for the future of our company?
- Will the absence of our owner negatively impact our future prospects?
As for the second question –"Can we put a deal together and raise the financing?" - it’s often easier than you think. But there are quite a few variables that impact this including:
- The willingness of your owner to sell and at what price
- The structure of the deal
- The financial health of the company
- The availability of capital (banks & private equity) at the time, and,
- The amount of money that you and your managers are willing to invest
How do we figure out what the company is worth?
This is where you’re going to need some outside professional help.
It’s not just a question of what is the company worth – it’s also a question of how the deal is to be structured, i.e. how much cash is given to the owner at the closing and what is the amount and the nature of payments made to the owner afterwards.
Typically, companies are valued based on their expected future cash flows. A company’s historical performance is used as an indicator of future performance. So you’ll often hear that a company was valued at, say, a 4 or 5 times multiple – meaning it was valued at 4 to 5 times the company’s current annual cash flows or EBITDA (earnings before Interest, Taxes, Depreciation and Amortization).
Your advisor will help you come up with a valuation and a structure based on (1) the company’s historical performance and future prospects, (2) a comparison of what other companies in your industry have recently sold for, (3) what the owner’s expectations are, and (4) what are the various financing options that are available to you.
Who should lead the discussions? Who should participate in the Management Buyout?
The individual who normally leads the buyout is the General Manager or Divisional President of the company – the second in command who is not a family member.
This person is the natural leader of the group and will continue as President once the Management Buyout is completed. As the leader, this person will represent the Management Buyout group in discussions with both the owner and the various financial partners who you engage to complete the buyout.
The number of people who are included in the initial buyout should be restricted to key personnel and typically includes the heads of Operations, Finance & Accounting, Marketing, Personnel, Distribution, Service and Branch Managers.
The number of participants in the Management Buyout at this stage needs to manageable - typically four to eight individuals initially. Once the Management Buyout is completed, additional shareholders can be brought in as desired.
How much money will I have to put at risk?
There’s no right answer here.
What most financial partners (bankers, private equity) will say is that it has to be an amount that is significant for you, but not so much that you’ll lose sleep over its potential loss.
In our experience, we suggest that managers consider investing the equivalent of one full year’s pay.
You will not normally be required to provide personal guarantees to the bank so you risk only the amount of money that you invest.
How do we raise the financing?
The “value” of the company is different than the amount of cash that is paid to the owner when the deal closes. Deals are financed from a combination of the following sources:
- Traditional banks
- Subordinated debt
- Payments to the Seller post-closing
- Private Equity
- Your team’s cash investment
Traditional banks: Traditional banks will normally finance up to 40% (and more on larger deals) of the transaction at close. Banks look primarily to the security that the company can provide (accounts receivable, fixed assets) and, increasingly, to the cash flows of the company (Cash Flow Loans).
Subordinated debt: Subordinated debt, sometimes called mezzanine debt, is a loan that has no tangible asset security and relies solely on the strength of the company’s future cash flows. It ranks behind the bank, so is “subordinated” to the bank’s first claim on the assets, and cash flows of the company. Interest rates range as high as 18% and are typically tax deductible. This may appear to be very expensive debt but should be looked at as cheap equity.
Payments to the Seller post-closing: This is where creativity comes into play when structuring the deal. These payments bridge the gap between what the owner thinks their business is worth and what you can actually pay them at closing. Seller payments can come in the form of a vendor note (VTB), royalty payments, performance related payments, or a minority equity interest in your new company.
Private Equity: Private equity (PE) can come from PE Funds, Crown Corporations, and private individuals. These investors are your “partners”, not your bankers. And they each have their unique cultures and methods of dealing with you. They typically look at exiting their investments within 5 years and look for Internal Rates of Return of 25%+.
Regardless of who your financial partners are, you need to do your “due diligence” on them. These will be your “partners” for a long time so getting the right fit – working with people who you like and respect and who are experienced in helping private companies grow – is very important for the future success of your Management Buyout.
How much money can I make?
Many people believe that owning shares in your own private company is the best investment you can make because:
- Studies show that Management Buyout companies are significantly more profitable than non MBO companies; and,
- In certain countries such a Canada, owners of private companies get preferential tax treatment on the gains in the value of their shares.
While the ultimate value of your company, and your shares, is a function of how well your company does, it’s not uncommon for managers to get a 3-5 times return on their money and more. But keep in mind, there are no guarantees and if your company fails, you could lose all your invested money if the company performs poorly.
What’s the process and how long will it take?
The process goes like this:
- Get the owner to agree that you can look at pursuing a Management Buyout
- Pick your core managers to participate in the Management Buyout
- Pick an advisor to help guide you through the process
- Agree on the key components of the deal, summarized in a Letter of Intent
- Create an Information / Financing Memorandum to present to banks and investors
- Meet with a variety of banks and investors, obtain Term Sheets from them, and choose your financial partners
- Work with your financial partners as they perform their due diligence and obtain formal offers of financing from them
- Generate the legal documents necessary to close the deal including a Purchase & Sale Agreement, Loan Agreements, Subordination Agreements (between the various financial partners) and a Shareholders Agreement
- Close and fund the deal
The time it takes to do this can vary between 3 to 9 months.
What’s the biggest challenge for my management team in doing a Management Buyout?
Probably the biggest challenge that our management team will face once you’ve completed your Management Buyout is that they now are wearing two hats – they are both owners and employees.
Before you start down the MBO road, your team must realize that they are firstly employees and shareholders secondly. Just because they are now owners of the company does not mean that poor job performance will be tolerated – being an owner doesn’t mean you can’t get fired. And while you may all be owners, you still report to a boss who has the ultimate say and partners who expect you to pull your weight.
In Their Words
The MBO Group seems to have a unique ability to uncover interesting and worthwhile opportunities in the Canadian private company market. I have had the benefit of working with them in a variety of situations. They have always been able to capture the essence of what makes a project assignment or deal work in a very strategic way that others can embrace. With a rare ability to communicate clarity they are able to efficiently bring individuals as well as groups to understand what it takes to achieve success.
FCA, Former CEO & President, Marsulex Inc.