A management buyout (MBO) can provide an effective way for business ownership to transition to an existing management team, helping to maintain continuity and stability within the company. Whether you are a business owner considering succession options or part of a management team exploring a potential buyout, understanding the process and key considerations involved is essential before moving forward.
This article will provide you with the essentials if you are considering an MBO giving some food for thought on the general process, financial and practical considerations and timelines to factor.
What is a management buyout?
A management buyout (MBO) is a transaction where an established management team, or manager, acquires all or part of a business that they are already employed within and typically run day-to-day. The seller of the business (or part thereof) may be the current owner-manager, shareholders of the company running the business or a larger group company structure.
Typically an MBO arises as a result of the current owner looking to step back and retire, health or financial reasons, execution of a succession plan or undertaking a restructuring of the business where an element of the business is no longer required.
Management buyout example
123 Ltd is a limited company providing commercial cleaning and maintenance services. 123 Ltd is solely owned by its founder, Tobias. After 40 years in business, Tobias is looking to retire but is concerned about the culture and values of the business changing if he sells to an unknown third party or competitor. Tobias would rather see the business continue in the hands of his trustworthy and well respected team of managers.
The management team has worked with Tobis for 15 years and know the business extremely well. They decide, collectively, to buy the company from Tobias through a management buyout.
The management team does not have sufficient personal funds to purchase the company outright and therefore look at funding options such as equity investment (their own money), a loan from Tobias (purchase price (or a part thereof) is deferred and paid back over a period of time after completion) and borrowing from the company’s bank.
In order to streamline the process, the management team has been advised by its solicitor to set up a company to buy the shares (“NewCo”), NewCo will buy the shares from Tobias and the management team will become shares and directors of NewCo.
The transaction would then proceed to legals and both Tobias and NewCo would appoint its own solicitors to commence the legal due diligence process, negotiating the transactional documents and dealing with completion and post completion matters and everything in between.
Once completion has happened, more often than not the founder steps away and retires leaving the management team, via NewCo, as the new owners of the company and the controllers of the business – fully aligning ownership with management.
How does a management buyout work?
An MBO is a transaction in which the existing management team acquires the business they run, usually with a combination of investment options such as personal investment, loans via a bank and/or the selling party and deferred consideration.
The stages of an MBO typically include: agreement of heads of terms, undertaking a valuation and due diligence exercise, structuring the deal that works best for both parties (practically and from a taxation point of view), sourcing and securing funding and dealing with completion and post completion formalities.
Initial discussions and heads of terms
The process usually begins with a meeting between the seller and the management team – often led by the seller or the seller’s professional advisers. The purpose of this initial discussion is to set expectations early as to what each party wants from the transaction and the timing of when stages of the deal will be completed. The end result is an agreed set of heads of terms which professional advisers can refer to when advising on and preparing the transactional documents.
The heads of terms will detail the principal commercial terms of the transaction, including:
- Valuation and structure of the price and how it will be paid (and when)
- An exclusivity period and confidentiality provisions during the negotiation stage
- Key conditions to completion; and
- A proposed timetable
Valuation and due diligence
Valuing the business/company is often the most tricky element of the transaction. What the seller may think the company is worth and what they want from the transaction in monetary terms may be very different to what the management team is willing to pay.
The company’s accountant or an independent accountant will be best placed to consider historic and projected profitability, cash flow and working capital requirements as well as considering market comparables.
The due diligence process will involve (a) financial due diligence and (b) legal due diligence. The management team’s accountant will undertake a review of the business’ financial records and tax affairs, consider what working capital will remain in the business and what will be needed to fund projected costs, planned expenditure and growth plans. Legal due diligence will be undertaken by the management team’s legal team and will focus on key contracts and business commitments, property and asset ownership, intellectual property matters, employment and pensions as well as any litigation and regulatory compliance matters that relate to the operations of the business.
Whilst the due diligence exercise will be slightly watered down compared to when the buyer is an unconnected third party buyer, formal due diligence is still required especially if lenders and investors are involved with funding the transaction.
Structuring the deal
Most MBOs are structured via a newly incorporated company, NewCo, becoming the buyer and the management team having shares in NewCo. The transaction could take the form of an asset purchase whereby the parties agree a list of assets which will be sold and which will be used in order for the buyer to carry on the same trade. The seller will be left with any assets not forming part of the deal as well as the liabilities.
Alternatively, the deal could be structured in the form of a share sale with NewCo buying the shares in the existing company including all assets and liabilities which sit within.
Once the main structure is agreed, the management team will need to agree their respective equity share, this may be governed by the level of equity each person can bring to the table. Once agreed, the parties would be well advised to enter into a shareholders agreement documenting their roles and responsibilities in NewCo as well as cover off matters such as share valuation, dividend policy, decision making and how to deal with an exit, death or shareholder dispute. This should be in place at the time of completion of the transaction.
How to best structure the deal will depend on many factors and professional advice should be obtained early. An accountant and tax advisor can assist with looking at the tax efficiency and financial requirements. A lawyer can assist with the business formation and modelling and how to achieve the desired outcome within the contractual paperwork.
Securing funding
Whilst it does happen, it is very rare to see an MBO purely funded by the management team’s personal assets. Securing funding can take time and therefore this should be a step considered early on in the transaction – you can’t wait to deal with this at completion otherwise the deal will fall apart.
Most common sources of funding will include a mix of personal funds, bank funding and deferred consideration (often known as vendor finance).
External funders will expect to see (and scrutinise) a detailed and well thought out business plan including cash flow forecasts and growth plans. Funding terms and what security is on offer will need to be discussed and agreed.
Completion and post completion steps
At completion all parties will have signed (in wet ink or electronically) all transactional paperwork prepared and agreed between the respective legal teams. Any consideration to be paid at completion will be ready to transfer to the seller at the point that the legal teams agree to date all documents and confirm that legal completion has taken place. At this point, ownership and control passes to the management team.
There is a fair amount of post completion tasks for the legal teams to undertake such as paying any stamp duty payable on the shares acquired, filing all required documentation at Companies House to update the officers and persons with significant control of the acquired company. Where any security has been granted to a funder, registering this at Companies House and/or against title to any property assets.
The management team will need to focus on implementing any governance arrangements, consider and put steps in place to service the acquisition debt and manage the transition of the outgoing owner.
How long does an MBO take to complete?
Dare I use the saying “how long is a piece of string!” Timeframes will vary immensely depending on the size and complexity of the deal, the number and type of funders involved and how smooth the transaction proceeds.
Some time frames to consider:
- Small straightforward MBO (no external funding) – around 12 to 16 weeks where due diligence is light, no external funding is required and consideration provisions are not complex
- Mid sized transaction with external funding – 4 to 6 months allowing for more extensive due diligence, lender enquiries and approval
- Complex MBOs – from 6 months onwards given likely to be regulatory matters to consider, complex funding arrangements, detailed consideration and earn out provisions and potential post completion seller obligations and extensive negotiations.
Difference between a leveraged buyout LBO and a management buyout MBO
Whilst these terms are often used interchangeably, they describe very different aspects of a buy out. An MBO focuses on who is acquiring the business/ company, i.e existing management team, whereas an LBO describes how the transaction is going to be funded.
Some key distinctions between the two terms
- Who the buyer is – an MBO will involve the management team/a manager. An LBO can involve external investors and private equity
- Level and source of debt – an LBO will rely heavily on borrowed money, while an MBO may operate with a greater balance of funding models
- Control and ownership – managers usually gain control via an MBO; in an LBO control is likely to sit with an investor
- Risk profile – given the high leverage involved, LBO’s carry greater risk and greater pressure on repayment.
How to finance an MBO
Whilst touched on briefly above, the most common funding routes include:
- Bank loans – the company’s existing bank is a good place to start. Any loan is typically secured against the company’s assets or cash flow providing structure and security regarding repayments
- Private Equity – investors provide capital in exchange for an equity stake in the company (usually a minority interest but not always), may also bring some additional skills and strategic support to assist with growth plans
- Vendor loan notes – the seller may agree for part of the consideration to be deferred and paid later
- Personal finance – management team’s personal finances may be invested and is a good illustration of commitment
- Mezzanine finance – a mix of debt and equity, providing flexibility on methods of funding but often comes at a higher cost.
The importance of a strong business plan
A business plan is key for any business from a start up to a business entering growth as well as succession stage. With regards to an MBO, the heart of the transaction for a buyer is a robust and well thought out business plan. Lenders and investors need confidence that the business can service its debt, withstand foreseeable risks and support growth.
A strong business plan will show the commitment of the management team and also instil continued stability with its workforce, suppliers and customers.
The business plan should include:
- Financial forecasts
- Cash flow projections
- A growth strategy
- Assessment of risks and potential risks and mitigation methods
Risks and challenges of a management buyout
Whilst still a very attractive route for business owners looking to exit, there is still an element of risk with MBOs.
An MBO transaction can test the relationship between the seller and the management team. Negotiating the heads of terms with a long-standing owner or founder can be sensitive and emotions run high. Expectations of each party can differ hugely and can result in relationship breakdowns and fallouts. Managing the ever changing dynamic of the parties is essential to preserving goodwill of the business and resulting in a successful outcome for all.
There can be huge financial risk for both parties. If large amounts of debt are required to purchase the business, the management team will be under great pressure to service the debt from day one of completion. If the seller has agreed to deferred consideration, the seller will want to see the business thrive and any bump in the road could have an impact on how (and when) the seller gets paid.
Life after completion isn’t plane sailing! There will be increased responsibility on the management team shifting from operational roles to ownership roles whilst keeping staff morale high and maintaining customer and supplier confidence.
Top tips for a successful MBO
Our number one tip for a successful MBO is to plan – you can never plan too early. You should also consider:
- Engage advisers early – the right legal and financial support will help shape a successful transaction in a timely and well thought out manner
- Be realistic about valuation – a realistic price will ensure the business isn’t drained of all of its working capital from day one and will more likely be able to support debt and future growth and investment
- Align the management team – ensure the management team are on the same page and have a shared outcome and vision for the business. This will reduce risk and reassure funders
- Stress test financial forecasts – undertake an assessment of the best and worst case scenarios to understand affordability. It is also a good method to stress test your attitude to risk
- Communicate clearly with stakeholders – transparency with the workforce, suppliers and customers will help with a smooth transaction and ensure your stakeholders are on the journey with you
How Goughs can help
At Goughs, our experienced Corporate and Commercial team regularly advises business owners, shareholders and management teams on management buyouts across a wide range of sectors. We understand that every situation and every client, and their desired outcomes, are different, so we take the time to get to know you and your situation. This approach allows us to offer a tailored and bespoke service.
a smooth transition and safeguard the business you have built, for future generations. Get in contact with us to learn more about how we can help your business.
