It is safe to say that owning and running a private business is every manager’s ultimate goal. However, the world is becoming more complex and competitive than ever, and such a goal is becoming increasingly difficult to achieve.

Management Buy-Outs have become one of the most popular and financially rewarding methods for running a business, because it’s solely based on upgrading your position from an employee to a fully functioning manager and a stake holder in your own company.

Not only do you avoid the hassle of starting a business from scratch, but you also get to run a business that you are familiar with and genuinely interested in.

Management Buyout Guide (MBO): Definition, Process, Criteria, Funding Options, Pros & Cons

This guide will provide you with the definition, the process guide, the feasibility criteria as well as the funding options for a successful MBO.

WHAT IS A MANAGEMENT BUY-OUT (MBO)?

A Management Buy-Out is a transaction through which the management team of a certain company, who don’t necessarily own a share of the company, purchases the assets and the operations of the company they’re managing. This is particularly tempting for investors because of the potential rewards of having their own business instead of filling an employee position.

In addition, such an investment provides the manager with job security in a business he is most familiar with. A Management Buy-Out is perhaps every manager’s dream: to own their own business. This applies mostly to employees who spend ten or even fifteen years working for a certain company and accumulating experience in a certain field.

It is only natural to pursue owning their own private business and applying their own strategies to the market. Consequently, it becomes more convenient to build up equity and acquire the company they’re worked at and avoid the hassle of starting a new business from scratch.

MBOs are also extremely convenient for the seller as an exit strategy. Large corporations take advantage to sell divisions of their company that are not necessarily dealing with the scope of their business, aren’t creating much revenue, or simply are of no interest to the shareholders anymore.

In this case, such a transaction is a win-win situation, where corporations sell these divisions to the management team most familiar with their operations (the exiting management team).

THE MBO PROCESS STEP BY STEP

Before we get to the funding options for MBOs later in this guide, it is important to investigate how such transactions are undertaken.

Given the fact that, in the case of an MBO, the existing management team is unlikely to have enough money to buy the entire company immediately, the management team usually resorts to bank loans.

However, the management team is required to buy at least part of the company outright and lean on banks to finance the rest. Banks are rather reluctant in such investments due to the huge risk, and often require that the management team put much of their personal valuable assets at risk.

Source: Michelmores MBO Guide

The above figure shows how the company could be acquired through debt buying over a period of time. Such approach to acquiring the company puts huge pressure on the investors. The management team has to simultaneously work on the repayment of debt with interest rate as well as managing the company’s operations and elevating its value.

This is the common approach to an MBO, and it is definitely a risky one for both the equity investors and the banks. However, funding options will be discussed later in detail in this guide, to explore the alternative options available to investors seeking an MBO.

Judging from the scale of the investment, such transactions usually take up to 6 months till completion. However, this estimate assumes that an MBO management team has already been gathered, and the topic has been raised and approved by the owners of the company. If not, then it might take up to several years to make such preparations.

Given the size of the investment, recruiting a management team that is willing to take the risk might take a bit of time. Negotiations with the owners of the company might also take a bit longer than expected. Having funders before even raising the idea could be problematic. Each MBO is different. But once consent is established, the transaction itself takes approximately 6 months to completion.

Action One Two Three Four Five Six
Identify the opportunity x
Identify management team x
Appoint professional advisors x
Feasibility assessment x
Vendor negotiations x
Financial modelling and structuring x x
Prepare a business plan x
Fundraising x x x
Financial vendor negotiations x
Due diligence x
Legal documentations x x x
Project management to finalisation x x
Manage the business x x x x x x

Source: Bishop Fleming MBO Guide

The figure above shows the timeline of the process and the estimated time intervals for each step. As shown, the first five steps represent spotting the opportunity and raising the topic. The remaining steps constitute most of the schedule. It is important to know that with everything going on, the management team still needs to manage the business while simultaneously negotiating the deal.

The following steps are the most essential steps throughout the MBO process:

Initiation

Appointment of a Lead Advisor

A corporate finance advisor is almost essential to assist the management throughout the deal. The fees for the advisor can sometimes be split between the company and the management team. The advisor needs to have credentials and great experience in MBOs to be able to properly assist the management in the process.

It is the advisor’s job to constantly check if the management’s plan is still viable throughout different stages of the deal. An advisor can and probably should represent the management when dealing with the company whether on a legal level or not.

Some of the key services that an experienced advisor can provide are:

  • Objective evaluation of the deal
  • Handling negotiations with the company
  • Assist with funding options
  • Project management of the entire process

Approach the Seller

Now that an advisor has finally been appointed and informed with the objectives of the deal and the goal outcomes, it is time to approach the seller. This is also a key step through which an advisor can help greatly by giving tips and advantage points in negotiations.

An advisor can help by simulating possible talking points that the management (who is not necessarily familiar with negotiations on such a huge level) might not have in mind. Having the advisor lead the negotiations is a very valid option, and approach the seller with a mutually beneficial deal is key for negotiations.

Trying to undermine the value of the assets will only cause problems along the way, if not with the seller, then with the performance of the company when bought.

Agree with Seller

This is when negotiations actually take place and agreements on payments and strategies are laid out. It’s important as an investor to not be emotional when disagreements occur, and they probably will.

Remaining composed and professional in conducting such as a huge investment always gives the impressions that you, the management, are dedicated and serious in your conduct.

It is important to remember that if the negotiations don’t go as planned, the manager might return to his position as an employee in the company, and having such conflicts hanging in the air might make the work environment tense.

Preparation of Information Memorandum by the Vendor’s Lead Adviser

An information memorandum (IM) is a document presented by the company to potential investors to give an overview of the company. It is more of a marketing tool than a legal document.

Still, companies are obliged by law to present an IM to potential investors in more than 20 countries. As an investor, you should expect the company to present an IM when you show interest in buying out the company. This helps you understand the potential risks and rewards.

It is still important to be careful, as such a document is essentially a marketing tool where companies tend to highlight, and maybe even overestimate the value of their assets.

When preparing the IM don’t make the following mistakes.

Seeking Funds

Discussions with potential PE Houses and Bank backers

Once an agreement between management and the company is reached, it is important to reach out to potential private equity house and banks. Those will be responsible for providing the necessary funds for a successful buy-out.

Perhaps the simplest approach is to reach out to current bankers that you, the investor, might have had long relationships with, and have built a sound reputation over the years.

However, it still important to consult your advisor for other potential funders who might be interested in the business your target company is in. It’s important to remember that banks are typically reluctant to give out loans for MBOs since the amount of money and risk involved is huge. This is why there are typically multiple funders for MBOs.

Completion

Commencement of due diligence

The most suitable term to describe a due diligence is: Investigation.

This is your chance as an investor to check that everything is in order and in good working conditions. An investor’s position in the company prior to the MBO doesn’t necessarily allow him to be fully aware of the working conditions of everything in the company. This is why a due diligence is important to assess whether an investor is getting exactly what he is paying for.

It is important to leave no questions unanswered to avoid any hassle in later stages. Typically, the management in the case of an MBO will know more than in the case of an MBI for example, but it is important to remember that there are funders who are essentially taking a huge risk and need to be absolutely satisfied with what they’re putting money for.

Agreement of MBO team contracts and share options

After agreement, all parties involved in the transactions sign the necessary documents with the help of their advisers. Issues might arise later, and this is why you, as a manager, should keep in touch with your advisor till all parties are satisfied, and have access to the funds.

Transition

The new management finally takes over and starts running the business. It still remains important to take care of logistical issues quickly and smoothly to not disrupt the workflow. Here knowledge of change mangement comes in handy.

Funding Options

The struggle to find funders is serious. MBOs require a huge capital investment that is unlikely to be gathered entirely by the MBO team themselves. The funding is often provided through multiple sources. Here are the most popular funding options:

  • The MBO Team: While it’s unlikely to collect the entire amount required by the vendor through the MBO team solely, it is important that a fair share of the capital is provided by them. This does not only help in reducing the amount of debt, but it also establishes credibility and gives the impression that the new management is serious in its conduct. This is almost always required by PE investors.
  • Bank Loans: Bank loans are a function of how well the business is promising after the completion of the transaction. Banks will be reluctant to invest if the amount is too big and the business is too risky. However, they still remain a direct and relatively easy way to fund an MBO. The downside will be strict repayment rules.
  • Private Equity Houses: This is also a popular option alongside banks. However, venture capital and private equity loans are conditional and usually require an equity stake. This might not be favorable to the MBO team as this gives the PE House a say in decision making. It is important to be careful when picking the right vendor to avoid interference in business operations. The two main sources for returns for PE Houses are interest rates on the amount provided, and the capital growth of their equity stake.
  • Vendor Deferred Considerations: In most cases, the vendor doesn’t expect to receive the payment as a lump sum, and usually consider deferring a portion of the amount for the MBO to proceed. This is applicable in cases where the company’s performance doesn’t allow it many other funding options (such as bank and private equity loans) and the pre-existing management needs to endorse the new one. This is a bit risky and depends greatly on the performance of the new management.
  • Earn-Outs: This is a special kind of deferred consideration. The vendor may believe that the MBO is worth much more than its current financial status. In such cases, conditions are applied that if the business surpasses an agreed-upon level of performance, part of the revenues goes to the vendors. This protects the vendor’s financial interests and eliminates uncertainty for the MBO team.

Learn more about the mechanics of a MBO transaction.

MBO Feasibility and Funding Criteria

Rushing into an MBO is probably the worst thing an investor or a management team can do. The excitement of owning your own business must not take over proper planning. This is why a criterion for spotting the opportunity for an MBO is essential. The following are some of the most important aspects that need to be checked before submitting a proposal.

A company with poor records but a great management team is arguable better than a strong business with a set of poor executives. A competent management team is crucial for the success of an MBO. To be able to gather the right team for an MOB, there are considerations that need to be put in mind:

Your team must fill in all the necessary positions needed to run your business. These are typically:

  • A Managing Director
  • A Finance Director
  • A Sales Director
  • An IT Director

And possibly any business-specific positions that are essential for the continuation of your company’s operations. A funder needs to be fully convinced that the gathered team is able to run the company smoothly. Any unfilled positions might risk hindering or even the complete suspension of operations, and that is a huge threat to the funder’s money.

  • Any remaining unfilled positions need to be outsourced. It’s essential to fill the gap even with external candidates. This is very applicable if the potential business is planning to change strategies or to adopt a different line of production. This means that the current state of the company is likely to lack the experience, and such a gap needs to be filled externally.
  • When forming the management team, possible issues might arise from excluding other executive members of the company. These issues need to be resolved immediately to ensure a smooth, hassle-free negotiation and transaction. Exclusives who feel excluded might resign and cost the company a hassle in reappointing new members for such crucial positions. It’s also important to consider that if the deal doesn’t go through, the managing team will have to deal with members they’ve excluded. This might cause unwanted tension in the work environment. Such issues must be resolved in a friendly manner before negotiations start.

The considerations mentioned above are essential for an integrated and competent management team, but they’re not the only criteria for a successful MBO. There are considerations regarding the business itself that should not be overlooked:

  • Sustainable increasing profit: Being part of the company in the first place, such information should be accessible. It is always better to invest in an established and a performing company than trying to rescue a sinking ship. Even if your management team thinks the company’s bad performance is due to the existing management, convincing funders of this might be difficult. Consequently, unless your team is willing to take the full responsibility funding-wise, there is no point in going for the investment.
  • Potential growth: While the company may be performing well in the present, a plan for the future is essential. There is no point in going for the deal if your management team is going to apply the same policies anyways. This also doesn’t help in debt repayment. Debt will constitute a pressure in the beginning, and it’s important to have a plan to increase revenues significantly to sustain the business operations.
  • Strong cash flow: A key factor when reaching out for funders. Funders are unlikely to know much about the inner workings of your business and need to be convinced that the business you already run is making profit. Numbers speak louder than words in this case.
  • Interest in the business: Your team must be genuinely interested in the type of business they run. They need to be motivated to make a significant difference in the way their business is run.
  • Potential untapped market: Having undiscovered markets is promising. The existing management might be reluctant in expanding business. The new management team needs to be aware of potential new markets that will help in debt repayment and expansion in operations, which will lead to even greater profits.

In any given company, there are always considerations for MBOs, but very few are actually completed. The previously discussed points should lay out a check-list for investors who are assessing potential MBOs.

Read about management buyout lessons from real-life managers.

PROS AND CONS OF AN MBO FOR THE MANAGEMENT TEAM

While an MBO is a very attractive alternative to running your own business, there are still pros and cons that are worth exploring in order to make an informed decision:

Pros of an MBO

  • Familiarity: As mentioned before, the MBO team is already familiar and involved in the business and is most likely to perform better than an external team. Starting a business from scratch is harder, riskier and time consuming. It is also a great opportunity to gather a team of professionals who are interested in the business they run. The history they have working together and dealing with the same issues provides them with a similar solid background of the challenges of their market.
  • Financial Rewards: Making the transition from an employee to a manager will have a huge impact on the compensation of the management team members, if the MBO is successful.
  • Job Security: An MBO team eliminates the uncertainty of the job market by simply appointing themselves managers of the company.
  • Taking Business Private: In many cases, an MBO team will privatize the target company. This saves the business a lot of paper work, legislation, and unnecessary procedures that ought to be invested elsewhere.

Cons of an MBO

  • Limitations: While MBOs are a popular and perhaps the most feasible way to having your own business, they are still limited by the kind of company you’re working for. MBOs are most suitable for rather smaller companies. The chances for finding funders to assist in buying a huge corporation are very slim if not zero. This is why MBOs are more suitable for divisions of corporations that fall out their business scope. Having a solid history of cash flows and promising potential for success is necessary to be able to convince funders of actually taking the risk.
  • Capital: It’s unlikely to find a group of investors that have enough money to buyout a business. Consequently, loans will constitute a huge pressure on business. Unless the new management has new plans to increase revenues, funders won’t be eager to invest in the company.
  • Transition: The transition from an employee to a manager won’t be necessarily a successful one. This may lead to further complications and may cost the business a lot of money.
    • While the new management team could have had a history of managing the division or the company, it still not necessarily true in all cases. A high rank employee who is not necessarily in a managing position could take part in the deal.
    • It is also important to note that the management team could’ve have been responsible for local management and not necessarily involved in the vision or the overall policy of the company.
    • A division in a corporation will have pressures from upper management and board members that might have taken some the power they would have if they were running the division as a fully functioning company on their own. Consequently making the transition is a challenge.
  • Agreement: An MBO team might find it hard to agree on who ought to fill certain positions. This might cause unwanted tension and affect operations. Partnership doesn’t necessarily go smoothly. The MBO team might agree to take over the business but that doesn’t necessarily mean that they’ll agree on policy on the long run. This might cause challenges to the business. Although this is applicable in any given partnership, it is more likely to happen with an MBO team.

MBOs vs. MBIs

A Management Buy-In (MBI) takes a slightly different approach than that of an MBO.

Instead of having the company acquired by its own management team, the company is acquired by an external team that essentially replaces the current one.

In this case, one investor, or perhaps a manager, can acquire the entire company, manage it himself, or appoint a new management team. This process often requires lots of capital and investors need to have a private equity company to back the transaction.

The only way this could happen is, of course, if the buyer has great expertise in management, particularly that of large corporations. Otherwise, acquiring a business that might not exactly lie in the field of expertise of the investor becomes harder to manage.

However, such transactions are usually conducted with management teams (as with MBOs) led by a managing director, who typically has more experience. In addition, teams often compete with other management teams to find a suitable business to purchase.

What advantages does MBO have over MBI?

Perhaps the most important feature that makes MBOs such an attractive choice as an exit strategy is the fact that the already-existing management teams is much more familiar with the business than an outsider team.

Consequently, an MBO guarantees to some extent that the management team will do a better job at running the acquired company’s operations. An MBI might lead to laying off labor according to new management strategies.

However, an MBO is less likely to result in that since employees are, whether in managing positions or not, familiar with working with each other. This results in a smoother transition and is less likely to hinder the company’s operations in the transition phase. This also becomes convenient in cases where the managers of a certain division of a company don’t approve of the upper boards decisions regarding their division.

In real life, upper board managers will be more concerned with results. This might eventually lead to misunderstandings that may last years in running a business. Therefore it becomes convenient, when a large corporation feels the need to let go of a division that is falling out of the scope of their business, to allow the pre existing managers (who are already familiar with the challenges and the problems) to take over.

CONCLUSION

All in all, MBO still remains an easy and tempting option to running your own business; given you have what it takes to run it. Not only do you promote yourself to higher levels of financial success, but you also get to run the business your most familiar with and interested in.

While the financial risks associated with debts might seem tremendous, it still remains a fair compromise for the type of investment you’re bidding for. With the help of the right team you can make the market thrive and open up new paths for success.

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