The prevalence of Baby Boomer business owners nearing retirement means that succession planning has been a hot discussion topic in recent years; especially considering that the value of a private SME is typically a substantial part of the owner’s personal wealth.
While trade sales and initial public offerings are touted as the most common exit options, continued market uncertainty and the number of opportunities for acquirers mean that business owners are facing challenges in either realising appropriate values or finding suitors. Current market conditions, and in many cases the absence of family members to pass the baton to, make a management buy-out (MBO) a compelling option for business owners.
The management team is a key driver of a business, with much of the business’ goodwill tied up in the relationships of owners and senior management with customers, or specialist know-how. The position of the management team means that they are often the most appropriate parties to acquire the business. From our experience, the following criteria must be met for a successful MBO:
- an experienced and well-balanced management team and a competent replacement leader;
- a commercially sound business, on a stand-alone basis, with a history of generating consistent positive cash flows, that is capable of supporting an appropriate funding structure for the MBO;
- a willing owner and management team, with realistic views regarding the value of the business; and
- sound growth prospects.
Advantages of an MBO
An MBO transaction provides the following advantages for business owners and management:
- Confidentiality: where there are commercially sensitive issues, the vendor may not wish to allow competitors access to the business.
- Speed: the MBO can be a very quick process when all parties co-operate, also reducing distractions to the ongoing business operations.
- Reduced costs: reduced due diligence requirements and the possibility of using common financiers means an MBO will be cheaper than other business sale transactions.
- High probability of success: when owners and management hold open and constructive discussions, MBOs have a greater chance of success compared with other sale strategies. All parties know each other, transaction expectations have been set early, and management’s familiarity reduces uncertainty around business viability.
- Flexibility: MBOs can provide an opportunity to ‘stage’ a transaction, allowing existing owners to realise a liquidity event earlier, provide a gradual sale between owners, and provide management additional time to finance the purchase.
- Continuity/vendor satisfaction: exiting owners often feel confident in the future of the business, and that customers and employees will continue to be looked after.
- Opportunity: An MBO provides management with an opportunity to grow their personal wealth and receive greater rewards for their risks and efforts.
Funding an MBO
Managers don’t need large amounts of personal capital to invest in the business. Ideally, they should have an investment that is significant and that incentivises them to ensure investment objectives are met. There are three main MBO funding options:
- Vendor funding: sourced from exiting owners directly, or from the company. There are a number of possible structures that can provide flexibility where existing owners want to pursue a staged exit.
- Bank funding: depending on existing business debt, a large portion of buy-in value may be funded via bank debt, either to the company or management team, to acquire equity from existing owners.
- Private equity: management partners with a private equity funder. Structures can vary, usually combining debt and equity funding, and are typically only used in larger business transactions (>$5 million EBITDA).
Obstacles
From assignments our team has completed, we see a number of common factors that prevent MBOs being completed, which include:
- Valuation: incorrect valuation advice when initially evaluating the transaction, which creates a valuation gap between owners and management that is too great to bridge.
- Funding: an inability of management to secure necessary funding, or unwillingness to put some ‘skin in the game’, such as by re-mortgaging the house.
- Delays: delays in agreeing the terms and implementing the MBO will usually result in management or owners getting cold feet or seeking alternate opportunities.
- Other issues that may be encountered subsequent to the implementation of a staged buy-in:
- Owners not being prepared to let go of management responsibilities or control, which creates conflict between the parties; or
- The underperformance of the business post-transaction, particularly in a staged transaction.
Clear communication and negotiation between owners and the management team, to set expectations prior to agreeing to terms, will usually be able to address the above. Appropriate agreements, frameworks and mechanisms can be implemented prior to the issues arising.
Conclusion
It is important for owners and management considering an MBO to start planning as soon as possible, particularly where a staged transaction process is preferred. Effective planning and communication are critical in the execution of the transaction. The key success factors are:
- a strong relationship between MBO team and vendor;
- determining a fair market value for the business;
- determining the funding structure and capital/funding partners; and
- appointing experienced advisers to manage the process.
Matthew Swan is a manager in the PKF Corporate Finance team with more than 10 years of experience as an accountant, focusing on corporate finance and audit and assurance matters.
