June 13, 2010
If you're an owner looking to sell your business or an employee thinking of buying the company you work for, you should be familiar with the term management buyout (MBO). In its simplest form, an MBO involves the management team pooling resources to acquire all or part of the business they manage. A Leveraged Management Buyout (LMBO) is similar to a MBO, except that the buyers use company assets as collateral to secure financing.
Most of the time, the management team takes full control and ownership, using their expertise to grow the business. An MBO/LMBO acquisition, which can be sizable, is usually funded by a mix of personal investors, external financiers and the seller.
For a business undergoing a change in ownership, the MBO/LMBO offers advantages to all concerned. Most obviously, it allows for a smooth transition. Since the new owners know the company and its business, there is reduced risk, other employees are less likely to be apprehensive and existing clients and business partners are reassured. Furthermore the internal process and transfer of responsibilities remain confidential and are often handled quickly. Once a business owner has agreed to sell his company to members of his staff, there are usually a series of common steps in the transfer of power:
- Buyer and seller agree on a sale price.
- A valuation of the business confirms the agreed-upon price.
- Managers assess the portion of the shares they could purchase immediately, and then draft the shareholder agreement.
- Financial institutions are approached.
- A transition plan is developed that incorporates tax and succession planning.
- Managers buy out the sellers' interest with financial support.
- Decision-making and ownership powers are transferred to the successors; this can take place gradually over a period of a few months or even a few years.
- Managers pay back the financial institution. This is done at a time and pace that will not unduly slow the growth of the business.
Buyers will need to ensure that the venture is profitable or at least has good potential to be. Keep in mind that the MBO/LMBO requires substantial financing, which will have an impact on company cash flow. To compensate for the repayment, the buyer will need a strategy to increase cash flow through cost-cutting, improved productivity or building revenue.
A thorough financial analysis should reveal cash flow, sales volume, debt capacity and potential for growth. This will provide valuable information on the fair market value of the business and on management's operating flexibility.
How to finance an MBO/LMBO
The buyer(s) will need to develop a strong business plan to prepare for the acquisition. The forecast should be credible and realistically attainable. Personal and business contacts and referrals can also help a successor secure confidence from bankers. A small buyout usually involves only one institution. In larger transactions, several institutions may handle the financing.
In an LMBO, business assets are evaluated to determine the equity available for financing. The lender will use the assets as collateral. The financial institution will adjust interest rates according to the risks associated with the transaction.
The financer may ask the seller to finance a portion of the sale as a form of commitment to the venture, and as a sign of confidence in the management team. Be sure to shop around for the best terms.
Any of these types of basic financing may be combined to achieve a successful transition.
Personal funds can help secure confidence from a financial institution, add equity to the transaction and share risk. Buyers often need to invest a significant amount of personal money — which may involve refinancing personal assets — to demonstrate their commitment. Loan or credit notes from banks are often used to purchase owner shares in the business. This type of financing is attractive because of its simplicity—assets are used as collateral—and because interest rates are lower.
Seller/owner financing can extend payments over a number of years. This form of financing is tied directly to the seller and may include credit notes, loans or preferred shares. This may reduce cash outflow at time of transaction and make the transition easier.
Similarly, an installment purchase of stock allows the seller to maintain a level of control until he or she is completely paid off.
Selling stock to employees can be used in conjunction with an MBO/LMBO to finance the remaining portion. The Employee Share Ownership Plan Association explains how this type of financing enables other employees to purchase stock options in the business. This can give incentive to existing employees while the management team retains control of the business.
Subordinate financing can complement a management team's equity investment by bringing together some features of debt financing and equity financing without diluting ownership. If a profitable business maximizes the financing on its assets, and the management team's personal funds are insufficient, then subordinate financing may take on a higher risk to participate in the venture. Repayment terms are established at time of transaction.