How to execute a successful management buyout (MBO)

A successful management buyout requires an adequate strategic assessment and a financing structure that will ensure the company’s sustainability

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If you’re an owner looking to sell your business or an employee thinking about buying the company you work for, you should be familiar with the term management buyout (MBO).

In addition to having a good chance of being successful, this type of transaction can often be achieved by minimizing the impact typically associated with business transfers.

However, you have to prepare well if you want to maximize your chances of a smooth transfer of power.

Étienne Drouin, BDC Managing Director, Growth and Transition Capital, Atlantic and Central/Eastern Quebec, gives us some tips on how to successfully carry out and finance a management buyout project.

What is a management buyout?

In its simplest form, a management buyout management buyout (MBO) is a transaction in which the management team pools resources to acquire all or part of the business they manage.

Most of the time, the management team takes full control and ownership, using their expertise to then grow the business. Financing usually comes from a mix of personal resources, lenders and outside investors, and the seller’s resources.

It’s important to differentiate between the transfer of operational responsibilities and the transfer of ownership. The first is usually gradual, over several years, and transparent, first to employees and then to external stakeholders such as customers, suppliers and financial partners, who will then not be surprised when the actual transaction is signed and finalized.

The risk is reduced because the continuity of business operations are better ensured when the people who manage the company are the ones who decide to buy it. Because the buyers are an experienced management team that is already familiar with the business and its needs, the stakeholders (existing customers, suppliers, business partners and especially employees) often feel reassured.

Drouin sees two frequent patterns in management buyouts. First, a very strong leader, such as a general manager, buys the business, which is generally small.

“Sometimes the person who buys the business partners up with another key person, such as the person in charge of sales or production, but the leader remains very strong and usually the transfer goes fairly smoothly,” he says.

The second frequent model is the multifunctional group. “It’s when five or six people in the different key functions join forces to buy out the company, which is often bigger,” Drouin says. “A group is definitely more complex to manage for the transfer, but if the right people are chosen and the roles are well defined, the results can be excellent.”

What are the advantages of a management buyout?

BDC’s internal data clearly indicate that the success rate of a management buyout is higher than that of a third-party acquisition.

“The transition is usually much smoother when the buyers are already part of the company and are familiar with it than when they come from outside,” Drouin says.

The transition is usually much smoother when the buyers are already part of the company and are familiar with it than when they come from outside.

He notes that it’s not uncommon for the announcement of the company’s management buyout to be a welcome relief to employees.

“They are well aware that an entrepreneur getting on in years will eventually have to transfer the business, and with a management buyout, the fear that it will be sold to foreign interests or to someone who is not familiar with it and wants to change everything dissipates,” he says. “People like to be in familiar territory. Continuity is very important.”

What are the steps involved in a management buyout?

A series of common steps are usually followed to ensure a transition of authority from an owner to management.

Step 1: Find the right people to buy out the company

Properly selecting the co-shareholders who will take over the business is a critical step in the buyout process. “It’s a little like a marriage,” Drouin says. “Everyone has to share the same values and vision.”

He also stresses that they all have to be entrepreneurially minded. “It’s not a good idea to get someone to join the group because they have money to invest in it, for instance,” Drouin says.

You will also need to find a leader from among the members of the multifunctional group to act as president. “It’s not always natural and sometimes the group needs to be assisted with this strategic decision,” Drouin says.

It’s a little like a marriage. Everyone has to share the same values and vision.

There are also instances where an entrepreneur wishes to have the company bought out by management but does not see any candidates in the company who have what it takes.

“I’ve seen an entrepreneur go outside and hire somebody as general manager and say that they’ll take two years to show them how the business works before selling it to them. It worked.”

Once the key people are found, Drouin says a good practice is to sell them a small portion of the shares right away.

“For example, if the group acquires 10% of the shares, the company will have had time to gain value before the major transaction takes place a few years later. This can make a big difference in the total remaining amount to be financed.”

Step 2: Transfer knowledge and responsibilities

One of the most critical steps in a management buyout is the transfer of knowledge and responsibilities.

“This is the operational transfer,” Drouin says. “Those taking over must create relationships with clients, suppliers, financial institutions, etc.”

“This often takes a few years. But afterwards, when the transaction is announced, the various stakeholders are generally not adversely impacted because they’re already working with the buyers.”

Step 3: Negotiate a price

Is all this work really needed before talking about a company’s selling price?

Drouin believes that money is rarely a problem in the current environment, especially since management buyouts are usually successful.

“It’s harder to find the right people to take over a business in a specialized industry than it is to find financing,” he says. “The right projects in good companies with good managers will attract investors if needed. Young buyers need to know this.”

It’s harder to find the right people to take over a business in a specialized industry than it is to find financing.

To carry out the transaction, Drouin advises the seller and buyers to try to agree on a price range first. They can then go to their financial institutions to see if anything was missed and to assess the project’s feasibility.

“I recommend that the buyers themselves approach the financial institutions to gain experience and start building relationships,” Drouin says. “A lot of sellers feel like they’re being excluded when they’re used to being in control, but at some point they’re going to have to learn to let go, and that’s one of the first steps in the process.”

Step 4: Ask for a business valuation

What about having a business valuation done by an outside firm? “It’s highly recommended, but not essential if the parties agree on a reasonable price,” Drouin says.

The benefit of the valuation is that it removes emotions and perceptions that can hinder the transaction. “Sometimes there’s a mentor-mentee relationship that involves a balance of power that causes the seller to ask for a higher price than the business is really worth,” he notes.

However, the opposite can also be true: The seller may believe that they are making a gift to their protégé, but the protégé does not realize it. “What you want to avoid is one of the parties thinking they were taken advantage of, because then they’re not going to make any concessions on all the other details that they have to agree on,” he says.

Step 5: Financing the MBO

There is no one formula where MBO financing is concerned. “It’s specific to each situation,” Drouin says.

But he adds that one thing is certain—a certain amount of upheaval is to be expected. “It can be generated by the transaction (e.g., new management, loss of employees, fiercer competition) or by the external environment of the company,” he says. “Let’s not forget that most SMEs are influenced by variables they don’t control. The price of oil or the price of the Canadian dollar will not stop fluctuating because our company is going through a transfer,” he adds.

Various options have to be considered in finding a way to finance the project.

MBO financing options

Here are various types of basic financing that can be combined to ensure a successful transfer.

  • Buyers’ personal funds
    Personal funds are used to secure the confidence of a financial institution, add equity to a transaction, and share risk. Buyers often have to invest a significant amount of their own wealth, including by refinancing personal assets, as a way of demonstrating their commitment.

    “Buyers are obviously expected to personally invest in the company, as much as they are able to, to demonstrate their commitment to the project,” Drouin says.
  • Asset-based financing
    The company’s assets, such as buildings and equipment, are used as collateral to borrow money to finance the transaction.
  • Cash flow financing
    The company’s ability to repay—its normal profits—is used to repay an unsecured loan.
  • Mezzanine financing
    This type of financing allows the loan to be repaid based on the company’s performance to take into account the upheaval that will follow the transfer. “It’s more flexible than traditional financing,” Drouin says. “It’s a type of financing that provides flexibility, both for adverse events and to seize the opportunities that will present themselves to the new management,” he adds.
  • Seller financing
    This type of financing bridges the gap between the financing capacity and the agreed-upon price, spreads payments over a number of years, and has the seller share the financing risk, which is well perceived by all stakeholders in such a transaction. If both parties do not agree on the price, a contingent consideration clause (earnout) is often seen, which is payable based on the company’s performance.

    “For example, when the seller has invested a great deal of effort in getting a new client and it’s not yet known what effect it will have on the company’s earnings,” Drouin explains. “If the new client proves to be profitable, the seller will receive more.”
  • Sale of shares to employees
    Middle managers can be asked to take a small equity position in the company, for example, or all employees may be allowed to buy shares in the company. In addition to helping with financing, this strategy acts as a productivity incentive for employees.
  • Sale of shares to institutional or private third parties
    Depending on the size of the transaction and the extent of available leverage, another option is to partner up with passive investors, who should contribute more than money through their advice, networks and experience. “This is true for all partners at all levels, but even more so in this case,” Drouin says. “Make sure interests are aligned and there is a common vision of the future.”

Example of MBO financing

Here’s an example of MBO financing for an industrial equipment repair company. Remember that each situation is different and that the same arrangement for a transaction half as small or one that is five times larger would be fundamentally different.

Since the company had few assets, our client could only rely on limited senior debt financing.

Based on the company’s consistent profitability history and the calibre of the buyer’s management team, BDC provided cash-flow financing with a seven-year amortization period and deferred principal repayment for the first 24 months that does not utilize the company’s full repayment capacity. Mezzanine financing often includes a lump sum repayment of the principal, a type of financing that provided the cash flow flexibility needed to grow the business.

Project Amount
Acquisition by management—100% of shares
$4,500,000
Financing  
Mezzanine financing $1,500,000
Cash flow financing $1,000,000
Senior debt $500,000
Seller financing $600,000
Management’s investment $900,000
TOTAL $4,500,000

Set up a financial arrangement that ensures the company’s sustainability

While there are many options for financing a transaction, there is one key aspect: the importance of a financial arrangement that anticipates contingencies and future investments.

“In a business transfer, there are always unforeseen situations, good or bad, and the new team of owners must have the necessary leeway to make adjustments and seize opportunities,” Drouin says. “No one buys a business to leave it as is, so it takes money to grow it.”

Feel free to contact us to schedule an appointment with our experts to discuss a management buyout.

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