June 1, 2020
Hiding in Plain Sight: Management Buyouts
Internal Ownership Transitions Have Many Advantages
A management buyout (MBO) can generate fair value and achieve many other important objectives, which include reducing the risks inherent to an outside sale.
- MBOs reward long-time, loyal and deserving employees.
- An MBO can be an owner’s least risky succession alternative, provided there is ample reward – cash! – at closing.
- An MBO will likely require an infusion of private equity, which adds value to the company.
- An MBO is the alternative most likely to preserve legacy and culture.
The Best Option May Be Staring an Owner in the Face
Sometimes the best alternative is the most obvious one – the one hiding in plain sight. Based on that truism, selling to senior management in a management buyout (MBO) under the right circumstances makes a lot of sense. After all, regardless of who the buyer is, management‘s involvement is a necessity. Their cooperation and enthusiasm – not to mention their intimate knowledge of the company and stewardship of its culture – facilitate the sale process and help realize full value.
Management Is a Viable Buyer, But Will Need Assistance
When an owner decides to sell, it’s not uncommon to see senior management step forward and express interest. Some owners worry about management interest, but it’s actually a good sign. This is the team that knows the company best, has helped create value and been loyal. The benefits of management continuity and avoiding operational disruptions are obvious. And how this team is treated is in full view – to employees, customers and vendors. It just makes sense to welcome their interest.
However, management buyers often don’t know how to make a deal happen and most likely lack the financial resources. It may be a surprise to learn that these issues aren’t deal-breakers, not even close. They can typically be addressed easily with the involvement of a financial advisor. Conducting a purchase will require a combination of their own money – if only to have skin in the game – and outside capital in the form of private equity, which an advisor can facilitate. Plus, management can be involved in selecting the group that is right for the company and for them.
Private equity is in greater supply than ever before and aggressively seeking quality investment opportunities – even now. And the right institutional investor will contribute significantly more than just money. They are highly knowledgeable, promote strong governance, provide access to additional capital, and introduce incentive structures that can be very rewarding for high-performing management teams.
The management oversight provided by a private equity investor is appealing if a seller is providing partial deal financing in the form of a seller note, which is common in MBOs. A seller note will likely be subordinated to senior debt – meaning that it is unsecured and is paid after secured debts in the event of a liquidation – so the amount should be kept to a reasonable level. However, this form of payment can represent a valuable annuity with an attractive yield for a seller and is often the bridge to higher overall proceeds. The infusion of private equity capital helps reduce the size of the seller note, limiting risk and providing necessary oversight to ensure payments will continue through maturity.
A Need to Know the Market
Existing management knows the company intimately, which strongly suggests that they are a fair judge of its value. While true, it’s still a negotiation – particularly with private equity involvement – and options beyond the MBO should be explored or at least understood. Ownership should seek some degree of competition, both to keep everyone honest and because the market is the ultimate gauge of fair value. An owner my choose to sell to management for less, but he or she should understand the discount they are accepting. Even if pursuing an MBO exclusively, multiple potential financial partners and purchase structures should be sought. An experienced financial advisor provides both a check and balance, and valuable market intelligence to ensure the deal is reasonable.
Another attribute of an MBO is discretion. Rumors of a sale can damage a company and broad, public auctions of private companies generally do more harm than. A quiet horse race managed by a financial advisor experienced working with family-owned and closely held companies is advisable.
An MBO is the Alternative Most Likely to Preserve Legacy and Culture
One of the greatest threats surrounding ownership transition is cultural disruption. It also happens to be one of the most underrated elements of a deal. Destroying a successful culture threatens the livelihood of an otherwise vibrant company. Compatibility of merging partners is critical. Non-financial elements count!
A brazen quest to maximize value – wringing every last dollar out of a sale – can wreak havoc on a company. MBOs tend to lessen cultural risk because they mean continuity and provide employees with a sense of security. Since this is the team that worked with the owner to build the company, they are also most likely to respect and work to preserve the owner’s legacy.
When the owner is also the founder, or part of the founding family, the non-financial considerations of culture, legacy and stability, and the desire to reward key management with their own equity opportunity, prove even more meaningful. Ownership may not want to leave a lot of money on the table to accommodate an MBO and promote continuity, but it might be worth receiving slightly less in view of all the other benefits.
For more insights from the series, The Path to Private Company Liquidity: A practical guide to M&A for business owners, click here.