Financing a Management Buyout
Business owners wishing to sell are finding that the buyer pool, though generally robust, is on the sidelines for the moment – especially now in this time of Covid-19.
Buyers want to see how the overall economy will rebound from the government-mandated recession that the world has been plunged into as a result of widespread lock-downs.
Deals have been put on hold or, in some cases, collapsed altogether.
But if you’re a business broker advising a business owner – or an owner wishing to sell – there’s a group of potential buyers that are less likely to feel the need to wait; the business’ employees. Depending on the size of the company, a sale could be structured as a management buyout or an employee stock ownership plan.
I’ve discussed a single-employee buyout in a previous post in which the manager of a small jewelry retailer became the buyer of the business. But the same concept is used in larger transactions where there is a layer of managers – multiple employees managing different aspects of the business. Both these situations are ripe for a management buyout.
Existing managers are intimately familiar with the business, its history and its prospects. They are unlikely to need the same level of proof that the business will fully recover once the world’s economies are reopened.
The added benefit of a management buyout is that an existing management team will give a lender more confidence that the business will continue to be run profitably which will result in a greater willingness to lend – and possibly at better rates.
But financing – even for the best of deals – is a dicey situation at the moment so here are a some of the potential funding options that can be used to finance a management buyout.
Though third-party funders will probably provide the majority of the acquisition capital, it’s important that each individual that will be involved in the acquisition invests some meaningful amount towards the purchase. They should each have “some skin in the game”, so to speak.
This investment amount need not necessarily be large relative to the size of the overall transaction, but it needs to be meaningful enough so that each individual demonstrates that he of she is “fully committed”. Such a commitment will illustrate to lenders and investors that the team of buyers is incentivized and will likely do whatever it takes to grow the business.
Seller financing in the Main Street and Lower Middle Markets is a factor in over 80% of the time even when the economy is roaring. It’s even more important now.
A wise seller – or one advised by a professional business broker – should be willing to facilitate the management buyout by deferring a portion of the purchase price for two reasons:
1) The amount deferred (“deferred consideration”), generally in the form of loan notes, is a time-honored way of reducing and delaying payment of capital gains taxes.
2) The wise seller will realize that facilitating the management buyout in this manner is likely to make the deal more palatable to lenders.
Earn-outs are a type of deferred consideration and are often part of transactions where the seller and the buyers can’t agree on a valuation of the business. The seller may have more confidence in the business’ future performance than the buyers do. In this case an earn-out, whereby the buyer agrees to provide an additional consideration to the seller when certain financial targets are met, can be a solution both parties can agree to. It allows the management team to avoid overpaying based on performance projections, and enables the seller to remain involved with the business post-sale and earn a bigger price if the targets are reached.
Our course, The Basic “How-To” of Becoming a Business Broker”, teaches how to market and sell businesses.
Become a Professional Business Broker…
The first source of capital that generally comes to mind in a management buyout is the local bank – a conventional lender. The smartest move here is to work with the bank the business has used, hopefully for years to handle its deposits.
The business’ current banker knows the business – knows its history, its financials, how it is viewed in the community. The banker most likely has the business’ tax returns on file and probably knows the management team and the individual buyers personally.
Among the other aspects of the deal that a lender will look at, the first two items of this post – how much each of the buyers will invest and whether and how much the sell will defer – are arguably the most important and certainly the first aspects that will be considered.
If you’re a business broker advising on such management buyout, let the buyers know that assets owned by or to be transferred with the business – such as property, machinery, inventory and FF&E (furniture, fixtures and equipment) can be used as security for a loan. And because the provision of security reduces the level of risk for the lender, they will many times offer a lower interest rate.
Private Equity Groups
I’ve discussed Private equity groups (PEGs) in previous posts – most notably here – and they are a legitimate source of financing for a management buyout under certain circumstances.
Unlike conventional lenders, PEGs invest for equity; they’re not in the business of lending. As such, this source of funding is more expensive than a lender.
PEGs look to quickly turn their capital and generally want to cash out in four or five years with a fairly strong return. Lenders, on the other hand, will be happy to collect their modest interest over a much longer term.
As a result, to interest any PEGs, a business must be poised for growth and the management buyout team must seriously consider whether the business can achieve such growth. PEGs want a big return for their investment.
The Bottom Line
There are other methods of financing a management buyout, of course, from so-called social finance sources and non-conventional lenders to mezzanine financing and family offices. The thing to remember is that, if the business being acquired is successful and poised for growth, debt financing with be cheaper than equity financing all day long.
If you have any questions, comments or feedback on this topic – or any topic related to business – I want to hear from you. Put them in the Comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a safe and profitable week!