How to finance an MBO.
How To Finance An MBO
A management buy-out, or MBO, is the acquisition of a business by its existing management team from its existing owner, usually (but not always) with the help of external finance.
If you’re considering an MBO, it’s because you and your management team see an opportunity to take ownership of the business you have been working in to build and realise a capital gain for yourselves.
The opportunity may have come about because you were fortunate enough to be approached by the owner.
This is quite rare, with more common reasons for an MBO opportunity presenting itself being:
The owner wishes to retire and doesn’t have any succession;
A wish by shareholders to de-risk by realising cash;
Some (not necessarily all) shareholders wanting to exit;
An institutional owner of a private company (such as a private equity house) deciding to realise its investment.
MBO’s are an excellent opportunity for entrepreneurial managers to acquire a significant equity stake in an established business that they already know.
But the whole concept of buying the company that you work for, and raising the cash you need to do so, is daunting for many and therefore very few actually actually do it.
In this guide, I will walk you through the process and outline the funding options that are available to you as well as spotlight some of the mistakes managers make when trying to complete an MBO.
How To Buy The Company You Work For
An MBO is a complex process and will be a time-consuming, draining and even emotional journey for you.
It will literally be your life for 3-6 months, which isn’t easy when you’ve still got a day job running the business you are trying to buy!
So every single member of your management team has to be completely committed to it.
You should also find an experienced advisor to help you - not just for the finance (I can help you with that!) but an advisor with extensive experience negotiating and completing MBOs.
Most of them work on a contingent basis i.e. they only get paid when the deal completes and a good one will be worth every penny.
After all, this will probably be the only MBO that you are involved with in your life and getting expert advice at an early stage is sensible.
First and foremost, the advisor will assess the opportunity and estimate your chances of success…
Is the MBO feasible?
You should never pursue an MBO unless there is a good chance of success.
Your advisor will assess the feasibility of it - and they are in a really good position to do so because being a third party, they can ask the right questions.
A good advisor will be impartial and honest with you on the chances of success.
You’ll also need to consider competition; do you have any advantages over other buyers?
Why should the owner sell to you and not just seek a trade sale?
You’ll need to be able to assess the alternative options available to the owners and assess the likelihood of trade interest.
Even at this early stage, you need to consider what the deal structure could be and what price can be supported.
There’s no point spending time and energy on it now only to discover further down the line that your price expectations are way out of kilter.
And you need a pretty good steer on what your funding options are too.
You’ll be a long way off a formal offer at this stage but a good advisor will have a good idea of what the financing structure will be.
The feasibility study should be carried out fairly quickly and if the conclusion is that an MBO is practical, the next step will be to approach the vendor to obtain approval to pursue the MBO.
Agreeing the deal
Assuming the deal has been considered feasible with a good chance of success, you will need advice on how to approach the owner.
Unless the subject has been raised by the owner, some managers regard the initial approach as the most difficult and sensitive issue.
This is a key stage in the process where planning and timing are critical.
As a first step, you should seek permission from the owner to consider an MBO.
It is particularly important to judge the current owner's willingness to sell and any particular sensitivities before making an approach.
Approaching the owner with a sensible, well considered and achievable offer will be the key to establishing yourself as a credible buyer.
The key to valuing a business effectively is in understanding all the factors which contribute to its worth.
Factors to consider:
Past profitability;
Future prospects (markets, customers, new products);
Asset values; and
Cash generation.
You’ll also need to agree with the owner on the rules of engagement and the steps in the process, the timeline, approach and goals.
Once an in principle deal has been agreed, a ‘Heads of Terms’ document is drawn setting it out.
It has to be in principle at this stage because it will be subject to due diligence, funding etc.
The owner will usually set guidelines concerning the supply of information in order to seek a level playing field with the MBO team and other potential buyers.
Using the adviser or funders as the lead negotiator with the owner can help to preserve the relationship between the management team and the owner.
You can focus on promoting the MBO as an attractive option for the owner and beneficial for the business.
If this is managed well, the owner will be less likely to go to market for competing offers.
Getting the funding you need
This stage will usually begin at the same time as negotiations with the owner.
In order to obtain the funding you need, you’ll need to set out your plans for the business (including detailed profit, cash flow and balance sheet projections) and demonstrate how these will be achieved (a good advisor will do this for you).
The plan will need to instill confidence and stand up to detailed due diligence.
Debt funders will be keen to examine the cash flow forecasts of the business in order to assess the likelihood of the business supporting interest and capital payments.
Asset based lenders will want to value the assets of the business that you want to use as security to fund the deal (more on this shortly).
You’ll need to meet and present the business case to a number of banks and financial institutions to secure the funding you need.
If, following the initial meeting a lender is interested, they will provide an indicative offer of the funding they are prepared to provide and the terms on which they will provide it.
Completing the deal
Once an in principle deal has been agreed with the owner and lenders, it is normal for the vendor to grant a period of exclusivity during which due diligence, financing and legal documentation can be completed.
Investors and lenders will carry out their due diligence and asset valuations to verify the information they have been provided with to this point.
When due diligence is underway, the drafting of the legal documentation also begins.
The period of exclusivity is usually the most demanding on the management team, with due diligence and the finalisation of the funding and legal documentation running at the same time, together with any final negotiations with the owner (which is common).
There will undoubtedly be some twists and turns but ultimately, assuming the due diligence and legal process does not throw up any ‘deal breakers’ the MBO transaction completes.
Now the hard work really begins!
Considering an MBO - this is how to fund it
Most managers do not take the idea of an MBO seriously because they mistakenly believe that without a lot of personal cash to sink into the deal, they have no chance of getting it done.
But in reality, whilst your management team will be expected to show it’s commitment by investing funds in the deal it will likely be a very small amount of the total funds raised to buy the business.
There are plenty of funding options available to you.
Funding to support an MBO usually comes from banking and/or private equity in the form of debt and equity respectively.
Management Equity
The personal investment required by members of the buyout team needs to be meaningful to each individual taking into account their own financial position and personal circumstances.
A sum equivalent to the individual’s annual salary is a pretty good rule of thumb.
It’s less about the amount and more about demonstrating to lenders and investors that the management team has ‘skin in the game’ - that they are truly committed to the long term future of the business.
Good for: Demonstrating commitment to lenders and retaining equity in the company.
Business Loan
You may be able to finance all or part of your MBO with a loan - over a fixed term with fixed repayments.
The lender will have security over the assets of the business and will be repaid in priority to any other lenders (this is why it is sometimes referred to as ‘senior debt’).
It’s the simplest way to fund an MBO, but really only available to businesses that can demonstrate a very sustainable level of EBITDA and cash generation.
Banks have had a limited appetite for this type of loan in recent years, but there are an increasing number of lenders in the market that specialise in funding transactions like MBOs on effectively an unsecured basis.
Good for: Businesses with few assets, but very robust and sustainable EBITDA and cash generation.
Asset Based Lending
If the business you are trying to buy has assets on the balance sheet like trade debtors, stock, plant & machinery and property, you may be able to leverage them to raise the cash you need.
An asset based lender will advance a set amount against one or more of those assets - up to 95% of the total outstanding debtors, up to 50% of the value of your stock, for example.
ABL is a good option because it is more accessible than senior debt - the lender is principally secured by the value of the assets, so the loan is not completely dependent on the financial performance of the business.
The business still has to be viable, but EBITDA and cash generation is not as important as it needs to be to secure a sizeable senior debt facility.
ABL is also a good way to generate a significant level of funds, usually a lot more than can be generated with a traditional loan facility.
This is of course completely dependent on the company’s asset base, but if there are significant assets to leverage there is no more effective way to leverage them than with an asset based lending facility.
Another key benefit of ABL is it’s flexibility - it also provides you with on-going working capital, after the MBO has completed (should you need it).
You continue to receive advances against debtors and stock on a revolving basis, removing your reliance on a bank overdraft or other facilities.
Good for: Businesses with a strong asset base.
Private Equity
Funding from a private equity or venture capital investor will always be conditional upon their taking an equity stake, usually as a minority shareholder.
The investment returns on a private equity investment are twofold: interest income on the funding provided and capital growth in the equity stake.
Private equity providers make the majority of their money on the sale of their shareholding when the company is sold, usually within a period of around five years after the MBO.
Consequently this type of finance is typically only available in support of those buyouts where substantial capital growth and a relatively fast exit is anticipated.
Good for: Quick growth and fast exit.
Vendor Deferred Consideration
Vendors (owners), as you would expect, prefer the consideration to be paid to them in full at legal completion of a transaction.
But this is rarely possible and vendors usually need to defer a proportion of the consideration in order for an MBO to proceed.
It can be either in the form of deferred loans - after the bank is paid off - or equity, generally in the same proportion of ordinary shares and loans as the private equity house.
Vendor financing can be useful in bridging any price gap.
However, some vendors may particularly appreciate the opportunity to reinvest part of their proceeds in the new entity and so provide them with an ongoing involvement and upside potential.
Good for: Reducing the day 1 cash commitment and keeping the owner ‘invested’ in the business for a period of time.
Earn-outs
An earn-out is a specific type of vendor deferred consideration whereby additional consideration is payable to the vendors contingent on the future trading performance of the business following completion of the buyout.
The vendors may believe that the business is worth more than the MBO team does or more than can be funded based on its past financial performance.
An earn-out structure may lead to additional consideration being payable to the vendor if the business achieves or surpasses specific financial targets following completion of the buyout.
Good for: An earn-out helps to maximise the value of the business for the vendors and eliminate uncertainty for the MBO team.