If you’ve ever dreamed of buying out the owner of your company, running it the way you want and accumulating the profits from your efforts, you might be interested to know that many businesses in B.C. will change hands this way over the next five years, as we see the largest cohort of baby boomers reach the age of 65.
For owners of companies with sales of less than about $20 million, the notion of selling to the second in command is a viable option, so understanding its feasibility should be part of any succession plan.
A management buyout (MBO) involves a manager (or management team) buying out the company he or she works for, in full or at a minimum, a controlling position. Management buyouts most commonly occur when the owner is retiring and doesn’t have children to take over the business. They also arise when the business owner can’t sell to a strategic party, such as a competitor, because it’s too small or because the owner prefers to keep the business in employee hands. Other instances involve spinning out a division from a larger company.
The benefits of management buyouts make them a win-win-win to the seller, the buyer and the economy. Managers often cite their newfound control as a key benefit. With new ownership and energy, the business gains a new lease on life. Sellers who are concerned with leaving a legacy are often motivated to see their baby continue under the stewardship of people they trust. Importantly for the economy, business ownership and jobs stay in local hands.
Here are some key factors to keep in mind when considering a management buyout;
- The owner must be willing to sell. This is often the key stumbling block where the owner has not emotionally accepted retiring.
- The owner wants to sell to the manager. Establishing a strong relationship with the owner is critical to managers pulling off an MBO.
- The business must be viable and capable of supporting outside financing.
- The team of buyers must have broad capabilities to run the business successfully, a strong reputation with stakeholders and the ability to take on the responsibilities of ownership.
The management buyout process begins years before the transaction, as the management team progressively takes on more responsibility. The owner should also seek tax advice for succession at least two years prior to the transaction. Additionally, the process itself requires establishing a fair valuation that is reasonable and gets the owner what is needed for retirement. A vital element is obtaining outside financing, and here the decision must be made whether to use debt only or equity and debt.
Bringing in a private equity investor should be considered where the managers lack sufficient equity to complete the deal and want active investors on their board. Private equity in such a case will usually require giving up a controlling stake, so the managers must balance the need with answering to another “boss.” Debt financing is often available to complete the deal without outside equity. Conventional lenders will provide term financing against hard assets, and some will even finance intangible goodwill. Beyond this, subordinated debt, leveraged against the cash flow of the business, can stretch to three or four times EBITDA.
Lenders usually look for a minimum of 25% equity in the deal. When this is unavailable, mezzanine financing can be used. This is like subordinated debt, but adds an equity return commensurate with the risk. Finally, vendor financing is also common in MBOs to tie the owner’s interests to those of the buyer and to support vendor representations and warranties.
Management buyouts are not for the faint of heart. But there’s no doubt that leveraging one’s unique position together with external financing can offer significant rewards.
Robert Napoli’s column was originally published in issue 1203 of Business in Vancouver.