Company owners wanting to make a strategic exit can consider management buyouts as an option. This strategy involves selling the company to a single member or the entire management. These top executives may acquire a majority stake in the company or purchase it outright.

The management buyout (MBO) strategy is typically used by private company owners wishing to retire and leave the company in capable hands. Members of the management coordinate efforts to own and take full control of the company instead of selling it.

The management, employees, customers, investors, and other stakeholders stand to gain from this initiative. Since all of them are familiar with the company and its workings, the transition is smooth.

The process eliminates complex integration that often results in failed acquisitions, and the company will continue running as before.

Understanding Management Buyouts

Management buyouts are a form of acquisition transaction where the top executives of a company purchase it from its owners. The owners sell the entire company as is, complete with assets, debts, and anything else associated with the brand.

Members of the management see the potential rewards in becoming company owners as opposed to remaining employees. They may pool their resources to acquire a part of or the entire business under their control.

If these executives think they are in a better position to run the company profitably, they offer to purchase it. Aside from private company owners, larger corporations may also choose to sell off smaller units. This form of divesting is effective for consolidating their finances for other purposes.

Funding Management Buyouts

To execute the acquisition, the management must organize the necessary funding. Here are some of the options:

• Executives may use their personal funds, such as savings and other assets, to purchase the company. These individuals are typically wealthy and have substantial personal assets.
• Executives reach out to private equity firms for funding. However, these PE firms may require a share of the company as compensation for the investment.
• Seller financing is also an option that involves an agreement between the management and the company owner or seller. The owner may agree to accept a promissory note for the unpaid portion of the purchase price.
• Bank loans are also a source of capital, but MBOs are a risky investment. For this reason, they may offer only a portion of the funding. The management may have to look for other sources as primary investors.

Mezzanine Financing

Mezzanine financing is a blend of debt and equity financing. Lenders provide funding on condition that they can convert the debt into equity or stock options in the company. That is, in case the company defaults.

However, the lenders can exercise this right only after venture capital companies and senior lenders get back their investment.

The risk factor is balanced between senior debt and equity. In the case of bankruptcy, mezzanine financing lenders get priority over existing owners to recover their capital.

Mezzanine financing for management buyouts has warrants embedded into it, similar to embedded equity instruments. This factor lends flexibility to the investment when dealing with bondholders.

Leveraged Management Buyouts

MBOs are a form of leveraged buyout (LBO) https://hbr.org/1988/01/lbos-for-smaller-companies where the acquisition takes place using funding from third-party sources. If third-party investors provide the major portion of the funding, the acquisition becomes a leveraged buyout.

Most management buyouts are invariably leveraged since companies cost a substantial sum of money. The buyers must raise a combination of debt and equity to pay the price.

Transitioning from employees to owners does come with its share of risks. While the potential for profits is high, so is the higher risk of running losses.

How Management Buyouts Proceed

Management buyouts (MBOs) typically involve a series of steps:

1. The transaction starts with a viable business or an opportunity the management or a particular member identifies as worth investing in. The business would have to have adequate potential to scale and generate profits.
2. The management and potential buyers devise a business plan that outlines how they intend to run the company. As with any other business plan, it will include a vision of the direction in which the new owners intend to take the company.
3. At this point, the buyers may want to estimate the funding they need to buy the company.
4. The next step is approaching the owner with a proposition to purchase the company. The buyers will communicate their intention to buy in a private acquisition. If the deal is public, there might be an auction in which interested parties propose their bids.
5. Due diligence is always crucial, as buyers want to review the in-depth details. Despite being the management, they must ensure that every aspect is covered.
6. Once the deal closes, the management completes the transaction and starts implementing its intended changes to take the company forward.

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Why Management Buyouts Occur

Considering the high risk factor accompanying MBOs and the high chances of failure, the company management may still push ahead. Here are some of the key reasons that drive a management buyout.

Lack of Offers from Third-Party Acquirers

Companies coming up for sale don’t always get good offers from third-party acquirers. Many reasons may prevent the sale from concluding, such as issues with the company’s financials or the changing economic landscape.

Buyers may not consider the company a viable investment, or issues may arise in the due diligence. The lack of adequate funding to purchase the company can also be problematic.

MBOs can be a safer solution since the top executives may have a handle on resolving the problems. They may know exactly how to maintain continuity.

Owners Can Transition to a Private Equity Investor

Management buyouts typically occur when the company owner is ready to retire but also maintain a stake in the company. MBOs allow them to transition into the role of a private equity investor. The executives pay the owner a substantial sum, allowing them to retire comfortably.

At the same time, the owner can retain some degree of control and say in how the company is run. The value they bring to the table can be indispensable to keeping the company on an upward growth trajectory.

They will continue to act as a mentor and steer the company in the right direction. In addition, the owner, now a private equity investor, can also get a share in the profits the company generates.

Owners Benefit from a Better Deal

Taking on the role of a private equity investor may result in higher returns for the owner. Selling the company in the open market often involves aggressive negotiations with third parties, driving prices down.

However, selling to the company’s executives allows the owner to walk away with a significantly higher price. That’s because the management need not pull out cash reserves to pay the owner. Instead, they can convert the selling price into stock and offer returns similar to those of a PE firm.

Regardless of whether the company is entering into an M&A deal with internal or external buyers, the discovery phase is crucial. Both buyers and sellers should know how to navigate the due diligence process. Check out this video, where I have explained in detail how it’s done.

Finding Third-Party Buyers is Challenging

Most importantly, the owner need not scout the market for third-party buyers and simply allow the management to purchase. The sale proceeds seamlessly without creating a buzz in the market that can shake customer confidence in the company.

External buyers and brokers typically evaluate an acquisition according to its potential for generating minimum returns. They may also operate on a minimum valuation criterion. For instance, some brokers may require a minimum valuation of $5M.

Buyers and brokers drive a hard bargain once a company comes up for sale, pushing its prices down even further. Although there are many buyers in the under $5M and $10M market, they tend to value companies at much lower figures.

Several other issues can arise, such as maintaining confidentiality and company secrets when finding external buyers. A management buyout circumvents all these issues since the sale can occur internally without the information being released.

Owners Get Favorable Terms and Conditions

During a management buyout, the company owner could be in a better position to negotiate beneficial terms. For instance, they can require an “earnout clause.”

This clause entitles them to a share of the company’s future earnings. These earnings can be in the form of a percentage of the revenues or any other conditions.

However, outlining the earnout conditions in detail is crucial. Owners should ensure the new owners honor their agreements and make payments as decided. Another concern is the management clause.

According to this condition, the owner may be required to stay and work in the company for a fixed tenure. In this case, again, determining the terms and conditions of this tenure is crucial to ensure transparency about responsibilities. And compensation for their time.

When company owners have spent decades building it from the ground up, they want to eliminate the possibility of mismanagement. Selling to third parties means no control over the company once the sale concludes.

Selling to the management may allow the owner to specify terms like keeping workers and securing their jobs. Or maintaining a certain way of working and running specific units even if they aren’t performing well.

Factors like these contribute to the company’s essence that external buyers may be unable to comprehend.

Saving on Time and Transaction Costs

Mergers and acquisitions typically involve extensive costs because of the large team of professionals engaged. For instance, a single deal requires an M&A advisor, broker, expert lawyers, and accountants to manage the legal aspects. Due diligence and in-depth evaluations can also add up the costs.

Once the deal is final, transaction and registration charges are added to the final bill. Even if the deal falls through, participants must cover the professional fees. Then again, brokers require a percentage of the deal amount as a fee to enable the deal.

An internal management buyout can eliminate these costs and finalize the deal at a fraction of the expense.

Ensuring Company Stability and Scalability

External buyers may choose not to retain the existing management in favor of their own teams to run the company. Or, the existing management may not agree with the new policies buyers introduce. These policies may or may not serve the company’s interests.

Since the executives running the show are familiar with the company’s functioning, they are adept at decision-making. They may also be in a better position to steer the company and ensure its stability and scalability.

Incoming executives that buyers bring in may be unfamiliar with the company, and their decisions could result in instability and failure. Management buyouts also occur when the company executives are confident in their expertise to run the company.

The executives may have the expertise, experience, and skills to run the company better than its owners. This is why they may offer to purchase it from them and take it to new heights. The chance of higher gains and profits is also a deciding factor.

Continuation of Company Culture

Failed integration and synergies often result in both parties running up huge losses in an acquisition. Typically, companies have entirely distinct cultures and work processes. Aligning two entirely different teams involves an extensive process and meticulous preparation from HR departments.

A lack of understanding can prove to be disastrous. More so when the acquirer lets go of key workers and personnel to eliminate overlapping talent and skill sets. Job insecurity and loss of morale can also lead to unnecessary employee attrition.

A management buyout makes these issues irrelevant. The company continues operating as before but with some core changes that lead to improvement and long-term profitability.

The Takeaway!

A management buyout has several key benefits for all the stakeholders involved. And that includes the owner, top-tier management running the company, workforce, investors, and customers. The company benefits from new leadership but with mentoring and coaching from the old owners.

The owners and founders may have built the company from the ground up and can offer in-depth information. The new owners learn about the pitfalls founders navigated successfully and understand the company culture and mission.

This is why the MBO M&A strategy could be a win-win situation for everyone involved, most of all, the company itself.

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