What is a management buyout (MBO), and how do you finance one?
Management buyouts, are a popular choice for businesses globally and happen across various industries. In this article, we’ll explain what they are, why they’re done, their pros and cons and how you can finance them.
Management buyouts are a popular route for employees to transform into accomplished entrepreneurs and run the business they once worked for. First made famous in the US in the 1970s and 80s, they were previously known as ‘going private’ as they took publicly owned companies off the market and put them back in the hands of private owners.
For example, in the UK, the well-known fashion retailer New Look was taken from public back to private ownership with a management buyout which put its former founder back in the driving seat.
They’re popular succession routes for founders or owners looking to exit a business. Rather than selling to an external party, a management buyout, as the name suggests, is when an existing management team purchases the company they work for, either in full or partially, with the help of external financing and investment. Typically, the management team will take on a controlling interest and have the authority to lead the business in whichever direction they see fit.
A leveraged buyout (LBO) is the generic name for the purchase of a company using borrowed capital, such as debt finance. The company’s buyer could be its employees, using an employee ownership trust (EOT), an external bidder, a private equity firm, or the previous management team – an MBO. That means if a management team uses financial leverage, such as a business loan, to purchase a majority stake in a business, they perform a leveraged buyout.
The management buyout process will differ from business to business depending on the size, acquisition deadline, complexity and the number of external advisors involved at any given time. However, there are a few more generic steps of the MBO process that every business, regardless of their sector or size, will take. Some of these are:
The most obvious first step of the MBO process is understanding if the option is even viable. Founders or majority stakeholders looking to exit a business may have many different routes available, of which a management buyout is just one.
If you’re a founder planning your succession route, you’ll first want to understand whether your management team is interested in becoming owners. Secondly, you’ll need to discover how experienced and aligned they are with the vision for your business’ future. It’s common for founders to initiate the MBO process years before their exit date, investing time into training and observing their management team before passing on the torch.
If you’re a member of a management team looking for a buyout opportunity, you’ll need to be fully aligned with your colleagues and have a robust strategy and rationale for your buyout, including how you’ll finance the MBO.
Due diligence is a critical piece of the MBO puzzle, and it’s an extensive process undertaken by all parties on the purchasing side. Before structuring a deal, the management team must conduct their own due diligence to fully understand how the business operates and gain confidence and certainty that the company they are buying is exactly what they think it is – warts and all.
Once the management team has carefully considered all areas of the business it intends to buy, and is confident with its findings, it can continue structuring a deal, as the report results will impact the sale price and negotiations.
After management has done its due diligence, it’s time for finance providers, investors and private equity sponsors to start theirs. This will include commercial and legal due diligence, market research, and an accountant report.
Determining how much a private company is worth can be tricky, as it’s not an exact science. Unlike public companies with stock prices and shares, private businesses do not list their stock prices on the market.
Additionally, they don’t have the same reporting standards as publicly-listed businesses, so they’re less standardised and must be interpreted in their own terms. Standard valuation methods include: company comparable multiples, transaction multiples, discounted cash flow (DCF) and net asset valuations.
Typically, the management team and any external sponsors will create a special-purpose vehicle (SPV) known as the holding company or ‘Newco’. The ‘Newco’ business receives the down payment from the MBO team, the equity financing from the private investors, debt financing from the senior lender and the mezzanine financing from the secondary lender. All funds and legal contracts run through the holding company, which is used as an acquisition vehicle to purchase the target business.
Well before a valuation has been placed on the business, the team buying out the company will need to weigh up their financing options. An MBO is rarely financed with one source of capital. Usually, it’s a mix of senior and mezzanine debt, as well as institutional equity from venture capitalists or private firms sponsoring the deal.
Financing an MBO is not just about having enough funds to cover the purchase cost, though; it’s about having suitable liquidity to support the long-term strategy for the business once the ink has dried. This means having enough financing to cover the legal and transaction costs of the deal, the capital and operational expenditure to run the business smoothly, and the funds to cover any existing debt being taken on.
At OakNorth, we provide senior debt finance in days and weeks rather than months by traditional lenders. We work closely with private equity firms, sponsors, and business owners looking for experienced advisors and legal teams that understand complex and specialist needs.
Warranties are a critical part of the MBO legal process and paramount to the success of any acquisition, but often they’re the most contentious part of a management buyout. Warranties are put in place to protect the buyer (Newco) if false statements about the target business could damage its value or share price.
Given that the management team buying the target business should have been very closely involved in running the business, some sellers would argue that warranties are unnecessary. Despite this, it’s prudent for buyers to seek a warranty to cover areas of the business they may have had no involvement.
This is the final step of the acquisition process and involves exchanging contracts. The MBO becomes a legal commitment between the Newco business and the seller at this stage. Once contracts are agreed and signed, the deal will move to completion.
As mentioned, an MBO is a type of leveraged buyout, which means, in most cases, the primary funding source comes from senior debt – aka a business loan. Secondary sources of finance usually come via private investment – in return for business equity, and mezzanine finance, also known as secondary or subordinate debt. Each source of financing has its advantages and disadvantages and is used for different scenarios. Here’s a brief breakdown of each:
Debt finance, known as senior debt or a business loan, is the cheapest source of capital and is often the preferred method of financing for an MBO. Banks or alternative lenders typically provide senior debt financing and it can be short or long-term and secured or unsecured. The borrower receives an agreed amount for the MBO or any capital expenditure needed to keep the business operational. The lender will expect to receive this amount paid back over a selected time frame with added interest. The business’ assets and cash flow secure the loan along with personal guarantees.
As debt finance is a type of business loan, whereby a company borrows capital and pays it back with added fees and interest, there are risks. Management teams and businesses should only take on debt financing if they’re confident that they can make the repayments. If they’re unable to, lenders can recuperate the money by other means – usually by seizing assets.
At OakNorth, we provide specialist debt financing for corporate transactions like management buyouts. Unlike high street banks, we’re founded, and still run by entrepreneurs, who have exited their own company previously. We know firsthand the barriers that business owners, investors and management teams face during the acquisition process. Get in touch today to find out how we can support you with your own buyout.
Mezzanine finance, or secondary or subordinate debt, is a secondary business loan that ranks below senior debt. This, therefore, makes it riskier for the lender, as a first charge does not secure the loan. The added risk makes the capital more expensive for the borrower, so it’s typically a smaller amount over a shorter time to bridge a financial gap. In our complete guide to mezzanine financing, you can learn more about subordinate debt and how OakNorth works closely with secondary lenders to help you get the funding you need for your MBO.
The management team and external backers will provide capital to finance an MBO in return for equity in the target business. External money is usually raised from private equity (PE) firms, who will provide funding in return for equity shares, board seats and dividends in the target business. Private equity firms are looking to invest in already profitable, well-established companies that can generate high returns when they exit the business – typically in three to four years.
While private equity financing is common for management buyouts, it doesn’t mean it always goes well. If management teams and investors don’t share the right synergy, they could end up losing control of their own vision. Private investors also hold significant stakes in the target business, and investors are rewarded with performance-based compensation, which naturally eats into the company’s, and management team’s profits.
Management buyouts are a compelling choice for both the buyer and the seller. Founders or owners looking to exit a business to retire, or move on to new ventures can preserve the legacy of the company they grew from the ground up, leaving it to a team of people they know and trust. At the same time, management teams can take the helm and capitalise on the hard work they’re already doing by taking a controlling stake in the business. But these aren’t the only advantages of an MBO. Others may include:
A successful acquisition minimises disruption to the target business’ employees, values and culture, customers, and operations. The management team is already responsible for success in those areas, so they’ll unlikely want to do a complete 180. Experienced leadership teams will already know which areas need transitioning.
While management buyouts aren’t without their complexity, and have their own unique challenges, they’re usually still seen as an easier route than an external trade sale. This is because external third-party buyers have a lot more to learn about the business they’re buying. Given the perceived risks that come with a trade sale, the timeline for the signed deal can be lengthy, with critical factors such as due diligence, legal and regulatory checks and warranties taking the bulk of the time.
An acquisition takes months, so the chances of confidential information leaking to external sources – like the press, or employees are high. If employees hear whispers about a buyout, they can get anxious about the future of their role and may start to look for new opportunities before any official announcement. Additionally, if news of a buyout becomes public, it can attract attention from rival bidders, or the business’ direct competitors and suppliers. This news could destabilise the market and any valuation. With an MBO, although information can still get out, it is less likely given that those directly involved in the process are already internal team members.
Familiarity is critical for employees’ stability, performance, and peace of mind. MBOs often provide a level of consistency that external trade sales do not, improving overall morale. If employees know that the new owners are the same people that created the growth, culture and values they have come to know and love, then the takeover becomes a positive and not something to fear.
Additionally, there is less risk of top talent fleeing if new career pathways open due to management moving into new roles. And, because the management team has a developed understanding of the business, it’s more likely to focus on maintaining stability and creating growth – rather than cutting down on costs and creating efficiencies. However, this isn’t always the case.
Founders invest a lot in the culture of their business. When they’ve spent their whole life creating something successful, it’s undoubtedly hard to let go and step away from the empire they built. If they’ve done an excellent job in their leadership, the management team they sell to will want to continue their legacy and uphold the culture they created. And if founders sell to management, although they’re no longer the owner of the business, they can still often step into non-executive advisory roles if they wish to stay part of the business.
Management teams are experienced individuals putting themselves forward to become entrepreneurs and business owners. Unfortunately, this means they don’t have the same access to financing as industry titans – businesses or private investment firms with liquidity set aside specifically for strategic acquisitions.
Management teams can access debt finance from banks like OakNorth, or alternative lenders, under their new holding company, but the amount they can access has limits. This often means it’s easier for outsiders to outbid the management team. But, if founders value the other benefits of an internal acquisition over the final sale price, they’ll be willing to accept a lower offer.
Many factors come into play when it comes to financing an acquisition. But, management buyouts are different in that they involve a new group of individuals coming together to start their own business. While this can be a great strategic move, it doesn’t come without risks, and lenders will want to understand where these risks lie and how much security they have against them.
If a lender doesn’t feel like the management team has the right experience or strategic vision for the business to remain stable and grow its revenue, it’s highly unlikely they’ll finance the deal.
At OakNorth, we’re always keen to help business owners find the right succession plan and new teams take the driving seat successfully and seamlessly. When assessing an MBO, we look for a thorough and viable business plan that pinpoints growth projections, expansion plans, and risk areas. We’ll also evaluate the management team’s experience, credibility, and other business factors such as cash flow, revenue and earnings before interest, tax, depreciation and amortisation (EBITDA).
Both outside investors and lenders will want to know with certainty that the management team is fully committed to making the business a success for the long haul. One way they can prove this is by putting in their equity; the other is by agreeing to a personal guarantee with a lender to secure debt. This means that if, for whatever reason, the business does not continue its success and the loan cannot be repaid, the lender has the right to recuperate any losses through the individual.
Usually, MBOs are backed by sponsors such as private investors. These investors are critical in financing the acquisition, but depending on how much capital they put down, they may become more than just a silent partner. When selecting who to work with, management teams need to be very careful that their goals and ambitions align with those of their investors. Not only is this important for safeguarding success, but it will be apparent to banks and lenders if there is a need for more unity and direction within the business, hindering their chance of securing debt.
The tax implications of a management buyout vary depending on who you are and the structure of the acquisition. Here are a few to consider, but your professional tax advisor will be able to give you specifics on your case.
Capital Gains is a UK taxation on the profit you make when you sell an asset. Founders and shareholders are likely to pay at least some capital gains tax when they sell, but relief may be available for business owners.
In some buyouts, the selling shareholders receive earnout payments based on the company’s future performance. These payments are typically subject to individual income tax based on the relevant jurisdiction’s tax laws. The timing and structure of earnout payments can impact the amount of tax, so it’s essential to consult with tax professionals to ensure compliance.
If a management team takes out a business loan to fund the acquisition, the interest payments they make on that loan are tax deductible. The specific tax treatment of financing arrangements can depend on various factors, including the jurisdiction and the terms of the financing.
Despite macroeconomic headwinds and instability, in 2022, UK businesses were still leading in Europe for new business deals and exits. Interestingly, regarding management buyouts specifically, new research shows that economic and political uncertainty can increase the number of MBOs. This is likely because internal management teams have greater insight into their business’s strength than outside buyers, such as private equity (PE) firms.
During instability and unpredictable cycles, private equity firms find it more challenging to forecast accurate financial information, so they typically pull back to ‘wait and see’. But these ‘wait and see’ periods are advantageous for internal buyers – helping them strike while the iron’s hot, with less competition from external purchasers and, therefore, a better final cost.
Yet, despite less competition in the market from external bidders, it’s not always easy for accomplished entrepreneurs to hand over the baton to like-minded management teams during a recession. Many lenders pull back their debt financing options, so finding the right funding partner can be tricky, even for the most experienced teams.
At OakNorth, we understand that economic downturns can create rare growth opportunities for tenacious businesses, which is why we’re committed to financing throughout cycles for both new and existing customers.
In 2022, as other lenders pulled back, we helped two co-founders of BTTC Infrastructure, a management consultancy focused on rail infrastructure projects, exit the business, and pass over their shares to the new management team. The MBO, financed by OakNorth, was a pivotal part of a broader expansion strategy that helped restructure the organisation so they’re set to scale. Listen to Sam Havill, Director of BTTC talk about why he chose to partner with OakNorth.
We also supported specialist engineering firm Clavis IDS with an MBO refinance and some working capital to help them deliver continued growth into new markets and product areas. Hear Clavis’ story from Director, Mark Errington.
If you’re a founder looking to exit your business, or an experienced business leader looking for a fast, flexible, and trusted financing partner to help with a management buyout, get in touch today.