Management Buyouts are one of the most attractive methods by which managers can accumulate substantial wealth.
Without a buyout, management will continue to increase shareholder value for which they may hold little or no equity, and thus not participate in the enormous wealth creation for which they are substantially responsible. However, Management Buyouts are a type of transaction that few managers have any experience or knowledge of. Fortunately, there are advisors and attorneys that are experienced, and funding sources that seek out such investment opportunities.
The Risks of Management Buyouts and your Current Employer
One note of caution: Once a manager or management group embarks on this course, once they announce their intentions to the shareholders or board of directors, their motives and their dedication to operating the business may be questioned. They may believe that such action my management, no matter how presented, could trigger a disruption within the company and be picked up by the rank and file employees and possibly customers and distributors. Therefore, once management has decided to embark on this path, it should have a strategy in place, a timetable in which to attempt to complete the purchase, proposed terms developed and possible sources of funding already in mind.
Consider this situation. The 45-year-old manager of a division of a large company, or the CEO of a mid-size privately held company has run the business for the past 6 or 7 years, delivering growing revenue and profits year after year, and has built a strong team underneath him or her. (I will use the male gender hereafter for ease of writing, with no slight intended to female executives, a number of which I have assisted and funded over the years and hold great respect for).
One morning, while driving to the office, the thought suddenly occurs to the CEO that if the business were sold today, the shareholders would benefit very nicely but he might only receive a bonus, a one-year employment agreement with the new owners, and payment for the small stake that he might hold in the business, but not much more. He might receive a low six figure bonus for facilitating the sale. And what would life be like reporting to a large corporate owner? Possibly the business would be relocated and consolidated within a larger and similar business. That would require relocating his family to some unfamiliar city. Or perhaps the acquirer is known to the CEO and it’s a fine organization. Still, integrating within an established company hierarchy and now competing with other executives who have been there for years, is a risky career option. This is why most CEO’s leave the company as soon as their employment agreement expires.
If the buyer is a large corporation, there is a high likelihood that the business will be consolidated into an existing division of the buyer, in part to achieve those very economies that justified paying an excessive premium that was required to win the auction that the investment banking firm held to sell the division or company. In a matter of months, this could end what seemed like the perfect job as CEO of an operation he was largely responsible for building where he enjoyed excellent pay, bonuses and other perks. How could this have happened so quickly? And how dramatically did life change. And would the option of a Management Buyout have been feasible? He will never know unless that option is explored.
Part of the dilemma is the lack of control that professional managers have over the destiny of the business they manage. Their achievement in having built the business also created the high valuation that caused the owners to decide to monetize it through a sale. The investment banking community is always eager to assist in that process by encouraging the owners to sell the company and convert their illiquid holdings into cash . . . and earn a substantial investment banking fee for doing so.
The process of selling a company, once begun, is almost impossible to stop. Once the bankers been invited to visit, they will pull out their slide decks which illustrate and convincingly show that a high price can be achieved based on comparable transactions. By then the decision shifts from whether or not to sell, to which banker should be given the sales mandate. That begins the slippery slide down the path that almost ensures that the company will be sold within 6-9 months. That is a very demanding and distracting process which the CEO is charged with managing. That involves meeting with the many prospective buyers that will be paraded through the company, countless meetings with attorneys, accountants, and consultants that specialize in your industry. What had been a comfortable 8-hour work day now becomes a 12-14 hour day to ensure that the business is managed while satisfying the many requests from the investment banker, financing sources, as well as prospective buyers and their advisors.
And then it suddenly ends. But not before weeks of last minute informational requests and changes in the terms of agreement, all accomplished through many late-night sessions, missed weekends, and family events that had to be put off or missed. Following the closing, the transition begins during which changes are announced, and the buyer lays out the firm’s new strategy. Often it’s not what you had been suggesting to them – but one which they had in mind long before they began the acquisition process, but it’s not your strategy. Even if the acquiring company doesn’t immediately announce changes, they will do so eventually and you will discover why the majority of CEO’s leave the company, often before their employment agreement has expired. It’s just not the same business any longer.
One firm that did it right was Equifax, Inc. While working for them as the head of their research division, I identified an acquisition of a terrific company in California which I helped negotiate the purchase of. Following the purchase the Senior VP to whom the newly acquired company was to report to called me and thanked me for the excellent job that I and my team had done. I said, ‘Thank you, John, I appreciate your calling to say that. In fact, I’ll be going out there next week to help them put together their strategic plan going forward.” John replied, “No, Andy, you won’t be going out there. In fact, no one from Corporate will be setting foot in the Company; not the benefits people (who couldn’t wait to squeeze their generous benefits plan down to corporate standards), not the finance people, not even the CEO of Equifax. Just me . . . I will be the only permitted to visit for the first 12 months. No one else, including you, may communicate with them.”
So, for a year I had no communications with the newly acquired company. But then I did call the CEO who exclaimed, “Andy! Good to hear from you. Where have you been? By the way, these guys at Equifax are the greatest. They never bother us, and John has been great to work with.”
What a brilliant post-acquisition assimilation strategy! Unfortunately, this story is the exception, as most acquirers cannot resist the temptation to tamper with their newly acquired business and ‘improve it.’ In fact, multiple studies have indicated that 70% of all acquisitions fail or underperform . . . not due to missed forecasts or structural difficulties, but due to management issues such as the loss of key managers or the introduction of new managers into the business who were unfamiliar with the business, the culture, and the personnel.
A management buyout can avoid this and realize for the management team the financial benefits that will otherwise accrue to the new corporate owners. A management buyout can reward those who have been responsible for the Company’s success thus far, not by depriving the current shareholders of the full value they are entitled to, but by structuring a buyout that pays the selling shareholders what they are entitled to, while incentivizing and rewarding managers/owners going forward.
The Right Steps to Completing a Successful Management Buyout
How is a management buyout accomplished? Through a multistep process that focuses on careful planning that should begin before presenting your proposal to the shareholders or corporate owner.
1. Assess the likelihood and willingness of the existing owners to consider a management buyout. This is delicate subject to raise that will forever change your relationship with those having the power to approve or disapprove a buyout. Once you reveal your intentions, they may not be well received. How you communicate this will vary widely depending on your relationship with the owners or parent company executives, and their perception of you and your value to the company, as well as their appetite for selling the business at this time. So, defer raising the topic until you’ve taken the following steps.
2. Conduct a feasibility study. Before going into any detail with the owners or parent company executives, find out whether the business can attract the financing required and generate sufficient earnings to pay off the debt and generate the return investors will seek. The next three steps describe how this should be done.
3. Engage an Advisor. Preferably this should be a professional who truly believes in the concept of management buyouts, and puts long term ownership ahead of short term fee generation. Otherwise you may be engaging a wolf in sheep’s clothing, i.e. an investment banker who professes to support a management buyout but will cut and run the moment the buyout looks difficult, and advocate to the owners that they sell the company instead to the highest bidder. His loyalty must therefore be to management who are seeking to do a buyout, and contractually engaged by management, not the company. Therefore, the Advisor should be more of a consultant than an investment banker in his orientation and approach.
4. Financially model the buyout. This can be done in two stages and is generally performed by the Advisor. However, if the CFO is to be part of the management buyout, then he should take on much of this responsibility, with guidance from the Advisor.
First, a build a financial model must be built that looks at the business at a high level, to determine the feasibility of a buyout. This requires a 5-year forecast of sales and earnings (EBITDA) provided by management, preferably prepared in two scenarios: a base case and an aggressive case. The Advisor will then add sheets or modules that layer in the various debt and equity securities that will be needed to finance the buyout. These modules will calculate the return on investment and cash on cash return which each security will receive.
If the forecasted return on investment for each security are insufficient to support the transaction terms likely to be required to successfully buy the company or division, then the management buyout will not succeed. The price likely to be deemed fair and acceptable will not be supportable and you should not proceed, unless it is an underperforming company. In that instance, an alternative set of terms could be structured in which management will ‘earn’ a significant equity stake in the business if certain financial goals are achieved. This too, needs to be done carefully as you do not want to commit to goals that are unreasonably high and unattainable. You may want to structure an option to purchase the remaining stock at a set price or multiple, if certain goals are achieved.
The financial model should show the maximum price you can offer without incurring excessive risk to the business and to the managers participating in the buyout. At the conclusion of this step, the first decision to proceed or not to proceed will have been reached.
5. Develop the strategy needed to accomplish the buyout. This begins with how to approach the current corporate owner or shareholders. You need to profile what you believe they are looking for, strategically regarding retaining the business, and financially, that is, what valuation should they reasonably expect.
Valuing the Business
You probably have some idea already what the business is worth, having followed the activity of other companies in your industry that have been bought or sold. Finding out the price and terms of those businesses may not be easy as they may not have been publicly disclosed. Even if they were, they might not be truly comparable to your business. An underperforming business might have been sold for what seems like a high multiple of earnings or EBITDA, but their low earnings distorts that ration. Or businesses sold may not be truly comparable and have product mixes that are different, or may be much larger, in which case their size alone usually justifies a higher multiple.
You can engage a valuation firm however a competent advisor should be able to do a sufficient job to help you value the business. That valuation needs to be examined in light of what the financial model justifies what you could afford to pay for and finance the acquisition.
Structuring the Terms to Offer
There are financial elements that could also encourage the owners to sell, such as offering the opportunity to retain an equity interest in the business. This serves two purpose:
The financial model can show how retention of an equity stake could provide the sellers with an additional return. This could help close the gap between what price they might seek versus what you can comfortably offer.
Non-Financial Elements that could Influence the Sale
There are other non-financial elements that could influence or persuade the shareholders or corporate owner to sell. For example, if there is any chance that a sale of the business could lead to its relocation, and the loss of jobs locally, you might contact local, state or federal government officials and agencies who could bring pressure to retain the business locally and see it retained in ‘friendly’ hands. They could apply pressure that could favor your proposed buyout as opposed to an outright sale to some distant and dispassionate buyer.
The Strength and Commitment of the Buyout Team
You should also assess the strength and fortitude of those managers who will be participating in the management buyout. Do they understand the career and financial risks because if they do not, their resolve may weaken midstream? Are their families willing to support them for what is going to be a challenging 2 or year period? Are they able to accept the discomfort of owing a substantial amount of debt and possibly having to personally guarantee a portion of that debt or offer other pledges or guarantees? And finally, do those managers leading the buyout have the ability to think like owners and not as employee-managers? These should be considered as you decide who to invite into the management buyout group.
Structuring the Buyout Group
You might be better having two or perhaps three levels of participation in the buyout, for example:
There are often vesting rights to the shares or options so that if someone leaves before they are fully vested, they may not receive their full allotment. In some instances, stock options must be exercised and paid for if the employee leaves the company or they expire.
Hereafter, this paper focuses on the involvement of the first level.
Finally, once the financial model is complete and the strategy has been set forth, everyone in the first level of participation must sign on and confirm that they appreciate the magnitude of the commitment being asked of them and their families, and not just be influenced by the financial rewards that they may realize from a successfully executed management buyout.
6. Approach the Corporate owners or shareholders. This should be done early in the process so as not to waste time or money, and to determine their receptivity to a management buyout. You may be doing them a favor by saving them the cost and distraction of engaging an investment banker for a process that will last 6-9 months to sell the business, not to mention the huge distraction to management and the business in general. Alternatively, they may tell you that they have no interest in selling the business. So, find out early.
But do not approach management of the parent company or key shareholders before completing steps 1-5, because once you’ve tipped your hand, they will want to know what your intentions are, and how carefully you’ve thought it out. They will almost immediately ask what price you have in mind as well as whether you have the financial means or funding sources identified to meet their price expectations, whatever they subsequently are. You need to answer their questions confidently but not necessarily in detail.
However, by raising the buyout question you may cause them to consider the value of the business. They may feel it necessary to engage an investment banker undertake an assessment of its value which might result in a price that exceeds what a management buyout could support. That’s an unavoidable risk. They have a fiduciary obligation to the other shareholders to have some basis for evaluating your proposal when it is received.
At this first meeting, you might tell them that you would like to invite them to retain some ownership, not only because it makes it easier to structure a transaction, but it would give them a second opportunity to earn a good return on their investment as they would be participating on the best terms as investors that will be backing you.
Finally, they will ask you when you intend to submit a proposal. You should say, ‘soon’, adding that it will be contingent upon securing the required financing commitments which you and your advisor reasonably believe will be obtained.
Tell them that you’ll prepare a written proposal and should have it ready within 2-4 weeks. But before ending this conversation, probe for what their fixed requirements are. For example, if they must have ‘all cash’, that is important to know so you don’t prepare a proposal that depends on payment that includes a note or shares of stock as part of the consideration. Or they might say that they must retain a board seat. Or that a transaction must not be overleveraged, i.e. with too much debt and too little equity. Or they may say, “Just bring us an offer.”
Ask for a designated point of contact with whom you can communicate, and suggest that all such communications should occur confidentially, off premises, so that there is no disruption to the day to day management of the business.
Finally, indicate that in no way will this affect the way you intend to manage the business during the negotiations, or afterwards in the event that this does not result in a sale. Profess your loyalty to the firm and to fulfilling your responsibilities as CEO.
7. Prepare a Buyout Proposal. Working with your advisor, prepare a proposal. Consider what terms of sale they are likely to favor, not just what ideal terms you’d like to propose. Otherwise you may have your proposal rejected out of hand. If your proposal is too far from the mark, they will feel insulted and may contemplate whether you can be trusted to continue to run the business now that your true intentions are known. So, your proposal must be balanced and indicate some flexibility to avoid being rejected out of hand.
Hereafter, you will be expected to perform a balancing act, continuing to work on behalf of the business while quietly working to structure a management buyout. During any interaction you have with them you must show a continuing commitment to running the business as though there are no side discussions about your buying the business. They must see you still as the trusted and competent CEO who is managing the business on their behalf.
The goal is to prepare and have them execute a Letter of Intent (LOI) which details the purchase price, financial terms, and other material conditions of sale, with a 90-120 day period during which you have exclusivity to close the buyout. This should contain language that prohibits them from negotiating with anyone else or engaging an investment banker to sell the business.
Instead of an LOI you might go directly to a Purchase and Sales Agreement, however we recommend that you do not do this. Instead, a comprehensive LOI can be prepared and executed within 1-2 weeks so that you can move forward with the search for funding. It is better to build momentum starting with a positive step by executing an LOI and locking up the deal under exclusivity so that you can confidently raise the funding. Concurrently the attorneys can draft the definitive purchase and sales agreement which will take time and a lot of negotiating back and forth.
One suggestion: Whenever possible, the principals should always negotiate the key points, and not leave this to the attorneys. This will keep legal costs down as well as avoid tension and stubbornness that often develops when lawyers supplant the principals in the negotiating process.
8. Raise the Financing. Your advisor should by now have already canvased several funding sources on a preliminary basis to determine their interest. There typically are multiple types of securities which may be used:
The goal is to achieve a balance of debt and equity which:
The use of debt over equity can achieve both goals however excessive debt can impact cash flow. This is where the forecasting model becomes an essential planning tool to balancing a firm’s debt and equity structure. Too much debt may result in too high a debt coverage ratio, which is a ratio that senior and mezzanine lenders focus on. When it is too high, they see the possibility that the Company could experience a liquidity problem or that its expansion and growth plans could be constrained by a cash shortage. Very few companies actually achieve the forecast they present to lenders and investors which is often optimistic and presumes that there will be no recession. So, it is important to use the conservative or base case forecast to structure the financing to ensure that there will be sufficient working capital to fund growth while meeting anticipated capital investment needs in a growth or a recessionary economy.
Often heard is the phrase, “You can never raise enough cash!” Yet the reluctance to dilute ownership and then overleverage the Company can lead to a liquidity crisis. One strategy some firms take is to raise money from high net worth investors who may be eager to enjoy the high returns that accompany private equity investing. When the business experiences a cash shortfall and needs to raise cash, as often occurs when the economy is in recession or the Company has had a weak quarter or two, the high net worth investors are also feeling the effects of a recession or fear that the Company may be in an irreversible decline. They often balk at investing another 20-30% of their original investment.
One way to pressure them to participate is to do a ‘rights offering’ in which they must ‘pay or play.’ If they participate on a pro-rata basis to their original investment, they maintain their equity percentage. If they do not agree to participate, their ownership will be diluted, sometimes rather deeply to encourage them to participate.
Institutional investors however are much more likely to provide the needed capital to ensure that the Company remains in business and maintains its momentum. But capital raised in difficult times comes at a cost, usually at a lower valuation if it is equity, or a higher interest rate if it is in the form of mezzanine debt. There may be other terms imposed such as requiring that they be given an additional board seat, certain approval rights regarding expenditures, hires, etc., and in dire circumstances they may seek a controlling interest or vote on the Company’s board. They also may require that the CEO be replaced by someone of their choosing. So, be careful about who you you’re your advisor invites to provide the financing.
9. Closing the Transaction. The events leading up to the closing are feverish, and are orchestrated and led by the attorneys on both sides. You need to remain closely involved and read all the agreements, making sure that they comply with the terms of the LOI.
Today most closings take place electronically with everyone working from their respective offices, with lots of last minute phone calls and exchanges of revised documents. Where possible, depending on the location of the parties, I recommend that the closing be physically held at one of the attorney’s offices, with the key members of the buyout present as well as the key executive representing the selling company or selling shareholders. There will be last minute items to be negotiated, and doing so remotely often leads to posturing whereas if done ‘in person’, the parties can see one another, work out issues as they come up while the attorneys type up revisions, and the principals are motivated to ‘get the closing over with.’ It also leads to a celebratory handshake or a toast, that is memorable, and leaves everyone with a sense of accomplishment of a ‘deal well done.’
I once had a closing scheduled with a company we were funding and the attorneys were feverishly working on the closing documents. The CEO called and asked if everything was in order so the closing could occur that afternoon as scheduled, at our attorney’s office. “No, I said, we can’t close.” I said, inwardly smiling. She said, somewhat alarmed, “Why not? Isn’t everything ready?” I replied, “Yes, except for one thing. We haven’t ‘broken bread’ yet and I have a requirement that I must have a meal with whomever we are financing.” She exclaimed, “Oh my God, Andy! Alright, let’s meet downtown in an hour, and have whatever they may still be serving at 2 pm, and then walk over to the attorney’s office.” I said, “Fine, that suits me!” So, we met, had coffee and dessert, and closed on the financing an hour later. Ten years later we still stay in touch, and I recently have been advising her on her next venture.
Back at the Company following the closing, it should be ‘business as usual’ as flaunting it in front of the rest of the management team or employees will likely breed resentment and envy. Any celebration among the new manager/owners should occur privately among the participants over dinner with spouses.
However, it should be announced discretely and promptly, with some statement as to the what changes if any are being contemplated, as everyone will be concerned for their job, their continuing responsibilities, and reporting relationships. You need to address this right away to avoid speculation and if there are going to be changes, make them promptly, having planned them prior to closing.
10. Post-Closing, Back at the Company. The first 90 days are critical. Employees, customers, distributors, bankers, mezzanine lenders and investors will all be looking for changes that confirm that the Company is on a positive course. Everyone is on cue, waiting for the early signs, so take the initiative and communicate to each of your constituents with the appropriate message, and do so periodically thereafter.
11. Strategic Plan. The firm’s strategy should already be in place, either as a continuation of that which the CEO created prior to the management buyout, or that which was developed during the buyout process.
Once the transaction is completed however, the firm’s strategy should be reexamined within a few months of closing, and annually thereafter. Much has been said and written about strategic planning. I have long been an advocate of it, having been educated early in my career by some of the best professionals in the industry. Strategic Planning is a process that takes days to do properly, and years to get ‘right.’ It is best conducted with a facilitator from outside the Company, who can be objective and won’t hesitate to run rough shod over sacred cows that some managers might prefer to keep hidden. It should be accompanied with some outside market data that includes conversations and interviews with key customers and distributors. This last step is most avoided by managers, yet it has been, in my experience, a huge value-add to the process.
Strategic Planning need not be the all-consuming process that it was in its heyday when Boston Consulting Group pioneered its use, but should be a part of the planning process that is customized for your company and then conducted annually. The plan should be highly visual in nature and minus the lengthy written document that were produced in earlier years but are usually forgotten by the following Monday morning and left unread until the following year. The process should involve a cross-section of personnel within the Company.
12. Board of Directors. A board of Directors should be formed that includes a diverse group in addition to the one or two members that the mezzanine or equity providers that have stipulated that they receive as a condition of their financing. I recommend that you have one person from the Company, the CEO, a strong financial executive from outside the Company, and at least one and preferably two sales and marketing executives from outside the Company. If the seller is retaining a significant equity stake or holding a large note, then they may stipulate that they receive a board seat as long as their interest is outstanding. Five to seven board members is optimal.
I recommend monthly meetings for the first 1 or 2 years, and quarterly thereafter. 2 of the 3 meetings in a quarter could be telephonic but the 3rd should require that board members make every effort to attend in person. For the telephonic meetings, I recommend using an online service that includes video so that board members may see one another. This also discourages board members from doing email, muting the microphone and making other phone calls, etc., something we all will admit to being guilty of during voice-only conference calls. Seeing people and having them see you engages everyone in what you are saying and keeps everyone’s attention at a high level.
There are terrific internet conferencing tools available with video, including GoToMeeting, JoinMe and Webex, or even Skype. I’ve used them all, and recommend them in that order. Everyone have the option of voice dial up, which some people like to do if they are traveling. Also, the lag sometimes experienced with voice over the internet can be distracting, so some people prefer to use the dial up voice option while using the internet viewing capability on their screen.
The ‘care and feeding’ of the board is an essential part of the management process. As the CEO, you should run the meeting, following a prepared slide deck or at least an outline of topics. If you have designated someone else as chairperson other than yourself, their role should be to begin and end meetings, and perhaps deal with matters of order, call votes, etc., following Roberts Rules of Order. But it should be clearly understood that you, the CEO, are running the meeting.
Board meetings all too often are dominated with a review of the past quarter’s financial performance as well as management changes, major new orders, and capital expenditures requiring approval. After 2 or perhaps 3 hours, the board is ready to adjourn for lunch or dinner, just about the time that you are ready to get into the ‘meat’ of what’s happening, and where the Company is headed. The fact is that boards often spend too much time on the financials, and I have seen slide decks that contain 10-20 slides that just address the financials. This is the common language which every board member understands whereas matters of strategy, technology, new product launches, key customers, marketing initiatives, service problems, etc., are company and industry-specific and those may not be familiar or easy to critique. Board members like to critique and it is easy to with the numbers. But coming up to speed on the other aspects of the business requires doing some homework and education.
Hold Topical Board Meetings
Setting a board agenda and covering everything that needs to be covered is challenging, so I suggest the following:
First, move the financial discussion to the last hour of the meeting, or limit it to one hour, but that may be difficult to achieve in practice. Also, only hold summary reviews of the financials at the two telephonic/on-line meetings, and hold an in-depth financial discussion at the in-person meeting, which should be a longer meeting anyway.
Second, invite managers with responsibilities in each area to be discussed to participate and/or be present at the board meeting. The VP of sales should go through a detailed discussion of his department’s initiatives. The VP of manufacturing should do likewise. Finally, the CFO or VP Finance should lead the financial discussion, not the CEO, which allows the CEO to ask intelligent and probing questions even though he may already have the answers. This process of inviting your key executives to present reinforces your ability to delegate authority and your willingness to empower these executives. This gives the board greater confidence that the management team is competent and operates as a team underneath you, and that the company is not being managed by an autocratic CEO.
Third, in addition to having the managers report on their respective areas, select one area of the business that the manager in charge of that area within the Company will deliver a detailed presentation. This should be done at the in-person meeting so that a plant tour, demonstrations, or other exhibits can be used to ‘educate’ board members. This should be a 1-2 hour session, with the executive leading the session inviting some of his team members to present and otherwise participate. All too often board members do not grasp the true nature of the business that the firm is engaged in, or understand the complexities of what the company does. Given the significance of the issues with which boards are required to make decisions, every board member can and should be educated in this manner.
Eventually the Company will encounter problems, challenges, difficulties or whatever, and the board will have to make decisions that will be more wisely reached if they have had first-hand knowledge gained from these ‘educational’ sessions.
One more point. The CEO should establish a key ground rule for board members. All communications with company executives should be through the CEO and not directly with anyone else in the Company without your expressed permission. You should ask for this because any direct communications by a board member undermines your authority. Exceptions might be made for other key members of the buyout management group. Board members should not have a problem with this so long as you are bringing those executives to board meetings with some regularity and encouraging them to remain during lunch so they can interact with board members informally.
13. Planning for the Sale. Isn’t it premature to plan for the sale of the business right after you’ve completed a management buyout? No, it’s not, because your outside equity and mezzanine investors have already thought about it, and planned for it. They are driven to thinking about a liquidity event because the investors in their funds expect a return of their investment. If the funds investing in your company are in their 4th or 5th year since they were raised from their investors, then the fund is already late in its investing cycle, and they will expect the company to seek a buyer within 5 years at most, and probably earlier. They will always have their hand ready to slap the ‘sell’ button. This may be contrary to your thinking as you just completed a very tiring 6-month process to buy the company.
Actually, the time to begin thinking about the sale of the business should begin in steps 4 (Strategy) and 5 (financial Model) because this influences what capital sources you may seek. For example, as noted, most ‘funds’ have a set life during which fund managers seek to liquidate their portfolio. Five years is typical, but funding sources and investors welcome and as you will learn, encourage an earlier exit. But realistically, some firms don’t exit until the 7th, 9th or 15th year. To the investor, that is a disaster as the time value of money erodes their return on investment. A ‘quick flip’ in 2 or 3 years at a good price is desired by most capital providers. Not only do the Fund investors get their investment back sooner, the risk is of a long-term investment is eliminated, and their fund as well as their investors enjoy the return of capital.
If that time horizon of say, 5 years is reached and the CEO and members of the buyout group as well as some of the investors would rather remain in the investment for 7, 10 or even 15 years, that requires quite a different type of investor which the Advisor should be seeking. For example, it might be a more suitable investment by a Family Officer that does not have a specific exit requirement. Or perhaps a Business Development Company that has income as its primary objective, and may be quite happy to remain in the investment for longer than 5 years.
Timing expectations also may influence how the financing is structured. There may be a call provision that permits the Company to buy back the stock at various times, or a put provision that allows the investor to demand that their shares be purchased at various times.
There are other ways to achieve earlier liquidity for capital providers. A new mezzanine fund or private equity investor could be brought in with sufficient capital to take out those investors that wish to exit the investment. Or the firm might undertake a recapitalization of its ownership:
The CEO of a company we had invested in as well as raised money for in the past called me and announced that he had just signed a letter of intent to sell the Company for $42M to a private equity firm. While surprised, this was in his nature to do, and then seek board approval for. However, I was even more surprised at the terms of the LOI which heavily favored the private equity firm. Not unexpectedly, a month later the CEO called and said he had backed out of the deal because he didn’t like the details of the transaction as they were revealed in drafts of the purchase and sales agreement. “What should I tell the other investors and the board, all of whom already have high expectations of receiving a good return on their investment from this sale,” he asked? I replied, “I’ll be out there Monday morning and I’ll work up an alternative structure that involves a leveraged recap.” The following Monday I walked him through an analysis that showed that each investor would receive about half the cash that they would have received from a $42M sale, but a multiple of their original investment, plus they would retain their full ownership percentage in the company. He agreed with this strategy and the Company concluded the recapitalization a couple of months later.
A couple of years later the Company received a $95M offer from another private equity firm, and that transaction closed a few months later. Management is still there and they retained an ongoing stake in the Company in addition to receiving a significant distribution in cash.
In conclusion, a Management Buyout offers those who have invested a great deal of time and ingenuity into building a business with an opportunity to acquire wealth of significant proportions. It is challenging to structure and to negotiate with the current owners, and must be done while remaining mindful of the need to continue to manage the business. However, the benefits are huge and could not be attained while remaining as an employee of the firm. Thousands of firms have been purchased in this manner. With proper planning, sound counsel, and proper matching up with capital sources, perhaps your business can be acquired by you and a select team within your organization.
Written by Andy Clapp
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