Planning, funding and valuing a Management Buyout (MBO)

What is a Management Buyout (MBO)?

In its simplest form, an MBO involves a company’s management team combining resources to acquire all or part of the company they manage. Most of the time, the management team takes full control and ownership, using their expertise to grow the company and drive it forward.

An MBO may offer a vendor an attractive alternative to sale to trade for a variety of reasons; for example, the number of potential trade buyers may be limited, the vendors may be nervous about approaching competitors and disclosing sensitive information, or they may feel strongly that the company and its staff carry on independently in what they believe to be “safe hands”.

In considering an MBO, a number of considerations need to be made, such as the desire, credibility and dedication of the management team buying the company, the availability of finance and whether all parties involved can agree upon the funding mix. If all the boxes can be ticked, the MBO route can provide a vendor with the assurance of their company’s future success and the management team with a significant opportunity to benefit from those successes.

The hallmarks of a business that would facilitate a successful MBO are:

• A company with a good track record of profitability;
• Good future prospects for the company without high-risk factors;
• A strong dedicated management team with a mixture of skills;
• A vendor who is willing to explore a sale to the management team and who will accept a realistic price;
• A deal structure that can be funded and supported by the future cash flows of the company.

Advantages of a MBO

For a company undergoing a change in ownership, the management buyout route offers advantages to all concerned.

Most obviously, it allows for a smooth transition of ownership. In addition, since the new owners know the company, there is a reduced risk of failure going forward. Other employees are less likely to be concerned, and existing clients and trading partners are reassured it will be “business as usual”. Furthermore, the internal changes and transfer of responsibilities between the vendors and management remain confidential, while any due diligence required by funders is often handled quickly.

The strength of the management is a critical factor in contemplating the potential future success of the company. Therefore, any funders pay close attention to the skills, experience, knowledge and credibility of the management team as well as their plans for taking the company forward.  And while the management team can reap the rewards of ownership, they have to make the transition from being employees to owners, which requires an adjustment in mindset from managerial to entrepreneurial, and all parties need to ensure this is a transition that is achievable.

(Potential) Challenges of a MBO

(Potential) Challenges

Management buyouts can be a complex process and there are various potential challenges that need to be considered and, to the extent that they can be ahead of completion, overcome. These challenges include but are not limited to:

1. The suitability of an MBO to the business in question – perhaps most importantly, assessing the suitability of an MBO as the best exit option is a critical step before initiating the process. Suitability will vary depending on the particular circumstance, but typically include the vendor’s price expectations, the business’ continued growth prospects, and the quality and competency of the incoming management team.
2. Suitable management team incentivisation – the management team needs to be motivated and aligned to the goals of the buyout, as their performance and dedication are crucial to the success of the transaction and ongoing growth of the business.
3. The recovery and protection of vendor loans – given the significant role that vendor loans likely play in the financing of an MBO. Negotiating suitable terms, establishing realistic repayment schedules, and ensuring the ongoing cash flow stability of the businesses are crucial to securing the recovery and protection of the vendor’s loan.
4. The reputation and performance of the business post buyout – maintaining and developing the reputation of the business post buyout is critical to sustainable success. A change in ownership and management structure, regardless of the new management team already being known to the business, can create uncertainty among stakeholders – particularly for employees, customers and established suppliers. The management team must be able to demonstrate their ability to continue delivering on quality, meet financial objectives, and manage the concerns of stakeholders in order to ensure a smooth transition and onward long-term growth.

Funding a management buyout

It is rare that a management team will have sufficient funds on their own to buy the company, and so finance is often needed to successfully balance what all parties are trying to achieve.

Typical sources of finance include:

• Asset finance – Funding that enables businesses to leverage against the assets in the company, usually property, stocks or debtors, can be a very viable option to asset-rich businesses considering MBO;
• High street and private debt – in addition to asset finance, banks will often consider providing a cash-flow term loan, repayable over 3-5 years to assist an MBO. Private debt funds have become far more active in the market than high street lenders;
• Private Equity (PE) – PE funds will focus on backing good management teams. If the growth prospects, underlying profits, team and business are strong, then financing an MBO using Private Equity is very realistic. PE funds can provide additional benefits beyond cash to help professionalise a management team, fill holes and expand the business;
• Vendor loan notes – Often, the sellers have to help fund the transition and leave some of their consideration in the company as loan notes to be repaid over time.

Our established relationships across debt and equity providers mean we are then well placed to design MBO structures that work for all parties and introduce and negotiate the right financiers on the right terms to support the next stage of the business’ development.

The tax consequences of a management buyout

Depending on the proposed MBO structure and funding, there can be various different tax consequences that both vendor and the purchasing management team will need to understand and, as required, put in place appropriate solutions for.

Some examples of key variables that may need to be considered are:

• Is the proposed MBO a share or asset purchase?
• Will a NewCo be created for the purposes of the acquisition?
• If so, have they considered the implications of:
  • Business Asset Disposal Relief (BADR, formerly Entrepreneur’s Relief) available to vendors;
  • The EIS, Venture Capital Trust (VCT) eligibility for any Private Equity investment coming in as part of the deal; and,
  • Any potential income tax liabilities for management.
  • Are there any further restructuring requirements that form part of the proposed MBO?
• Is there an earn-out period for the vendors? – How this is structured may have implications for BADR entitlements.
• Is Stamp Duty payable?
• Is any bank interest tax-deductible from the borrowed?
• What are the VAT considerations?
• If external finance is sourced, who is receiving it – NewCo, the target company or individual purchasers?
• What are the expected exit options for the purchasing management team in the future that guarantee they are not liable for income tax?

The earlier you seek tax advice in your MBO process, the better it is, as it avoids undue delays further down the line and minimises potential tax burdens for all involved in the transaction. In addition, we work collaboratively with our tax team to ensure that the consequences of any decisions made as part of the wider transaction are weaved into the entire process and planned accordingly.

Valuation and deal structure

A further key component of an MBO transaction is determining the purchase price and/or valuation of the target business. The typical valuation methodologies for UK companies are also applicable to MBOs. Our team have extensive valuation experience and can provide both sides with a well-researched and evidenced guide to what fair value should be, why, and in what scenarios the buyers can increase the valuation for when they sell in time.

Beyond valuation, it is also important to consider the deal structure in regard to the timing of payments to the seller and if there are any conditions on performance related to subsequent payments.

To support management, we will typically assist them with:

• An outline of the future business plan and forecast
• A detailed understanding of the company financials, including normalised working capital, normalised profit, cash and debt;
• Up to date, fair asset values of any equipment intended to be used in asset finance arrangements;
• Impact of any discounts that may need to be applied;
• The company’s current debt capacity, if further debt is intended to be used as a source of funding; and
• Anything that may impact future growth or free cash flows of the business.

These factors will all be considered when calculating an appropriate valuation for the business. In addition, it will verify the affordability of the intended capital structure for the incumbent management team after the MBO is completed.

The MBO Process

The key steps of a management buyout process include:

1. An initial appraisal of the business at a high level based on understanding the company financials, market, services, people and development prospects;
2. Understanding what the sellers are trying to accomplish and how committed the MBO team are;
3. Assisting the MBO team in the development of their business plan and detailed financial forecast to understand growth, affordability and debt servicing capabilities in detail;
4. Undertaking the valuation and evaluating the ideal deal structure;
5. Detailed financial analysis conducted, including testing the forecast financial model to show the serviceability of debt and returns to potential investors;
6. An evaluation of possible tax consequences is undertaken;
7. Approach to funders, a small buyout may involve just one funder while in the event of larger transactions, several may handle the financing;
8. Offers from financiers come through, and the deal terms are negotiated;
9. The preferred financiers are selected, and due diligence starts;
10. Legal drafting and tax consequences are appraised in detail, including any necessary communications with HMRC;
11. Any issues from Due Diligence are raised and addressed;
12. Completion and change of ownership takes place;
13. We prepare the management team for their first board meeting.

An MBO can take several months, so the vendors and management team must be ready to fully commit to the transaction for that time frame. This can be challenging since the company must be run as normal and kept on track while the transaction is ongoing.