Do I have to put my own money in to fund an MBO?

This guide explains the two typical MBO funding routes, what funders expect you to contribute, why they care about it, and what makes a management team fundable in the first place...

If you are part of a management team looking to buy the business you already know and work in, the honest answer to this question is that it depends entirely on who is funding the overall deal.

Where the seller is funding a large part of the transaction themselves, the amount of your own money at risk can be modest. Where the funding comes from a bank, private equity or high net worth individual, you will almost certainly have to put capital at risk.

We have structured, funded, negotiated and planned the tax and group structures of hundreds of Management Buyouts (MBOs) over many decades. In our experience, management teams who want to buy the business they know and work in through an MBO typically have two routes of funding, where the business has less than £1 million of pre-tax profit. These are.:

Vendor funding
Third Party funding

In both cases, the funder will typically require the MBO team to stand up and act like an owner, rather than an employee, in addition to putting their own cash at risk, but of course the quantum’s will vary depending on the route and circumstances.

This article explains both routes, what funders expect you to contribute, why they care about it, and what makes a management team fundable in the first place.

MBO funding route one: vendor funding from the seller

The first route is the most common route. Here, the seller is friendly, believes fully in the team, understands the team’s business plan, and is willing to fund a significant proportion of the deal through vendor funding, which is where the seller is paid out of future profits.

In those circumstances, the seller normally takes advice from corporate financiers, valuers and lawyers, who will suggest to the seller that they should ask the management team to put in some ‘hurt money’, typically about one times annual salary before tax, raised from savings, friends, family and extending mortgages.

Hurt money: Hurt money is the cash a management team puts into the deal from its own resources, aptly named, as losing it would genuinely hurt. Its purpose is to demonstrate the team has something meaningful to lose if the business does not perform.

In the UK, there are also tax consequences to an MBO. Putting cash at risk through hurt money is often an important contributor to planning the personal tax affairs of the MBO team and accessing capital tax treatment – failing to get this right can lead to challenging tax bills at both the Company level and the individual level.

The quid pro quo of this route is the seller has a disproportionate influence on the terms of the deal, in negotiating valuation and in the structure of protections. Fundamentally, in this route the management team do not put much at risk relative to the second route, and the trade-off they accept in exchange is less control over how the deal is shaped.

MBO funding route two: bank, private equity and external investors

The second route sees third parties fund the deal. This includes banks, private equity and high net worth individuals. These funders absolutely and always do expect to see the management team put in hurt money, and it is nearly impossible to raise funding from strangers without having to put proper capital at risk and showing that the management team are more than employees.

MBOs funded by third parties normally pay the seller faster, and lead to more negotiation pressure on deal terms as third parties are normally experienced and able to push the seller in a way that an MBO team without their own funding struggle to. However, they will also expect the MBO team to put capital at risk and show that they can step up beyond the level of a senior employee and operate as an owner.

That last point is the one that matters most. A stranger funding the deal has no history with you, no view of how you behave when a large customer leaves, and no way of testing your commitment other than what you are prepared to lose.

Why funders reject management teams who offer time instead of money

There is one exchange that ends funding conversations more reliably than any other. It happens as soon as the management team say, “We’re not putting in as much money, maybe only a few thousand pounds each, but we are giving up our time, and we could walk and go and get another job.” This is the fastest way to turn off anyone funding an MBO.

Every employee has the ability to walk away. Every employee has the ability to do other things, and every employee can control what they do with their time.

An ownership mindset seldom allows for this mentality.

In a funder’s eyes – be that the seller who’s taking deferred payment to fund the deal, or a third party – an employee asking to be an owner who is also threatening to walk away or not put in the cash that the funder expects as reasonable leads to mistrust that can be hard to recover without a third party managing the deal.

Putting capital at risk is entirely different in the minds of most funders to putting time at risk. The two are not comparable, and mixing them up can be a clear indication that the management team are not ready to be trusted at the next level. Other solutions such as share options and growth shares are often then part of the solution instead of an MBO.

A recent example of an MBO which could not be funded

The prospective MBO of an engineering company which made sustainable profits of around £400,000 of profit after tax a year shows how quickly the gap opens up. The seller wanted to sell 75% to 100% of the business in order to retire. The management team of three all had similar skills and between them could raise about £50,000.

This level of hurt money was a little low but the seller had sympathy with the position the management team were in. The selling shareholder was unwilling to reduce valuation expectations below the independently valued market price, which was sensible, because pricing below market value would have created a tax risk for the buyers. The seller was willing to fund 40% to 50% of the valuation through deferred consideration and profits, which left the remaining balance to come from a bank. A business plan was drawn up and taken to a selection of banks. Given the historical earnings of the management team and the safe, stable nature of the business, the banks view was that they would effectively be buying the business for the management team as the £50,000 was not sufficient.

That left a clear gap. The management team were not risking enough, and the seller was not willing to lend any more. There are classic bridging tools that corporate finance teams such as Price Bailey use in exactly this circumstance. However, before they could start to be designed tension started rising.

What became clear was:

The MBO team could individually put more money in each, but they didn’t fully trust each other and couldn’t easily be open with one another to sit around a table and agree the Heads of Terms of a Shareholders Agreement between themselves.
The MBO team’s overlapping skills made the bank nervous – all three were ‘do’ers’ and ‘relationship holders’ but not natural work winners or numbers people, and the more the bank got to know the team, the more nervous they were about the success of the business plan.
The MBO team wanted to pre-agree pay rises in the business plan.
Tension started to rise between the selling shareholder and the MBO team over the amount of risk both sides were willing to take.

Ultimately, it was not the business that was the problem, it was the various parties faith in each other.

A professional lender is not going to effectively buy someone’s business for an MBO team in circumstances like the one above.

They will expect changes in personnel, proper advice to be taken at a shareholder level to form the right agreements that set the guardrails for trust, and for capital and time to both be put at risk. In other words, having a stable and profitable business was not enough.

Ultimately, two of the MBO team decided to put their own cash at risk to setup on their own.

In rational terms, this was the right answer. Two did have the right mindset but they were not the two favoured by the seller. The third MBO team member remained and became an options holder. Value was then eroded within the business and the seller was forced to delay retirement.

The 5 fundamentals to get right before valuing your MBO

The scenario above was entirely preventable. However, we find that first time sellers and first time MBO’ers often rush to valuation and funding rather than starting with the fundamentals of :

Do we trust each other really?
Are we actually happy to live with the risks that owners have, or do we prefer to be employees?
Is the upside of buying really worth it compared to setting up on our own?
Do we have an investable and rounded set of skills between us?
Can we keep our cool during a negotiation?

Getting these 5 fundamentals right is critical before you start valuing a business for an MBO.

If the answer is “no” or “maybe” to some of these questions then there are many other options available to create hybrid equity incentives including an Employee Ownership Trust (EOT), a hybrid EOT with an embedded Enterprise Management Incentive (EMI) scheme, or a trade sale with growth shares for the senior managers.

How to test whether your MBO funding route is realistic?

Engaging a corporate financier such as Price Bailey early puts someone experienced across both sides, getting to know the seller and the management team, how each of them thinks, and whether either funding route is realistic. If neither is, it is far better to know that now than after several months spent selling the business to a management team backed by a funding partner who was always going to withdraw.

Reaching this point within a few weeks or a month, rather than three or four months, matters more than most teams appreciate, as when an MBO fails after several months it can be hard to go back to the original position of shareholder and staff.

What happens if the management team cannot raise the money?

A classic and common answer from management teams is, “I can’t raise the money.”

Funders want to see management teams fight for it, whether that means friends, family, small loans or savings, because the effort itself is part of what they are assessing.

They might even ask for a statement of assets and liabilities to see what you can borrow against, or what you can draw from in terms of pools of savings. That request sounds intrusive, but it is standard for any lender, and refusing to engage typically tells a funder what they need to know.

It is worth noting that it’s rare to see a personal guarantee that puts someone’s house at risk.

The top five characteristics of a fundable MBO team

Whichever route applies, funders assess the team before they assess the numbers. The teams we see that are successfully funded tend to share five characteristics.:

They understand the business from multiple perspectives, including winning work, delivering profits, and understanding the numbers and the accounts.
They have all been in the business for a minimum of a year, ideally three or more years, and they are all employees rather than contractors.
They have a plan for growth which shows they can grow profits enough to cover the cost of financing with headroom on top. If team members want to be paid more, that increase needs to come out of growth, which means the financing is paid off more quickly and profits after tax can be distributed or reinvested in faster growth.
They think like owners rather than employees, which means accepting that their earnings go to the back of the queue and that most owners have their own capital at risk. Both points need to be understood as a genuinely riskier environment in which you might not earn more in the short term.
They hold the key relationships with customers, suppliers and staff, so that when push comes to shove, the person those people would phone is a member of the management team rather than an exiting shareholder.

How can Price Bailey help?

If you are considering an MBO, either as a seller or as part of the management team, the most useful conversation is the early one about which funding route is realistic and what each side would need to put in. At Price Bailey, our Corporate Finance team works with both sides of MBOs to establish that quickly – well before months of negotiation are spent on a structure which was never going to complete. You can contact us using the form below for a free initial call.

We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information on this page is intended as a general guide only. While we work to keep our content accurate and up to date, we cannot guarantee that it reflects the position at the time you are reading it. No responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm. For more information on our editorial process, click here.

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