MBOs & MBIs - MBO Guide
This guide covers some of the fundamental aspects relating to the management, the business and longer term considerations you will need to address.
Is there a strong management team?
Remember the mantra that VCs invest in 3 things: management, management, management.
Who will advise the team?
The choice of corporate finance adviser is key. An accountancy firm that has conducted the company audit for years or who completes tax returns for the prospective CEO is not an appropriate choice. It is vital to get the right corporate finance adviser on board who brings transaction experience and deep knowledge of the funding markets.
How much will the team members be expected to personally invest?
Management will ordinarily own a disproportionate proportion of the business relative to what an incoming investor is paying (formally called the “envy ratio”). As a rule of thumb, management should be expected to invest anywhere from six months to one year’s gross salary to demonstrate commitment and have some ‘skin in the game’.
Are there or what if there are any gaps in the management team?
An incomplete team is not necessarily a hindrance and gaps can generally be plugged. However, a strong leader is essential and funders will want to understand your staffing strategy. In identifying any gaps, consider the impact on the team’s resources of any lost ‘group services’ (accounting and credit control, tax & treasury).
Who will lead the management team and co-ordinate fund raising efforts?
The team should nominate one person to lead the process and negotiations. This is normally but not always the CEO. Whomever is chosen, it is imperative that the other team members believe in that individual’s ability to manage the process thereby affording them the time to focus on the day-job.
Will management be expected to give warranties about the business?
Management is in a privileged position and would be expected to give straightforward assurances about factual matters.
The extent of the warranties given and limits on group and individual’s liability is a matter for discussion and negotiation at the legal stage of the transaction.
Specialist insurance packages are available to cover for warranty claims but the premiums are expensive.
Liability under warranties can be inter-alia ‘joint & several’, ’several’, ‘capped’, subject to de-minimums levels and time dependent. Legal advice should be sought to understand the significance and implications of each.
Will management be expected to give personal guarantees?
Debt and other asset funders might seek more security than is available from company assets and may require the signing of personal guarantees. This adds an extra element of risk to the management team and requires careful consideration. The extent to which these are given are subject to negotiation.
Does the team have a plan?
The business plan is the primary marketing tool of the management team and should reflect the bought-in collective thinking of the group. Whilst it is not imperative to have such a document before speaking to potential advisers, it is important to clarify strategic thinking and to build a case for investment before speaking to potential funders.
The plan itself will typically be a moving document but will ultimately require management to warrant it as part of the legal process.
Any disputes between management or differences of opinion on strategy should be discussed candidly in private. The plan and subsequent presentations should present a unified team, wholly committed to the process and of one voice.
Is the business cash generative and able to support a high level of debt?
MBOs (or leveraged buy-outs in the United States) will typically be financed through a combination of debt and equity. One class of funder is looking for a capital repayment and an income stream whilst the other is looking for capital growth.
Post-completion free cashflow must be sufficient to repay interest and capital to providers of debt and furthermore the company’s earnings (amongst other measures) must be sufficient to satisfy a raft of bank covenants.
Are there assets that loans can be secured against?
From management perspective, debt is cheaper than equity and should be maximised where prudent to do so. Banks and other funders will require security over assets in the event of default or liquidation, so consider the availability of fixed assets, debtors stock and other assets as security.
Highly leveraged or geared situations can have significant implications for earnings consistency (and thus covenants) should top-line earnings fluctuate. This is because fixed debt has to be serviced whatever trading conditions prevail. Failure to meet repayments through poor trading and/or cashflow management will bring about a default position which can cause debt funders to call on early repayment. It is therefore very important that the correct balance of debt and equity is achieved to effect the transaction.
Does the company have a consistent track record of turnover and profit growth and is there scope for further improvement?
Equity funders are looking for those ‘stellar’ companies that will grow substantially and which can be sold over a relatively short time horizon (through secondary buy-out, trade sale, IPO) returning a healthy capital gain to the investor. A company with no vision or growth potential is not an attractive proposition for equity funders.
Past performance is one benchmark of growth capabilities but is ultimately flawed, for as the caveat goes, “past performance is no guarantee of future value”. Funders therefore have to understand what is management’s strategy for controlled & sustained growth.
Is there a good breadth of goods and services sold?
Over dependence on a narrow band of goods and services leaves the company vulnerable to adverse market influences. Demand can be fickle and so it is prudent to have a number of different of product income streams split between existing products, cash cow products, new products, short-term opportunities, longer term contracts etc.
A balanced portfolio approach will help mitigate the risk for external funders.
What is the spread of customers and suppliers?
Whilst it is often easier to sell more to an existing customer than it is to sell to a new customer, care should be taken to reduce any over-reliance on one particular customer or over-exposure to one client in terms of tieing up working capital.
What is the exit strategy for the business and over what timescale is this likely?
- for providers of debt
- for providers of equity
Debt providers are concerned with liquidity and cashflow. Do cashflows support interest and capital repayment over a reasonable term of 5-7 years?
Equity investors in turn need to satisfy their own investors that they can return a profit. They will be looking for management to have considered where an exit is likely to occur. Whilst exit via an IPO is often mentioned, in reality, the likely exit scenario is a trade sale so consider who might buy you, why they might do so and when.
Be mindful that part of an equity funder’s due diligence is to look at the market and corroborate what management is saying. It is therefore not worth stating and is in fact probably damaging to say that Company X is a likely acquirer if they have no history of M&A activity. Funders will not have any confidence in management’s knowledge of the market and key players therein.
Would a secondary buy-out and refinancing in due course accelerate further growth?
The secondary buy-out market is active and offers funders another exit opportunity. Simply put, this is where another equity funder purchases equity in the business from existing investors. To do so however, the business will have to demonstrate sustainable growth potential beyond that already achieved.
To achieve this the company’s current middle managers could be ultimately groomed to succeed the incumbent management team to provide another exit opportunity.
Will the investors force me to seek an exit against management will?
Obviously a forced sale with a de-motivated and uncommitted management team is not in the interests of anybody. It depresses the price or more likely is going to scupper a deal. The legal documentation will contain appropriate ‘drag and tag’, first option and co-sale clauses that should be reviewed carefully in consultation with the legal advisers that govern the exit process.
What happens if I leave the company?
What happens to your shares will be of vital importance to you, the remaining management and the investors. External investors will want to protect their investment and will be reluctant for the shareholder group to become dispersed. If you leave with your equity intact, the available pool of equity to incentivise incoming management will have shrunk and therefore the provisions governing the transfer of shares is of paramount importance to all.
Mechanically what will happen will depend on the ‘good and bad leaver’ provisions in the Articles of Association. These will stipulate what you can and cannot do if you were to leave. This might involve the forfeiture of your shares in the extreme as a bad leaver and payment for your shares as a good leaver. What price is paid or whether you can keep your shares (with subsequent restricted transfers) will depend on the appropriate circumstances of your departure.
In reality, this is an area of key concern to discuss with your advisers and funders.
How does one incentivise the wider management team?
Funders are keen to see key employees tied to the success of the company thereby aligning all interests at senior and other (managerial) levels. It is commonplace for an option pool to be established to broaden management participation. The proportion of shares warehoused for this purpose will be subject to negotiation.
A number of different schemes can be established including tax efficient schemes that should be used wherever possible.
Do you have a willing vendor?
There had better be otherwise nothing will happen!
The Company’s current Articles of Association might help with any dissenting shareholders via drag clauses.
Does the management team have the appropriate authority to pursue an MBO?
Divulging confidential company information to potential funders is prohibited under Company Law and management need to be careful not to compromise their ongoing employment if there is not a willing vendor or not a transaction to be pursued at this time.
The team should work in consultation with their financial advisers to identify if the current owners would accept an approach from a potential acquirer and the most appropriate means of approach.
How will the management team finance their investment?
The major clearing banks can provide packages to help team members raise the necessary funds either through re-mortgages or other (professional) loans.
Under qualifying conditions, the interest on loans for buy-in members might be eligible for income tax deduction.
Does the management team have the appropriate authority to pursue an MBO?
The financial adviser should work in conjunction with management to identify the most appropriate means of approach to the Company. This might be a direct approach to the existing members or board on behalf of an ‘unnamed client’ to test the reaction to a subsequent approach by management. (See Procedural Matters)
Consider which legal counsel will represent the management team?
Remember that the existing lawyer relationship that you might enjoy through the target company is likely to be compromised and that you will have to procure legal advice from another firm.
It is important to instruct lawyers who are well versed in such transactions so that costs are minimised and that you are not paying for anyone’s ‘on-the-job learning’. Experience is key if your best interests are to be safe guarded and the transaction to be expediently completed.
What is ‘Financial Assistance’ in the context of MBOs?
According to Company Law a company is not allowed to give financial assistance to anyone in relation to the purchase of its shares.
Security required by a lender over assets currently owned by the company in order to finance the purchase would ordinarily contravene the Financial Assistance Rules. However, the Directors can make a statutory declaration under well-established ‘white-wash’ procedures to circumvent this problem. This would include a working capital report being conducted by the reporting accountants to the transaction.
What legal documents are involved?
A lot of different documents are required depending on inter-alia the complexity of the deal and the number of funding parties involved. The primary documents of interest to management will include the Shareholders and Subscription Agreement which sets out the basis on which the funders are prepared to invest and the Articles of Association which will govern the extent and range of funders rights and powers and their interaction with the management team.
Your legal adviser should be well versed in this documentation and will be able to advise you what more clearly is involved in any particular transaction.
Will Newco be liable for liabilities on the transfer of existing employment contracts?
Consider TUPE (Transfer of Undertakings (Protection of Employment)) regulations. Unless employment contracts are substantially unchanged, Newco might be liable for redundancy claims.
Now that I own the business, can I pay myself a higher salary?
Management will be taking on increased risks and responsibilities and so can justifiably seek a pay rise as long as levels are realistic for the size, company stage and market. Funders will want to align management interests so that the principal payback to the team will be through realising a capital gain on exit. Funders will not want to and will not tolerate ‘life-style’ businesses where salary levels are completely unrealistic relative to the market.
What are the implications for Newco for the MBO team’s severance of an existing company pension scheme
This is an important area for concern on the demerger from a larger group and management should consult expert advice as early as practicable.
An actuarial adviser should negotiate the target company’s severance from existing schemes, transferring to the new company’s scheme Newco’s share of the pension scheme and any surpluses or identifying under funded pension schemes as a price negotiation point.
Is there any tax relief available for the management team regarding interest on loans taken out to purchase shares?
Appropriate tax planning advice is needed to ensure that the management team takes full advantage of tax efficient schemes where possible. The management team should consider establishing EMI options schemes for senior management and also ensure that business asset taper relief provisions are followed to reduce the effective CGT liability for management to 10% on the ultimate disposal of their shares within 2 years of completion.
It should be possible, providing that certain conditions are met , for MBO team members to claim interest tax relief for interest incurred on borrowings undertaken to provide funds to a company. If the buy - out ventures fails, income tax relief may be available on the loss incurred on the shares of the Newco.
What are the CGT implications of the acquisition of shares by Newco or the transfer assets used in an existing business?
The management team is advised to seek tax advice as soon as practicable to establish what and if any tax liabilities will crystallise from the transaction.
It is also important to understand the CGT implications of a transaction so that any previously undisclosed liabilities are identified and are appropriately used during price negotiations.
Will any tax charge crystallise on the transfer of assets outside an existing group?
Tax charges in respect of past asset transfers within a group made under special elections could crystallise on that asset now leaving the group. A thorough investigation or full audit of the group and company’s tax affairs is needed so to avoid unexpected tax charges stemming from historic tax planning.
Poor planning can frustrate and derail potential transactions. Management should ensure that they concentrate on putting their housekeeping in order before venturing too far down the funding path. Time should be spent identifying potential problems and addressing them. Preparation of a due diligence data-file would be a useful discipline to follow.
Consider implications of and readiness for:
Financial due diligence
Legal due diligence
Tax due diligence
Commercial due diligence