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Management buyout demystified Add to ...

As a generation of baby boomers approaches retirement, buyouts can be expected to grow in popularity as a way for senior managers to acquire the firms where they work.

In their simplest form, management buyouts, or MBOs, see a management team pool resources to acquire all or part of the business they manage. Leveraged management buyouts, or LMBOs, are similar, except the buyers use company assets as collateral to secure financing.

Transactions of this sort typically see management teams take full ownership of a firm, using their expertise to grow the business afterward. Funding usually comes from a mix of personal resources, external financiers and the seller. Internal processes and transfers of responsibilities remain confidential and they are often handled quickly.

Risk is reduced by the fact that continuity of the company's business is better assured when the people who have managed it are its buyers. Since the purchasers are an experienced management team who understand the business and its needs, existing clients and business partners often feel reassured, improving the prospects for a solid return on investment.

Such buyouts are not to be confused with MBIs, or management buy-ins, in which a team of outside managers buys a business, often with financing from private equity investors. Another variation on this theme is the so-called buy-in-management-buyout, or BIMBO, a combined MBO and MBI, in which an external group of managers buys into the business and joins forces with an internal management team.

A number of issues need to be considered when contemplating a management buyout:

  • Be transparent. Approach the company owner with your proposal and ask for permission before disclosing confidential information to financiers.
  • Check the feasibility of the initiative. Be sure the venture is profitable. Keep in mind that management buyouts, whether leveraged or not, require substantial financing that can typically reduce a company's cash flow. Cost cutting, improved productivity or increased revenues may be needed to cover these financing costs. Any thorough financial analysis will uncover figures on cash flow, sales volume, debt capacity and growth potential. These in turn will provide valuable information on the fair market value of the business you are eyeing.
  • Choose your management team well. You will need to put in place people with the right combination of skills to take the company through a transition period and run the business profitably.
  • Establish a fair way to share equity. There should be reasonable incentives for everyone involved in the process.
  • Remain low-key. Keep a low profile until the paperwork is signed. You don't want to reveal your interests to too many potential competitors and instigate an auction that causes the price to rise.
  • Retain good relationships. If your buyout bid fails, you may end up working with the same colleagues in the future.

When power transfers within a company from seller to buyer, both must first agree on a sale price, which is confirmed by a valuation. Managers then assess how many shares they are in a position to purchase immediately and draft a shareholder agreement. Financial institutions are approached, a transition plan is developed that incorporates tax and succession planning, and managers buy out the owner's stake in the business with assistance from the lender. The full transfer of decision-making and ownership powers to the successors can take place gradually, over a period of months or even years. Managers then pay back the financial institution at a time and pace that will not unduly slow the growth of the business.

How to finance an MBO/LMBO

It's critical to develop a strong business plan before making an acquisition of this type. Forecasts should be credible so you and your partners know what you're getting into. Personal and business referrals can help you secure the confidence of bankers. A single institution is usually involved in smaller buyouts while, in larger transactions, several institutions may handle the financing.

In leveraged buyouts, business assets must be evaluated to determine how much equity is available for financing. The lender will then use the assets as collateral, adjusting the interest rate charged based on the risks associated with the transaction.

In some occasions, the financer will ask the sellers to finance a portion of the sale as a way of demonstrating their commitment to the venture and confidence in the management team. It's always worth shopping around for the best terms.

The following are the most common types of financing used, often in combination, in such ventures:

  • Personal funds. These can help secure the confidence of a financial institution, add equity to a transaction and share risk. Managers often have no choice but to invest a substantial amount of their own wealth in such ventures, even refinancing their personal assets, as a way of demonstrating their commitment.
  • Loan or credit notes. When they come from banks, they are often used to purchase shares from an owner. The appeal of this type of financing is in its simplicity: assets are used as collateral, and interest rates are lower as a result.
  • Seller financing. These can set a schedule for payment over period of years and involve credit notes, loans or preferred shares. This reduces demand on cash flow when the transaction occurs. Likewise, an instalment purchase of stock allows sellers to maintain some control over the business until they have been completely paid off.
  • Stock sales to employees. These can help reduce the cost of financing a management buyout while giving employees new productivity incentives as full control over the business shifts to the management team.
  • Subordinate financing These can complement a management team's investment by bringing together features of both debt and equity financing without diluting ownership. If a profitable business maximizes financing for its assets but managers' personal funds are still insufficient for a transaction, subordinate financing can fill the gap. Repayment terms are established at the time of transaction.
  • Venture capital These can provide long-term, unsecured equity financing. This inevitably involves a partnership in which the venture capital group purchases shares in a business in exchange for ownership rights. There is no fixed repayment schedule since capital gains, or increases in the firm's share value, determine when the financing can be paid down. Venture capital investments can provide the new owners with great insight and expertise, but buy-back costs are undetermined at the outset.

Content in this section is provided in partnership with the Business Development Bank of Canada. BDC provides entrepreneurs with financing, venture capital and consulting services. To find out more go to BDC.ca.

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