Management Buyout: How They Work and Their Role in Succession Plans
Entrepreneurs must plan not only for the growth of their business but also for what will happen when they want to exit the business.
For some, the transition is easy. A family business might have a team ready to step in and a succession plan outlining their roles when the owner departs.
But for other business owners, there is no heir apparent. When there is no succession plan to guide a company’s future, a management buyout (MBO) is a way to compensate business owners for their work over the years and ensure that the business—and their legacy—lives on.
What Is a Management Buyout?
A management buyout is a business sale transaction where a company’s existing management team members buy the whole business or a majority stake from its owner.
Though multi-million dollar MBOs make headlines, management buyouts are just as common for small businesses. These types of transactions are usually financed with a combination of debt and equity and called leveraged management buyouts (LBOs).
How MBOs Are Used
Because MBOs have advantages for both the potential buyers or the business owner, they can be initiated by either side of the transaction.
A management buyout can be used:
As an Exit Strategy
A small business owner who wants to retire or exit the business but doesn’t have a family member earmarked to take over or a succession plan in place can use a management buyout to transition the business to new ownership.
One example of a successful MBO is Atchafalaya Measurement, Inc., a Louisiana-based oil and gas services company. The owner wanted to retire and didn’t have anyone to take over the business. They hand-selected two senior managers, who partnered with a private equity firm to acquire the business. The well-funded, new generation of leadership was able to install new systems and equipment and expand the company through acquisitions. Five years later, Atchafalaya merged with Southern Petroleum Laboratories, becoming one of the largest providers in the industry.
To Take Public Companies Private
A management buyout is also used to take public companies private and turn them around, usually away from the view of the public and stakeholders.
An example of a successful management buyout used for a turnaround is when Michael Dell, the founder of PC maker Dell, Inc., partnered with a private equity firm to acquire a majority stake in the business. Dell’s PC sales and market share were shrinking, and Michael Dell wanted to remake the company into a player in the enterprise solutions space. The buyout created a private company, and Michael Dell could expand its offerings without needing approval from a board of directors and shareholders. Five years after the buyout, Dell’s value tripled and went public again.
To Spin Off Divisions of a Company Into Separate Businesses
A management buyout can also be used to sell off a business division when a sector no longer aligns with the primary business or there’s greater growth potential in operating the division separately.
For example, managers of the accounting firm PricewaterhouseCoopers partnered with private equity to buy the company’s fintech unit when regulatory agencies rang alarm bells that the business posed a conflict of interest with PricewaterhouseCoopers’s main auditing business.
Advantages of MBOs for Small Businesses
MBOs are generally less risky sale transactions for both the buyer and seller of the business.
- In addition to allowing the existing business owner to exit the day-to-day management of the business and receive a cash payout for their hard work, an MBO is usually a less disruptive transaction than selling to an outside third party.
- The business owner, employees, and other stakeholders already know the management team, so the transition is smoother. These transactions typically take less time than selling to an outside party.
- Because negotiations remain limited to the existing players, there’s less risk that confidential information will be exposed to outsiders during the sale process.
- An MBO usually gives the existing owner peace of mind that the new management team knows how to run the business successfully.
- An MBO is less risky for the buyers. They already have a solid understanding of the business and can hit the ground running.
- As employees, the management team had limited control over the direction of the business and their own compensation. With an MBO, they gain greater control over their own future and that of the business along with the opportunity to reap greater rewards for the work they’ve put into the business.
How MBOs Work
Management buyouts are similar to any other type of sale. However, because the existing management team is already intimately familiar with the company’s workings, the process is often simpler and faster.
When the business owner initiates the idea for managers to buy the company, the team might have to play catch-up to prepare themselves for the MBO process. When the team initiates the process, it might have to work harder to convince the business owner that it’s the right buyer for the business.
When the management team initiates the management buyout process, it will have to:
- Assess the owner’s interest in selling the business
- Create a business plan outlining a strategy for running the business and the individual responsibilities of each of the team members
- Convince the existing owner that it’s the right buyer for the business
The owner of the business will have to:
- Decide whether the management team is the right buyer for the business
- Decide whether they will finance a portion of the sale, accept a phased-in payout, or insist on an all-cash deal
Once the owner of the business and the managers agree to pursue a sale transaction, the management team will have to raise financing and both parties must:
- Conduct due diligence
- Negotiate the purchase
- Finalize the deal
- Create a transition plan
Due diligence for an MBO is often less complex and shorter than it is for a sale to an outside third party, but it’s still a necessary step. The management team must take a step back to evaluate the business objectively, assess the risks of the business acquisition, and conduct a business valuation.
An independent business valuation will usually be required if outside financing from lenders or private equity firms is used to acquire the business.
Raising Financing for an MBO
Management buyouts almost always require some form of debt financing to acquire the business, and multiple forms of financing are often used. Buyers should also expect to put up funds to cover a portion of the purchase price.
The combination of debt and equity used for the purchase must provide a sound and sustainable capital structure for the company. If the new management saddles the company with debt, cash flow would be insufficient to service the loan or provide operating funds.
Debt financing can come from a number of different sources depending on the resources and credit of the borrowers, the size of the transaction, and other factors. Financing options include:
Banks and Other Lenders
Banks and other lenders issue loans based on cash flow or with collateral like business or personal assets. Traditional banks often consider MBOs a risky investment and approve loans only to cover shortfalls between other loans and the purchase price. Business development companies specialize in lending to small businesses and generally offer loans based on cash flow.
Private Equity Investments
Private equity groups that participate in management buyouts usually raise debt to fund the purchase in exchange for equity in the business. These investors usually provide considerable capital along with other resources, but they often also take a decision-making role in the management of the business. Venture capital is another form of equity financing that involves selling a portion of the business.
Seller Financing
With seller financing, the existing business owner loans the buyers a portion of the purchase price with a negotiated interest rate and repayment terms. Seller financing usually won’t cover the full purchase price of the business, and borrowers will have to look elsewhere to fill the gap between a seller-financed loan and the purchase price.
Mezzanine Financing
Mezzanine financing is most often used for larger transactions. It is a second loan that covers the difference between the purchase price of the business and a first loan. In these transactions, the first loan is considered senior debt, and borrowers must repay it before the mezzanine debt can be repaid. Because it’s subordinated debt—it ranks after the senior loans—it is seen as a riskier loan and carries a higher interest rate.
Phased Management Buyout
In a phased management buyout, the company’s management team initially receives only a small share of ownership with the right to acquire additional equity over a long-term arrangement. The valuation at which the new owners can buy additional equity in the business can be fixed at the time of the initial sale, or it can be tied to performance goals set at the outset of the transaction.
Earnout Financing
Earnout financing is a form of seller financing. The business owner loans the buyer a sum for the purchase of the business. Instead of a fixed repayment schedule, the payouts are tied to the performance of the business after the deal closes. If the business performs well, the loan is repaid faster. If the business doesn’t meet the performance metrics set, the loan will be repaid at a slower rate.
Employee Stock Ownership Plan (ESOP)
If the business being sold has an employee stock ownership plan, the buyers can borrow against it to fund the business purchase.
MBOs Have Many Upsides, but a Few Potential Downsides as Well
An MBO almost always has fewer risks for buyers and sellers than a business sale to an outside third party. The chances that the business will succeed under the new management are also greater than selling to an outsider because of the new owners’ experience and familiarity with the business.
But it’s also important for buyers and sellers to consider what can go wrong with a management buyout.
The plan for financing an MBO must be sustainable. Cash flow must be sufficient to service the debt. If private equity financing is used, the goals of the new owners must align with the private equity firm.
The new owners should also be prepared to transition from employee to entrepreneur and from manager to leader. At the same time, sellers need to be aware that the trade-off for the lower risk involved in an MBO is that an outside party might be willing to offer a higher purchase price.
For business owners without a clear succession plan, a Management Buyout offer a strategic solution to exit planning. Visit the BizBuySell Learning Center for insights on preparing your business for sale and identifying potential buyers, possibly within your existing management team.