The MBO (management buyout) process is gruelling, exerting significant pressure on management teams and those around them. And that’s just to complete the deal. Once the ink dries, don’t expect any let up in pressure. Even for a well-managed and successful business, the risks can be significant.
Reduce the stress and the risk of failure of a MBO by asking yourself some pertinent questions before you begin, and by understanding the lessons learned by management teams who have been there and done it.
MBO: Do I really want to do this?
“This is the high-octane end of the commercial world, it’s like fitting an eight-litre V12 engine into an aged VW Beetle and expecting it to perform,” warns MBO expert Andy Nash. For that reason, management teams need to ask if an MBO is right for them. “If you’re going through a divorce, even if your football team has been relegated, don’t do it,” he says. And he's only half joking.
Management team cohesion
“It may be a cliché, but business is all about people,” says David Petrie, head of the ICAEW’s Corporate Finance Faculty, “and incoming investors and venture capitalists back the people just as much as they are looking for a good product in a good market.”
“If you’re a divided management team, the relentless stress test of an MBO will prise open the cracks,” says Nash. The ideal management teams support each other with complementary strengths.
“You need to have a unified management team. If someone wants to bail or retire, that’s something you have to address early on,” warns Neil MacDougall, managing partner of Silverfleet Capital.
Make sure management teams agree fair and reasonable leaver provisions, Petrie advises. “It’s not uncommon for at least one of the management team to leave over the coming years. If they’ve been an important part of building value, they ought to be treated fairly.”
Is management realistic about the price?
Management is likely to have to engage in a controlled auction process, as vendors seek to get the best price they can. “You need to have a story as to why your deal offers a better price, perhaps because you understand what the business’ issues are,” Wright says.
The desire to secure a deal can push some management teams to bid too much, but this means very high borrowing and a reduced equity stake. The biggest cause of failure is paying too much in the first place, warns Nash.
The main objective is to avoid paying over the odds. “If you’re buying a division of a larger business, are they divesting because there’s no fit with the rest of the business or because margins aren’t great? Take into consideration the motivation for sale,” says Abby Ghobadian, M&A expert and professor of management at Henley Business School.
“The worst thing is if the company doesn’t make its own forecasts; they need to be realistic and achievable. The CEO and CFO need to be clear how much debt they can take on and service comfortably. That’s where good advisers are worth their weight in gold,” says MacDougall.
Does management understand its financial options?
There are various sources of funding that may be available to complete your MBO – banks, term lenders, subordinated debt providers, private equity, vendor financing – all of which have different costs and rules of engagement, and it’s very important that you understand them.
“Private equity and debt is still the most common way MBOs are funded, but the opportunity is there to explore other options that could be relevant,” says Andy Morgan, head of corporate finance. “The other thing that is growing is employee ownership trusts. It’s a small part of the market right now but certainly an option for transition from family ownership into the broader employee base, or as a tax efficient way of transitioning a majority ownership of the business.”
A good fit between private equity (PE) backers and management teams is essential. Ideally, PE backers will add value to the existing team by helping it to grow the business and define its objectives, management style and modus operandi.
“The way you source financing can make a huge difference to future success. Make sure you understand your financial partners’ requirements and what kind of control they want, and ensure that the debt burden doesn’t affect your cash flow and ability to service the debt,” says Ghobadian.
“We’d advise talking to some of the management teams of previous investee companies to see how those funding partners actually perform when things don’t go entirely to plan,” says Morgan.
Focus on running the business
The MBO process is seldom straightforward. As the seemingly never-ending negotiations appear to lurch from one near crisis to the next, it would be easy to focus more on the intricacies of the deal than running the business. But do so at your peril; any deterioration of business results could scare off financial backers.
Ghobadian says it’s important not to underestimate the transition from employee to business owner. “You can overestimate your capabilities and it’s very easy to take your eye off the ball. It’s a very exciting time but you need to be able to come back to earth and focus on running the business,” he explains.
During the transaction, make sure your financial management and control systems are solid and will stand up to due diligence, Petrie says. “If you’re buying a division of a larger business, make sure non-financial measures are included in your reporting. And work with incoming investors to make sure you’re measuring the right things,” he adds.
Who’s in charge?
Your MBO management team might all invest the same amount of money, so you should all have an equal say in running the business, right? Wrong. Being a shareholder means you directly benefit from the success of your business and the efforts of you and your management team – but it doesn’t mean that you should all have an equal say on how the business is run.
It is vital to understand that shareholders are employees first, shareholders second. Once you’ve completed your MBO you'll feel better about expressing views on the business, but no organisation can operate without someone at the helm who is a pragmatic, strong and capable leader – someone has to have the final say and make the tough decisions.
Life after MBO
How does management envisage performance will be improved after the MBO? “You need a clear story and a clear picture of a business that can grow,” Wright says. “Recognise if there are gaps in your management team and have a plan to fill them – it’s about being proactive.”
Bear in mind that in order to unlock the revenue potential, the MBO plan will often call for increased investment in areas such as product development, new equipment, staff training, marketing and, in the case of carve outs of non-strategic assets, a new accounting system.
Management team exit
The management team needs to consider what and when the exit will be, and who controls it. “Many mid-market MBOs become secondary buyouts, as initial PE firms exit and a new one enters; the new one may be equipped to help the MBO get to its next stage of growth,” Wright says.
As owners, you need to go into a MBO with your eyes open – most of your financial partners expect to be paid out before you see any money. While most bankers will consider allowing dividends at year end, its best to assume that they will say no. A good rule of thumb is to assume that your money is locked in for four to six years.
Take time to enjoy the journey. Despite the inevitable challenges, when you look back you may find it was the most rewarding time of your business career.
For more information on MBOs, please contact Andy Morgan, head of corporate finance.