Management Buy Outs (MBOs) allow the senior management team within a business to purchase the company from the existing owner(s). This approach can be particularly beneficial to companies as the new owners will have extensive knowledge of business operations, client relationships and the current market position. This ensures a smooth transition and continued success.
If you’re considering undertaking a management buy out, it’s important to understand the processes you need to complete and this blog will explore how you can plan accordingly.
What is a Management Buy Out?
Management Buy Outs are financial transactions completed by senior management teams within the business, to purchase the company from the existing owner(s). This type of buy out is appealing to managers as they’re likely to reap greater rewards and gain more control over the company, as shareholders rather than employees.
Although there is no guarantee of success, there are a variety of reasons why management teams consider a buy out, such as:
- More control - Members of management may not agree with the direction the company is going in. By completing a buy out, the management team have more control over the direction of the business.
- Financial gain - The management team may not feel they’re getting the full financial benefits of managing the company. By taking ownership they can reap the financial benefits.
- They have the right knowledge and expertise - This allows them to run the business successfully as they are equipped with the right skills and expertise.
The Management Buy Out Process
The management buy-out process involves several steps, including:- Conducting an initial appraisal - This should be completed at a high level and based on the company’s financials, market, services, people and development prospects.
- Develop an understanding of what the sellers are trying to achieve - How does a successful transaction look for the sellers and does that fit with what the management team are able to deliver?
- The MBO team should seek assistance with their business plan - This involves creating a detailed financial forecast to help understand growth, affordability and debt servicing capabilities.
- Undertake a valuation - This ensures the transaction is transparent and that the management team understands the financial health and potential of the company. A preferred deal structure should also be evaluated during this stage.
- Conduct a detailed financial analysis - This will include testing the forecasted financial model to show the serviceability of debt and the returns potential investors will get.
- Evaluate possible tax consequences - If required, tax clearances will need to be submitted to HMRC.
- Approach funders - In smaller management buy out there may only be one funder and larger transactions may require several.
- Funders provide their offers - This stage involves scrutinising any offers made and negotiating specific terms.
- The preferred funders (if any) are chosen - Due diligence will begin.
- Drafting and finalising the legal documents - This will be completed in detail in full discussion with the team.
- Any issues with due diligence are raised and addressed
- Completion and change in ownership takes place
- The management team prepares for their first board meeting
What stakeholders are involved in an MBO?
There are a range of stakeholders involved in MBOs such as:
The management team
The management team are responsible for initiating the buy out and conducting thorough due diligence to assess the business's financial health. This helps them develop a strategic plan for post buy out operations.
The management team must also arrange finance and negotiate terms that align with the firm's future cash flow. Once the buy out is completed they take over all (or the majority of) ownership allowing them to use their in-depth knowledge about the company to achieve growth.
The Current Owners
The current owners must provide transparent information about the company's financials, client portfolios and operational practices in order to reach a fair valuation. They’re also involved in negotiating the terms of the sale to ensure they reflect the values and interests of the company. In some cases, they also provide transitional support, which is crucial for the continued success and reputation of the business.
Funders
Funders assess the business's financial stability, growth potential and the viability of the management team's business plan. Funders are likely to be banks or private investors that set the terms of financing arrangements, which could include loans, equity investment or a combination of both.
Funders can also provide strategic guidance and financial oversight to make sure the transition is successful.
Legal advisors
Legal advisors offer expert guidance on the legal complexities of the transaction to ensure the MBO is compliant with all applicable rules and regulations. Their responsibilities include:
- Drafting and reviewing the contracts and other paperwork required to complete the MBO.
- Advising on the structure of the deal.
- Assisting in negotiations to protect their clients’ interests.
This helps businesses minimise legal risks and complete a smooth transition of ownership. If you’re looking for help with this, get in touch with Legal Clarity to see how we can help.
How to finance an MBO
Funding a MBO transaction can be challenging, as buyers often don’t have enough liquid capital to purchase the business with their own cash. This means they typically rely on external funding. This could include:
Private loans
Members of the buy out team will use secured and unsecured personal loans to fund the management buy out. Secured loans require homes, pension plans and other non-cash assets to be provided as collateral. This means the loans may take the form of equity release mortgages, bank loans or finance company loans.
As a result, good credit scores are usually crucial and all secured lending is at risk if the business fails after the MBO.
Business loans
MBOs can also be funded through business loans from banks or finance companies, made to the company itself, although this is quite rare.
Gaining unsecured lending will be dependent on the business's track record and the type of company they are, but the amounts advanced will be much smaller as compared to secured lending.
Secured lending often involves the lender taking a charge over the company and all of its assets and loans often last between 3 and 5 years.
Asset finance
Asset finance is where a company’s assets, such as its debtors, property or plant and machinery, are leveraged against to borrow money to acquire the company. If the business owns substantial assets they may be used as collateral for borrowing. This is also referred to as a leveraged buy out, as the company’s assets are leveraged to buy out the old owner.
In a leveraged buy out the company’s balance sheet liability burden increases at the same time as its assets base decreases. During the term of the loan, the business usually still has full access to its assets.
Private equity
This is where cash is provided by venture capitalists, hedge funds and private investors in exchange for shares, board seats, dividends, fees and varying degrees of control. It can be difficult to obtain funding, but it can allow a chance of scalability as the company grows.
Within 1 - 3 years many venture capitalists and equity lenders liquidate their position. This means the management team will need to look for new funding. They’ll also need to repay the investor based on a future valuation where they may owe more than was invested if the business has grown.
Mezzanine finance
A hybrid of equity and debt financing, mezzanine finance is a business loan that provides the lender with the right to convert to an equity interest in the company after a predetermined timeframe has passed, and/or in the event of default. In this manner, equity in the company can be used as security, but is not commonly used as the management team will not want to risk giving up shares in the company.
Vendor loans
Vendor loans involve the current owners helping to fund the transaction by leaving some of their consideration to be repaid over time. Whilst the vendors will transfer all of their shares on completion, they will often retain a degree of control over an extended period of time, until they’ve been paid in full. In today’s economic climate, these are regularly used to fund MBOs.
Key Considerations in a Management Buy Out
There are a number of key considerations and best practices that businesses must take into consideration for the MBO to be successful. One crucial consideration is the importance of having a strong and dedicated management team already in place as it’s essential that the management team has the right experience and expertise needed to grow the business and ensure the smooth transition of ownership.
The management team will need to be included in the key stages of the transaction, such as the valuation process, due diligence and financing, thereby ensuring they understand the transaction whilst also allowing them to add their own valuable input.
If required, the management team may also wish to carry out their own due diligence (separate to that of any funder) to identify any risks or liabilities they might face.
Strategic planning should also be undertaken to ensure business continuity and growth after the MBO. This will also highlight whether the management team is up to the task of running the company.
Challenges and Solutions in management buy outs
While there are a range of benefits to undertaking a management buy out, there are also some disadvantages, such as:
Difficulties raising funding
Management teams often don’t have enough money to facilitate the MBO themselves, requiring funding from banks or private equity firms. This can result in a large amount of debt at the outset of their ownership, which can put a lot of pressure on the success of the business. As a result ‘soft’ loans from the exiting owners have become more common.
Lack of business ownership experience
While management teams have experience in running a business or teams, they aren’t necessarily equipped to own a company. It can be difficult to know what qualities are needed to run an organisation and how to tailor them to the business they own, until they’re in the role.
Valuation disputes
Legal disputes relating to valuations can delay or derail the management buy out process. Having disagreements over what the company is worth can also lead to increased costs and potential damage to the business’s reputation, as well as straining relationships and complicating negotiations and transition plans.
Addressing potential valuation disputes should be completed promptly to ensure relationships and the transition of the management buy out isn’t jeopardised.
Other Legal Issues
Disputes with customers or suppliers, or the company’s non-compliance with specific laws and regulations (which may require immediate remedy) can delay the buy out process, increase costs and complicate negotiations.
Such challenges can be overcome by using various strategic approaches, such as:
Appointing a legal expert
Engaging with experienced legal advisors who are equipped to deal with corporate transactions and understand the legal requirements of your industry will give you access to an abundance of expert knowledge and advice. This will ensure your MBO is compliant and that all bases are covered.
At Legal Clarity, we have the knowledge and expertise required to guide you through a successful management buy out. We also provide flexibility and a personalised service, making it feel as though you have your own legal team.
If you’re looking for support and guidance with your management buy out plans, get in touch with us to see how we can help.
Undertake thorough due diligence
Undertaking thorough due diligence will identify any potential legal or financial issues, allowing solutions to be found at an early stage in the process. Undertaking due diligence includes examining contracts, arrangements with customers and suppliers and regulatory compliance.
Communicate clearly
Clear communication avoids misunderstandings and enables greater transparency throughout the process. This ensures any concerns are addressed early on and that solutions and contracts are agreed on terms that are acceptable to all parties involved.
Tax consequences
Depending on the proposed MBO structure, there are various tax implications that both the vendor and purchasing management team need to understand. Below are some questions that should be asked when considering an MBO:
- Is Business Asset Disposal Relief (BADR), previously known as Entrepreneurs Relief, available to the sellers?
- Is SEIS or EIS relief available for any equity investment that comes as a part of the deal?
- Are there any potential income tax liabilities for the management team on the acquisition of shares?
- Is there an earn-out period for the sellers? The way this is structured may have implications on BADR entitlements.
- What stamp duty is payable?
- Is any bank interest tax deductible?
- What are the VAT considerations?
- Who is receiving external finance, if sourced? Will it be the purchasing entity, the target company or individual management team members?
- What are the expected exit options for the management team in the future that guarantee they’re not liable for income tax?
It’s important to seek tax advice as early as possible to avoid delays and minimise potential tax burdens. Here at Legal Clarity, we work closely with a number of trusted tax advisors, should you require a referral. Otherwise, we’re here to help you and provide guidance every step of the way through your management buy out journey, including whether a management buy out is the right option for you, and advising on alternative options where necessary.
For further information or advice, get in touch with Legal Clarity today to see how we can support you through your MBO processes.
