Corporate Finance Guides
Guide to Equity Release (Cash-Outs)
Guide to Management Buy-outs (‘MBOs’)
Raising Development Capital
The Sale Process
The Descision To Sell
GUIDE TO MANAGEMENT BUY-OUTS (‘MBOs’)
An MBO is the acquisition of a business by the managers that run the business, normally financed by bank debt and, sometimes private equity (venture capital) plus a small amount of funding from the management team themselves. MBO opportunities normally arise in two situations. Firstly when an owner, who is also Managing Director gets to retirement age and wants to sell the business. Secondly when a group of companies wants to sell a subsidiary or division that does not fit with the long term plans of the group. In both these situations it is common for the owners to invite the management team to bid for the business, often in competition with other potential purchasers.
During the MBO process the managers have two hats to wear – as employees (they must continue to be ‘loyal employees’ during the sale process) and as potential purchasers. This can be awkward at times, and advisers can help by representing the MBO team in negotiations with the owner.
The legal structure of an MBO is summarised on the following page. In this example the current owner, Mr Smith, is selling his company, Red Widgets Ltd to a three-person MBO team. Note that a new ‘off the shelf’ company (commonly referred to as ‘Newco’) is used as the legal entity that raises the funding and acquires the target company. The MBO team are the shareholders of Newco Ltd. In this example, Ryan, the manager who is to take over from Mr Smith as MD, has a bigger shareholding than the others. It is important to note that the debt taken on by Newco Ltd, and its other liabilities are not personal liabilities of the MBO team as individuals. i.e. Newco provides a ‘corporate veil’ to protect the individuals. The personal financial risk for each MBO team member is limited to the amount of equity they subscribe (see below).
The funding requirement comprises the purchase price for the business, its working capital requirements and deal costs. The purchase price is negotiable and is generally determined by the profitability of the target company (5 x operating profits being a common guide), and the competitive pressure of the sale process. Most of the funding for an MBO is provided by third parties, i.e. banks and, sometimes private equity funds. Each member of the MBO team is normally expected to demonstrate their commitment to the venture by subscribing for shares in Newco with an amount that normally equates to their annual salaries. This is normally a small amount of the overall funding requirement, but a large amount for each manager personally: If Ryan is on £40,000 a year, the bank will expect him to subscribe broadly that amount, although this is negotiable. The main purpose of this contribution from the MBO team is to demonstrate to the bank that the MBO team are personally committed to the venture and will not ‘abandon ship’ if the going gets tough after, say 12 months. Most managers need to borrow the equity subscription amount, typically with a second mortgage on their home.
The current owner can help with the funding by allowing Newco Ltd to pay for part of the purchase price over, say 3 years; this is called deferred consideration’.
The MBO process generally takes 3-6 months, resulting in legal ‘completion’ of the acquisition of the target company by Newco Ltd. The MBO team normally have corporate finance advisers to advise them on the acquisition (negotiating the deal), to raise the funds and to help project-manage the process, and lawyers. The current owner will have his/her separate advisers.
For further explanation, please contact:
Jeremy Cole, Partner, Cole Associates Corporate Finance LLP