Is selling your business to your management team the best option? Yes for speed, cost and flexibility but not for valuations – and both sides need to watch for pitfalls.
There has been a notable increase in management buyout (MBO) activity in recent years as more equity funds enter the market looking to back ambitious management teams, says Katharine Byrne, head of the BDO corporate finance team and member of the BDO international mergers and acquisitions (M&A) group.
A distinctive factor in the Irish market has been the number of founders seeking to sell up. “Some had already weathered the storm of the last recession and the hit of both Covid and the Ukraine crisis has made them realise the importance of crystallising value for part or all of their equity,” says Byrne.
Many do not want to sell to trade players and are keen to see their business continue and grow. “This is where the MBO becomes a solution that not only secures the future of the business but provides a clear exit plan for the shareholders and incentivises the management team with equity in the company,” she adds.
The value of a trading business is generally determined by cash flow, market opportunity and strength of its management team.
For many vendors the advantages of an MBO is certainty and speed of transaction as a result of limited due diligence – if any – and very limited warranties, as well as the ability to retain more control of the process.
“A sale to existing management is particularly attractive if the vendors have a limited number of trade buyers or are concerned about the impact to the business or commercial sensitivity of approaching competitors,” says Byrne.
“Of course, the biggest risk of approaching management about a potential buyout is their reluctance to pay market value, especially if they believe that the goodwill of the company has been or is dependent upon their continued involvement.”
A good adviser will help you avoid common pitfalls such as the setting of unrealistic valuations, the failure to agree key commercial terms up front and poor communications during the process, all of which can lead to mistrust and damaged relations.
Gavin O’Flaherty, partner in the corporate team at Eversheds Sutherland, says: “When selling to a management team, the share purchase agreement will generally be quite warranty-light, given that the management should know the underlying business, so the teeth of the main legal work will be around documentation negotiation with less extensive due diligence work required. However, there can sometimes be vendor financing in MBOs, to allow the MBO team to finance the acquisitions, and that can require careful drafting.
“What you don’t want is an adversarial approach to be adopted. Given the effect of an MBO process on the business, it is also important that the negotiation window is kept as tight as possible; in other words, do the deal or move on.”
A good lawyer will work out the calculation basis of earn-outs and protections, making sure the valuation basis is clearly set out in the transaction documents.
“While there is an obvious advantage in terms of a reduced requirement for a market preparation exercise, given the existing knowledge the existing management team already have of the business, this can often lead to reduced valuations,” says Richard Grey, partner and head of M&A at A&L Goodbody.
Moreover, in a competitive sales process an MBO can significantly reduce competitive tension, generally seen as a key requirement to drive value from a sellers’ perspective.
“A potential third-party buyer may well be unwilling to compete with a potential management team acquirer as they may feel that the management team is best placed to know the true value of the business and accordingly any such potential buyer is always going to be at a significant disadvantage,” adds Grey.
In a third-party sale, particularly in the case of a sale to a corporate buyer, the vendor will typically exit completely and retain no involvement in the business. In the context of an MBO, primarily for funding reasons, the acquiring management team may often only acquire a majority stake in the business with the vendor partially funding such a transaction and retaining a minority stake in the business.
“From a future operational perspective it is important that the acquiring management team has sufficient flexibility and scope to run the business post-transaction and ensure that the vendor does not continue to control the business,” cautions Grey.
Speed and efficiency aren’t the only advantages of MBOs.
“If an MBO does not involve a sales process then sellers will not need to spend time marketing the business for sale,” says Philip Lea, partner, corporate and M&A at law firm Dillon Eustace.
“Typically an MBO process will make it easier to maintain confidentiality and avoid revealing trade secrets to competitors. Depending on the deal dynamics, particularly the funding structure, it may be possible to require the MBO team to accept more risk versus a third-party buyer who will not be familiar with the business. Adverse due diligence findings are one of the main reasons that transactions fail and with an MBOthis possibility should be substantially reduced,” he adds.
On the other hand, different management team funding partners, whether pillar bank, alternative lender or private-equity backer, will bring different requirements that may remove some of the key advantages of an MBO. “For example, with a private-equity backer they will likely require a full due diligence exercise to be completed, sellers are likely to find it harder to shift risk to the MBO team and the process may become more drawn out,” explains Lea.
If a seller does not have much involvement in the day-to-day operations of the company, then there is a risk that the MBO team could have been manipulating data or withholding information in advance of a sale to drive a lower valuation, he points out.
A sales transaction invariably involves a lot of time and effort from both sellers and buyers. Lea cautions: “If an MBO is ultimately unsuccessful then the performance of the business may be adversely affected by management and the sellers being distracted by the transaction, which may result in the company being harder to market in the future.”
Many of the downsides to an MBO result from the process dragging on. “To manage this riska clear timetable should be established at the outset with agreed valuation and heads of terms,” he says.
“In addition, we would recommend that evidence of committed funding for the process be provided at an early stage of the process, which is based upon a head of terms setting out certain key terms,” Lea adds.
“With respect to potential devaluation tactics, some of these elements may be mitigated through deal structuror example by retaining a stake in the businessor by contractual clauses such as anti-embarrassment clauses – which protect against flipping the business for a much higher valuation.”
The rise of private equity in MBOs
“MBOs now are not what they used to be,” says Éanna Mellett, head of corporate, Ireland, at law firm DLA Piper.
“The days of the old-style MBO, where the management team borrowed from the bank to buy the business has been replaced by deals backed by private-equity houses. What we see now are essentially private-equity backed management teams.”
These typically mean the management team doesn’t get a huge amount of equity in the first instance but are incentivised in such a way that, by the time the private-equity house wants to exit, typically three to five years later, they get to increase their equity stake in a secondary sale.
While the management team got more equity, quicker under the traditional debt route, there were disadvantages too.
“With the old style of doing things you borrowed from the bank and had to give personal guarantees. Your house was on the line. That’s not the case any more, making it much more attractive for management teams from a risk perspective,” he says.
Private-equity houses look for good revenue-generating businesses with potential for growth. Only a decade ago such funders were treated “with absolute suspicion” here, says Mellett. Now there is greater understanding of how they work and the advantages they bring. Their prevalence keeps trade buyers on their toes too, keeping the market competitive.
Many business owners now see them as a way of cashing in some or all of their chips. If it’s a route you are considering, you’ll need win over your team first. Mellett says: “PE houses won’t buy into a business unless the management team is on board.”
