What Is a Management Buyout? How Are They Financed?

Summary: Management buyouts (MBOs) are a common business acquisition strategy. MBOs provide professional managers the opportunity to become business owners. Most MBOs are financed with a high percentage of debt and are considered a specialized type of leveraged buyout. In this article, we discuss:

  1. What is a management buyout?
  2. Advantages and disadvantages of an MBO
  3. The role of the equity injection
  4. How to finance a management buyout
  5. Post-acquisition financing

1. What is a management buyout?

A management buyout is a type of business acquisition strategy in which the management team buys the company they operate. In some cases, an MBO can also include external managers with experience in the industry. Acquisitions done by an external group of managers are referred to as "Management Buy-Ins."

MBOs are often executed using a leveraged buyout (LBO) strategy that relies heavily on debt financing. A well-executed leveraged buyout can allow managers to minimize their investment while maximizing their returns. However, the benefits of a leveraged buyout model come with some risk.

Management buyouts are common in small business acquisitions. Most family businesses that are transferred from one generation to the next use a management buyout model. The MBO allows the older generation to cash out and provides the new generation with control of the business.

2. Advantages and disadvantages

Using a leveraged buyout structure as part of an MBO has advantages and disadvantages. These need to be carefully considered before using this strategy.

a) Advantages

An LBO's structure minimizes management's initial cash outlay. This structure maximizes the buying team's potential returns. This feature, coupled with management's intimate knowledge of the business, makes leveraged buyouts attractive in these types of acquisitions.

b) Disadvantages

Leverage is a financial double-edged sword. It can magnify returns if the company performs as expected. However, it can also magnify losses just as quickly if performance does not meet expectations. Furthermore, a highly leveraged company that experiences trouble may need additional equity contributions since the company is unlikely to qualify for additional financing.

3. The role of the buyer's equity injection

Lenders require the management team to use their own funds to pay for a small part of the acquisition. This contribution is called the equity injection. In most cases, the equity injection has to cover a minimum of 10% of the total transaction cost. Funds for the equity injection cannot be financed, nor can they come from the seller as "seller financing."

Due to their size, very large transactions don't usually have a significant equity contribution from the management team. Instead, the equity injection comes from private equity (PE) companies or family offices that participate in the acquisition.

4. How to finance a management buyout

The amount of equity and financing required for a management buyout varies by company size and industry. Most acquisitions aim for a ratio of 90% debt to 10% equity, though this ratio varies by transaction.

Management buyouts are usually financed by combining funds from multiple sources. Funding options are determined by transaction size, industry, and management team experience.

Transactions of less than five million dollars rely heavily on Small Business Administration (SBA)-backed financing. By virtue of their size, larger transactions often have access to more sophisticated financing alternatives.

Smaller transactions

Smaller transactions have an acquisition price below five million dollars. They use a combination of these financing sources:

a) Seller financing

The seller is a common financing source for management buyouts. Seller financing often consists of a term loan that is amortized over a period of time. On average, sellers finance 5% to 25% of the transaction value.

Seller financing has the advantage of keeping the seller tied to the success of the business after the sale closes. This involvement helps ensure that the seller does not exaggerate the performance of the business during negotiations.

b) SBA-backed loans

Most small MBOs are financed with an SBA-backed loan. These loans are actually provided by private and institutional lenders and not by the SBA itself. The SBA only provides lender safeguards that limit their risk. This backing gives lenders an incentive to lend to the small business market. It also allows them to provide more flexible qualification requirements.

c) Investors and family offices

Smaller transactions can also attract financing from individual investors and family offices. These sources are often flexible and can provide both equity and debt financing. Investors and family offices tend to be regional in scope and can be found through personal networks.

Midsize and larger transactions

Some of the financing options that small businesses use, such as seller financing and private offices, are also available for larger transactions. However, larger transactions also have access to additional financing sources.

a) Senior debt financing

Senior debt financing is provided through loans that have a first security position on the company's collateral. Loans can come from banks, investment banks, and other sources. From a lender's perspective, these loans are the safest to make. Consequently, they have the most challenging requirements to meet, including stringent covenants. Due to their collateral position, these loans tend to have the lowest costs.

b) Junior and mezzanine financing

Junior and mezzanine financing is subordinate to senior debt financing and has a lower priority of repayment. In some cases, mezzanine financing can be converted to equity. Consequently, junior and mezzanine financing loans are riskier and have higher costs.

c) Private equity partners

In some cases, the management team may secure financing through a private equity (PE) firm. The PE's investment may consist of equity, senior debt, and/or mezzanine debt.

Private equity firms may have objectives that differ from those of the management team. Private equity firms usually want to exit the transaction through a liquidity event after three to six years. Consequently, their funding programs often include stipulations of how the company is operated and what objectives must be met.

d) Family offices

Family offices also participate in larger transactions. They can provide both equity and debt financing. Unlike PE companies, family offices aren't always looking for a short-term exit and can have a longer-term view of the transaction. This perspective can be beneficial to the management team.

5. Post-acquisition financing options

One of the challenges of a highly leveraged buyout is that getting financing after the transaction closes is nearly impossible. Due to the high leverage, the company has little (if any) additional collateral to offer lenders. The best time to consider post-acquisition financing needs is before the acquisition closes. At this point, the buyer still has negotiating power. Not considering post-acquisition needs early in the process is a common problem for small business MBOs.

There are two common ways to finance operations after the acquisition:

a) Bank financing

Many transactions handle post-acquisition funding needs by carving out some funds from the acquisition package. This part of the loan is pre-negotiated with the lenders and is often the simplest to obtain. In smaller transactions, getting financing from your acquisition lender also avoids dealing with complex intercreditor agreements.

b) Accounts receivable financing

Companies that work specifically with commercial and government clients can use accounts receivable (A/R) financing. Commonly known as invoice factoring, this solution allows you to improve cash flow by financing A/R from qualifying customers.

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Editor's note:

This information should not be considered legal or financial advice. Given the complexity of business acquisitions, this document is not guaranteed to be 100% accurate or cover every potential option. However, we make every effort to provide you with the best information. If you have comments, suggestions, or improvements, contact us via LinkedIn.

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