Management buyouts (MBOs) are a common strategy to acquire a business that provides professional managers the opportunity to become business owners. In this article, we discuss:
- What is a management buyout?
- Common structures
- Advantages and disadvantages of an MBO
- How to finance a management buyout
- Post-acquisition financing
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.
MBOs are often executed as a leveraged buyout (LBO) and rely heavily on debt financing. A leveraged buyout allows 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.
Common acquisition structure
There are two methods to acquire a business. Each method has its benefits and disadvantages.
1. The buyer acquires all the stock
Buyers may acquire a company by purchasing all the stock from the shareholders. This type of transaction is simple to understand and execute but has drawbacks. The new ownership team inherits all the corporate liabilities. This includes past liabilities that may not be known at the time of the sale (e.g., litigation risk).
2. The buyer acquires all the assets only
Buyers can acquire all the assets of the seller’s company and roll them up into a brand new company. The new company gets the brand, equipment, materials, and employees. Consequently, from a customer’s perspective, the ownership change is invisible.
This structure provides some protection against inherited liabilities since the seller’s company ceases to exist. The protection is not perfect, though, and may not shield buyers against all past liabilities. In our experience, this is the most common method for small business MBOs.
Note: Learn more by reading our small business MBO case study.
Advantages and disadvantages
Using an LBO structure as part of a management buyout has advantages along with some disadvantages.
An LBO’s structure minimizes management’s initial cash outlay. This also 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.
Leverage is a double-edged sword. It can magnify returns if the company performs as expected. However, it can also eliminate returns just as quickly if performance does not meet expectations. Furthermore, a highly leveraged company that runs into trouble may need additional equity contributions since it is unlikely to qualify for credit.
How to finance a management buyout
The amount of equity and financing required for a management buyout varies by company size and industry. Small business MBOs can have ratios of around 90% debt and 10% equity. Larger transactions vary from 60% to 90% debt and 10% to 40% equity.
Management buyouts are usually financed by combining funds from multiple sources. Transaction size and industry help determine which options are available to the management team.
Smaller and midsize transactions are often limited to a few financing options. Most transactions under five million dollars rely heavily on Small Business Administration (SBA)-backed financing. Larger transactions, by virtue of their size, often have access to more sophisticated financing alternatives.
Smaller transactions have an acquisition price below five million dollars. They use a combination of these financing sources.
1. Equity from acquiring team
In smaller transactions, the acquiring management team always contributes equity to the transaction. The equity contribution, called the “equity injection,” averages 10% of the transaction. Funds for the equity injection cannot be financed nor can they come from the seller as “seller financing.”
Due to their size, larger transactions don’t usually have a significant equity contribution from the management team. However, the management team has to share ownership with other parties, such as private equity companies.
2. 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, the sellers finance 5% to 25% of the transaction value.
Sellers would prefer to get paid immediately and avoid offering financing to buyers. However, offering financing to the buyer helps as a marketing incentive to sell the business.
3. SBA-backed loans (smaller transactions)
Most MBOs under five million dollars 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.
4. 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 options.
1. Senior debt financing (larger transactions)
Senior debt financing is provided through loans that have a first security position on the company’s collateral. 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.
2. Junior and mezzanine financing
Junior and mezzanine financing is in a subordinate position to senior debt financing and, thus, is considered junior debt. Junior loans are paid only after senior lenders are paid. In some cases mezzanine financing can be converted to equity. Consequently, junior and mezzanine financing loans are riskier and have higher costs.
3. 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 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.
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 is a common problem for small business MBOs.
There are two common ways to finance operations after the acquisition:
1. 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.
2. Accounts receivable financing
Companies that work with commercial and government clients can improve cash flow by adding an accounts receivable (A/R) financing layer. Commonly known as invoice factoring, this solution allows you to improve cash flow by financing A/R from qualifying customers.
Want to finance a management buyout?
The first step to work with us is to submit this form. Once we review it, one of our associates will contact you to discuss the specific details of your acquisition.