How to Finance a Management Buyout

A management buyout (MBO) is a type of business acquisition in which the managers of a company purchase the business from the current owners or parent company. Management buyouts can be structured in a number of ways such as a conventional purchase or a leveraged buyout model.

Leveraged buyouts are often used because few management teams have the financial resources to buy the target company outright. They need external financing to facilitate the purchase, and are often interested in leveraging some of the assets of the target company.

Funding the purchase

The type of funding that is available to purchase the company is based on the size, brand recognition, assets, and cash flow of the company. Larger transactions, such as when a corporation is selling off a division, may be able to use a number of products such as bonds, senior and mezzanine loans, private equity injections, and so on.

Smaller companies or turnaround situations usually have fewer options than their larger or better-established counterparts. However, it is possible to finance the buyout of a small company if the management team is willing to use alternative financing. Such options include:

1. Equity from new management team: Perhaps the most important type of financing comes from the managers who are making the purchase. The management team that is organizing the buyout must contribute some of their own cash and assets to purchase the target company. It is not unusual for managers to raise the funds by selling off certain assets (e.g., stocks) or getting a second mortgage on their home.

The management team’s financial contribution is very important. Funding companies consider it a gauge of how committed the team is to the transaction.

2. Seller financing: One of the most common options to finance a management buyout is for the seller to provide financing (also known as deferred consideration). Usually, the seller creates a note that is amortized over a period of time. This option is an advantage for the management buyout team because sellers are usually more willing than banks to provide the funding.

Additionally, as a condition of financing the transaction, some lenders may insist that a portion of the sale be financed by the seller. This condition provides a measure of confidence to the lenders because it shows that the seller believes that the business will remain a viable concern once the sale is completed.

3. Bank loan: Although often hard to get, a bank loan is an effective way to finance a management buyout. The obvious benefit is that bank loans are cheaper than most other options. Learn more about business acquisition loans.

4. Assumption of debt: Part of the acquisition cost can be paid by assuming some or all of the liabilities of the target company.

5. Private equity: In some cases, the management team may be able to secure financing through a private equity firm. However, private equity firms prefer scale and tend to invest in larger transactions. Their investment may consist of buying shares and/or providing additional funding such as loans and asset-based financing.

Keep in mind that the private equity firm may have objectives that differ from those of the management team. Private equity firms usually want a liquidity event after 3 to 6 years. They look to exit the transaction in that time frame, allowing them to realize their gains. Consequently, their funding programs often include stipulations of how the company is to be run and what objectives have to be met.

Remember that the private equity firm is looking to maximize its short-term rate of return – often at the expense of future opportunities. Therefore, management teams must be careful to align themselves with the right funding partners.

Funding operations

Once the management team has acquired the business, they will likely need financing to operate the company. Six options that are commonly used to finance operations are:

1. Bank lines of credit: The most popular product to finance operations is a regular commercial line of credit. These lines offer great flexibility at a very competitive cost. Unfortunately, getting a line of credit can be difficult, especially if you had to encumber a lot of assets to finance the management buyout. Also, lines of credit have covenants that must be met to remain in compliance with the facility. This compliance can be difficult in the initial stages of operations. Learn more about business lines of credit and their qualification requirements.

2. Accounts receivable financing: Accounts receivable financing can help a company that has cash flow problems due to slow-paying accounts receivable. This solution can help finance your MBO immediately after the purchase, when cash is tight. It helps provide the working capital to make payroll and pay suppliers. Receivables financing can also help later on, once the company starts growing. Learn more about accounts receivable financing and how it works.

3. Inventory financing: Another way to get funds for your company is to finance your current inventory. While inventory financing can free up funds, it comes at a relatively high cost. This solution is more expensive than other alternatives and best used as a last resort – or in combination with other solutions. Learn more about inventory financing.

4. Purchase order financing: One of the challenges of getting a large order is that the company may not have enough working capital to cover supplier expenses. Purchase order financing can help you pay suppliers and deliver large orders.

However, purchase order financing can only help companies that re-sell third-party goods. They must use a third-party manufacturing facility and must have a minimum gross profit margin of 20%. Learn more about funding purchase orders.

5. Asset-based loans: Asset-based loans (ABLs) are umbrella facilities that combine accounts receivable financing, inventory financing, and equipment financing. In terms of price and flexibility, ABLs stand somewhere between a line of credit and a conventional accounts receivable financing line. Generally, ABLs have fewer covenants than conventional lines of credit. Learn more about asset-based loans.

6. Vendor financing:  One form of financing that should not be overlooked is your own vendors. If the new company is well funded, vendors may be able to extend more generous terms than they did to the seller’s original company. Changes in vendor payment terms, such as going from net-30 to net-45 (or higher), can have a quick and positive effect on your cash flow. Also, vendors don’t charge interest for offering terms, which makes it very cost effective. Learn more about getting credit from suppliers.

Common mistakes

One of the greatest challenges for leveraged buyouts is making sure that the business is not over-leveraged. If it is, your company will have little room for error – which leaves you open to financial problems. If things don’t go according to plan, the company could easily enter a financial tailspin.

One common way to over-leverage the buyout is to use operational financing to fund the company purchase. This scenario happens if the management buyout team decides to leverage their accounts receivable and inventory to cover part of the purchase price.

Leveraging these assets to buy the company leaves the management team with little cash to operate. Basically, you are using short-term future payments (due in the next 90 days or less) to pay for the purchase. This strategy leaves you with little working capital to operate. It also affects your ability to make payroll, pay suppliers, and, ultimately, run the business.

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Additional resourcesMBO Financing Case Study