MBO Case Study – Acquisition Target Carve-Out

Summary: This article presents the case study of a management buyout (MBO) of a small company with two vertically integrated business lines. This case study shows a transaction in which the seller carved out and sold one of the business lines to a company manager. The seller kept the other line of business as a stand-alone company. In this case study, we cover:

  1. The seller
  2. The buyer
  3. Initial acquisition attempts
  4. Going to work for the seller
  5. Structuring the acquisition
  6. Deal challenges
  7. Final deal structure
  8. Transaction outcome

Note: Since the company is private (rather than publicly listed), all the names have been changed to protect the privacy of the participants. Any resemblance to a person or entity is purely coincidental.

1. The seller: Green's Tree Services

John Green has owned Green Tree Services for the past two decades. The company started as a tree service business. However, John added a second line of business selling mulch a few years ago. Green's Tree Services is a family business, and John cares about his employees and customers.

Both business lines are vertically integrated. During operations, the tree service collects "green waste" (i.e., tree refuse). The "green waste" then becomes the feedstock for the mulching business. The mulching side of the business processes the feedstock and turns it into mulch. This mulch is then sold to clients and landscaping companies.

John was approaching retirement age and was interested in reducing his workload. Consequently, John decided to sell the tree service business while retaining the mulching business. This type of "carve-out" is not common in small business acquisitions due to the difficulty of finding a lender that can finance them.

2. The buyer: Red's Contracting

Susan Red, the owner of Red's Contracting, has been in business for a few years. The business is not her full-time occupation and produces little revenue. However, Susan had prior experience in landscaping and wanted to buy an existing business in the industry.

After reviewing several businesses and discarding those that had red flags, she found Green's Tree Services. Green's Tree Services had most of the features she was looking for and was offered at a reasonable acquisition price. Furthermore, she knew of the business and its reputation.

3. Initial acquisition attempts

Susan approached John about acquiring the business. While the conversations were amicable, John explained that he was looking for a specific type of buyer. Like many business owners, John had an attachment to his businesses. He knew all his employees personally and cared about their futures. John was also well known and respected in his community. He would sell the company only to a buyer who would take good care of the business and manage it well.

a) First round of discussions

After their initial round of negotiations, Susan presented an offer. John reviewed the offer and declined it. He had reservations about Susan's ability to operate the company long-term. John thought Susan had the right vision but lacked the experience to execute it. Having the offer declined was a major setback for Susan. However, she had prepared for this eventuality, and discussions were always amicable. Both remained on good terms after the negotiation.

b) Second round of discussions

After a few weeks, Susan met with John to negotiate a compromise offer. This meeting led the pair to come up with a creative strategy. Susan would work at Green's Tree Services and assume a management role. John would introduce her to the team and clients while mentoring her to run the business. If all went according to plan, Susan would be able to acquire the company from him within a year.

4. Going to work for the seller

Susan worked for Green's Tree Services for a year. During that time, she learned every business detail and prepared for the acquisition. The acquisition was more complex than common acquisitions because it involved carving out a portion of the business. Susan planned to acquire the tree service, leaving the mulching line of business to John.

Successful carve-outs are not common in smaller transactions because of their complexity. However, John and Susan had an advantage. John prepared the business for the carve-out while training Susan to run the company.

John instructed its bookkeeper to start assigning revenues and costs to their specific business lines. Additionally, the bookkeeper identified shared costs across business lines. This effort enabled them to create separate financial statements for each business line. This effort played a key role later on.

After a year of working together, John became convinced that Susan would be a great person to take over. They quickly moved to the negotiation stage, and Susan presented an offer.

5. Structuring the acquisition

Susan decided to use a management buyout strategy. She presented an offer with the following financing structure:

  • Acquisition cost $4,300,000
  • Equity injection: 5%
  • Seller financing: 5%
  • Business acquisition loan: 90%

a) Management buyout

A management buyout is a type of leveraged buyout. Company managers use it to acquire the business by using substantial financing. A management buyout structure can finance up to 90% of the acquisition's total cost in many cases.

b) Equity injection

Every small business management buyout requires that the buyer put some of their assets as an equity injection. The equity injection usually covers a minimum of 10% of the total acquisition cost. In some cases, buyers can provide a 5% equity injection. However, sellers must also offer a 5% seller-financing component subject to a stand-by clause. The equity injection cannot be financed or come from the seller. Learn more about equity injection sources.

Most buyers mistakenly believe that the equity injection is based on the business's acquisition price. The equity injection is actually based on the total cost of buying the business. This cost includes:

  • Cost of the business
  • Capital expenditures (new machinery or equipment)
  • Working capital financing
  • Closing costs

c) Seller financing

Seller financing plays an important role in most small business buyouts. It can also be a contentious issue among all parties. Buyers and lenders want sellers to finance part of the transaction. Seller financing demonstrates the seller's confidence in the business they are selling, and it reduces the risk for lenders. On the other hand, sellers want to get paid quickly while offering the lowest possible amount of financing.

In this transaction, the buyer offered a 5% equity injection. This proposed equity injection is lower than the 10% minimum that is required. However, this issue was handled by having the seller offer 5% in seller financing, subject to a stand-by clause.

d) Business acquisition loan

The transaction was financed with a business acquisition loan from an SBA-backed lender. SBA-backed loans can finance acquisitions under $5,000,000. They provide competitive rates and flexible terms to borrowers who could not qualify for bank financing. Learn more about the requirements to qualify for business acquisition financing.

6. Deal challenges

This deal presented several challenges. Some of these challenges are unique to carve-out transactions.

a) Getting accurate financial statements

Lenders require accurate financial statements to fund all business acquisitions. Carve-outs add a level of complexity to this requirement. Lenders need to determine if the new business that results from the carve-out will be able to service its debt. Consequently, lenders need to examine financial statements that demonstrate this capacity.

Fortunately, John and Susan had anticipated this challenge at the beginning of their discussions. They changed their accounting process so that reports would break out revenues and expenses by business line. Shared expenses were also labeled as such. These changes enabled them to create relatively accurate historical financial reports for the tree service line of business that Susan was buying.

b) Negotiating add backs

Having modified financial reports enabled John and Susan to negotiate "add backs" more accurately. Add backs are certain costs that are added back to the seller's discretionary earnings.

In this transaction, all joint expenses were added to the financial report of the tree service company. These expenses represented costs that could not be split between the companies. A simple example of one of these expenses is the cost of employing a receptionist. The tree service would need one, and the cost cannot be split.

The new financial report was critical in getting the deal done. It showed that the business, even with shared costs added back, could meet the debt service.

c) Low buyer's equity

The buyer used all their savings to provide a 5% equity injection. This is the absolute minimum that a buyer can inject into a transaction. Transactions with such a low equity injection tend to be difficult to execute. They require that the seller take a stand-by, which sellers dislike. These transactions are also sensitive to minor changes in costs, which can bring the number out of compliance.

d) Low seller financing

The initially proposed transaction had a 5% seller financing component with a stand-by clause. The seller was initially unwilling to provide financing but decided to help the buyer since he wanted to sell her the business. The seller financing component was necessary for this transaction since lenders do not finance more than 90% of the acquisition cost. Combined with the component of seller funding, the equity injection would cover the remaining 10%.

e) Lender unable to finance 90% of the acquisition

After reviewing the initial financial statements, the lender advised the parties that it was unable to finance 90% of the acquisition. While the opportunity had many good attributes, the lender thought the risk was very high. As a result, the lender offered to finance only 80% of the acquisition. The buyer would need to find a way to fill the remaining 10% gap. This situation became a significant problem and nearly derailed the transaction.

7. Successful offer

After a long negotiation, John agreed to increase the seller financing component from 5% to 15%. However, there was one important consideration. Only the initially proposed 5% loan would be subject to the stand-by. The remaining 10% could be paid as a regular loan. This arrangement led to the following financing structure:

  • Acquisition cost: $4,300,000
  • Equity injection: 5%
  • Seller financing: 15% (5% on standby)
  • SBA-backed financing: 80%

The structure was accepted by all parties and the transaction moved forward.

8. Executing the acquisition

The transaction went through all the usual documentation associated with SBA-backed financing. This documentation included all the appraisals that must be ordered before closing. After these activities concluded, the closing took place at the borrower's attorney's office.

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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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