We’ve never even thought about a Management Buyout – could we do it?
Canadian managers often confuse two very different issues when thinking about a Management Buyout (MBO):
• Do we want to own our own company? and,
• Can we put a deal together & raise the money?
Before worrying about putting a deal together, you and your managers need to first answer the question “Do we want to own our own company?”. Some managers want the opportunity to be their own bosses while others like the “safety” of being employees and not taking a risk.
Ownership sounds very attractive and the financial upside can be huge, but you need to honestly answer these questions before you start down this path:
• Do I believe in the future of our company?
• Do we have a leader in the group?
• Am I prepared to put some money at risk (say one year’s compensation)?
• Are we prepared to take full responsibility for the future of our company?
• Will the absence of our owner negatively impact our future prospects?
As for the question “Can we put a deal together & raise the financing?“, it’s often easier than you think but will depend upon:
• The willingness of your owner to sell and at what price.
• The structure of the deal.
• The financial health of the company.
• The availability of capital (banks & private equity) at the time, and,
• The amount of money that you and your managers are willing to invest.
How do we figure out what our company is worth?
This is where you’re going to need some outside professional help. Companies are valued based on their expected future earnings and its historical performance is used as an indicator of future performance. So, you’ll often hear that a company was valued at, say, a 4 or 5 times multiple – meaning it was valued at 4 to 5 times the company’s current annual cash flows or EBITDA (earnings before Interest, Taxes, Depreciation and Amortization).
But agreeing on a valuation is only part of the answer: agreeing on how and when the owner gets paid is a key issue in a successful Management Buyout.
Your advisor will help you come up with a valuation and a deal structure based on (1) the company’s historical performance and future prospects, meaning how easy will it be for you to pay off the debt in doing this, (2) a comparison of what other companies in your industry have recently sold for, (3) what the owner’s expectations are, and, (4) what are the various financing options that are available to you.
A good advisor will guide you on what is a “good” deal (& structure). A good deal is one where the debt you take on will likely be repaid within 5 years. A really good advisor will also be brutally blunt with you and tell you when the owner’s demands, or the financing you’ll need to meet their price, are simple too risky. The litmus test for a really good advisor is if they are willing to walk away from their fees (and most of us get most of our fees when, and only when, the deal closes) by telling you not to do the deal because it’s too risky for you. Happily, in Canada, most of the professionals we deal with are “really good” and meet this level of professionalism.
Who should lead the discussions? Who should participate in the Management Buyout?
The individual who normally leads the buyout is the General Manager or Divisional President of the company – the second in command who is not a family member.
This person is the natural leader of the group and will continue as President once the Management Buyout is completed. As the leader, this person will represent the Management Buyout group in discussions with both the owner and your various financial partners.
The number of people who are included in the initial buyout should be restricted to key personnel and typically includes the heads of Operations, Finance & Accounting, Marketing, Personnel, Distribution, Service and Branch Managers.
The number of participants in the Management Buyout at this stage needs to manageable – typically four to eight individuals initially. Once the Management Buyout is completed, additional shareholders can be brought in as desired.
How much money will I have to put at risk?
There’s no right answer here.
What most Canadian financial partners (bankers, private equity) will say is that it must be an amount that is significant for you, but not so much that you’ll lose sleep over its potential loss.
In our experience, we suggest that managers consider investing the equivalent of one full year’s pay.
You will not normally be required to provide personal guarantees to the bank, so you risk only the amount of money that you invest.
How do we raise the financing?
In Canada, deals are financed from a combination of the following sources:
• Traditional banks
• Subordinated debt
• Payments to the Seller post-closing
• Private Equity
• Your team’s cash investment
Traditional banks: Banks look primarily to the security that the company can provide (accounts receivable, fixed assets) and, increasingly, to the cash flows of the company (Cash Flow Loans). Banks will not finance the whole deal and need to see a sizable “equity” component in the deal, which comes from the sources below.
Subordinated debt: Subordinated debt, sometimes called mezzanine debt, is a loan that has no tangible asset security and relies solely on the strength of the company’s future cash flows. It ranks behind the bank, so is “subordinated” to the bank’s first claim on the assets, and cash flows of the company. Interest rates range as high as 18% and are typically tax deductible. This may appear to be very expensive debt but should be looked at as cheap equity.
Payments to the Seller post-closing: This is where creativity comes into play when structuring the deal. These payments bridge the gap between what the owner thinks their business is worth and what you can actually pay them at closing. Seller payments can come in the form of a vendor note (VTB), royalty payments, performance related payments, or a minority equity interest in your new company.
Private Equity: Private equity (PE) can come from PE Funds, Crown Corporations, and private individuals. These investors are your “partners”, not your bankers. And they each have their unique cultures and methods of dealing with you. They typically look at exiting their investments within 5 years and look for Internal Rates of Return of 25%+.
Regardless of whose financing you use, you need to do your “due diligence” on them. These will be your “partners” for a long time so getting the right fit. Working with people who you respect and who are experienced in helping private companies grow is very important for the future success of your Management Buyout.
How much money can we make?
Many people believe that owning part of your own company is the best investment you can make because:
• Studies show that Management Buyout companies are significantly more profitable than non MBO companies; and,
• In Canada, owners of private companies can get preferential tax treatment on the gains in the value of their shares.
While the ultimate value of your company, and your shares, is a function of how well your company does, it’s not uncommon for managers to get a 3-5+ times return on their money and more. But keep in mind, there are no guarantees and if your company fails, you could lose all your invested money.
What’s the process and how long will it take?
The process goes like this:
• Get the owner to agree that you can look at pursuing a Management Buyout.
• Pick your core managers to participate in the Management Buyout.
• Pick an advisor to help guide you through the process.
• Agree on the key components of the deal, summarized in a Letter of Intent.
• Create an Information / Financing Memorandum to present to banks and investors.
• Meet with a variety of banks and investors, obtain Term Sheets from them, and choose your financial partners.
• Work with your financial partners as they perform their due diligence and obtain formal offers of financing from them.
• Generate the legal documents necessary to close the deal including a Purchase & Sale Agreement, Loan Agreements, Subordination Agreements (between the various financial partners) and a Shareholders Agreement.
• Close and fund the deal.
The time it takes to do this can vary between 3 to 9 months and sometimes much longer, particularly if the owner hasn’t yet made up their mind to exit.
What’s the biggest challenge for my management team in doing a Management Buyout?
Probably the biggest challenge that your management team will face once you’ve completed your Management Buyout is that they now are wearing two hats – they are both owners and employees.
Before you start down the MBO road, your team must realize that they are employees first, and foremost, and shareholders second. Just because they are now owners does not mean that poor job performance will be tolerated – being an owner doesn’t mean you can’t get fired. And while you may all be owners, they still report to a boss who has the ultimate say and to partners who expect them to pull your weight.
MBO Group Canada: Ross Campbell