Making an exit
Wednesday, August 31, 2022
There are various ways for owners to exit a company, but one that seems popular is the management buyout – MBO. And it’s been used by Glossop Cartons, Medica Packaging and Rapidity in recent years.
But what exactly is an MBO?
Simon Blake, partner at Price Bailey, explains that an MBO involves a company’s management team acquiring all or part of the company they manage. He says that most of the time, the management team takes full control and ownership. Paul Taylor, a partner Fox Williams, says that the term MBO usually refers to a series of transactions that commonly involve the establishment of an acquisition company or group – Newco – and dealing with the equity interests and financing of Newco. He makes the point that “MBOs tend to be document-heavy transactions”.
For Blake, an MBO offers a vendor an attractive alternative to a trade sale for a variety of reasons: “The number of potential trade buyers may be limited, vendors may be nervous about approaching competitors and disclosing sensitive information, or they may feel strongly that the company carries on independently in what they believe to be ‘safe hands’.”
He adds that while it is potentially easier to agree on a value for the business, “the valuation may be lower than could be achieved through a trade sale as a management team won’t pay for the synergies available to an external buyer”. Further, while the vendor knows the people they are negotiating with, the MBO team knows the business.
Valuing the firm
As to how to value the business, Blake says that the same methodologies for trade sales are also applicable to MBOs.
He says that procedurally, advisors will look to develop an outline of the future business plan and forecast; they’ll create a detailed understanding of the company financials; find current, fair asset values of any equipment intended to be used in asset finance arrangements; examine any discounts that may need to be applied; consider the company’s current debt capacity if debt is to be used as a source of funding; and look at anything that may impact future growth or cashflow.
Advantages for sellers of an MBO
Beyond existing management’s familiarity with the business, Blake says that one of the chief benefits of the management buyout route is that it allows for a smooth transition of ownership. Sure, valuation is often easier, but in an MBO employees are less likely to be concerned, and existing clients and trading partners will be reassured that it will be ‘business as usual’.
On top of this, he says that “the internal changes and transfer of responsibilities between the vendors and management remain confidential and any due diligence required by funders is often handled quickly. This generally means a significantly quicker process than a trade sale and the seller will generally have more control over the process than with a sale to a third party.”
And an MBO may be the best option for a business which might be too small to attract much interest from trade buyers.
It takes time
Both Blake and Taylor know from experience that MBOs can take several months to complete and so vendors and management team must fully commit to the transaction for that period of time. As Blake says, “this can be challenging since the company must be run as normal and kept on track while the transaction is ongoing.” He adds that a strong management team must be in place to take the MBO forward and run the business post-completion.
A consideration for sellers is how they will support the MBO process. They could allow part of the sale price to be paid over a deferred period, or they could retain a minority interest in the business.
Allied to this, are concerns that Taylor highlights over exiting shareholder commitment. Where one or more is not onside, it’s possible, as he notes, that “‘drag-along rights’ – if they are contained in the articles or any shareholders agreement or the squeeze out mechanism under the Companies Act – may allow for a prescribed majority of shareholders to force the remaining ones to sell”. But of course, it is far better to proceed with unanimity.
And if sellers are actively involved in the business, Blake says it’s “important that all consider the commercial and financial impact of any planned changes to their working commitment to the business”. Similarly, he says that the MBO team needs to be well known to all stakeholders of the business as this “will speed up the transition towards any full exit and retirement desired by the current owner-managers”.
But before beginning MBO negotiations, Taylor recommends a side letter between exiting shareholders detailing points such as any agreed heads of terms; who will run the deal; which advisors have been engaged for the sale; potential costs; and the ramifications for shareholders who pull out of the sale.
The need for a good adviser
Advisers, good ones at least, exist for a reason – to provide independent advice. In Blake’s view, they should be guiding the seller and management team throughout the entire process, taking responsibility for many aspects of the sale.
This includes an initial appraisal of the business and understanding company financials, market, services, people and growth prospects. Then there’s the development of an understanding of what the sellers are trying to achieve and how committed the MBO team are. The advisor should also help support the MBO team and the development of their business plan and detailed financial forecast. Also needing attention is the valuation and evaluation of the ideal deal structure, a detailed financial analysis on, say, the serviceability of debt and returns to potential investors, and the evaluation of possible tax consequences.
But aside from these tasks, advisors should be able to help with approaches to funders as several may be involved; negotiating offers from funders; conducting due diligence; examining any tax consequences and communicating with HMRC; offering oversight of completion and change of ownership; and finally, preparing the management team for their first board meeting.
From a legal perspective, Taylor believes in the value of taking on the services of a corporate finance broker as they “can help free up time for you to keep the business running. Interview several to make sure you get the right fit for you and your company”.
Taylor also suggests finding experienced solicitors who have a strong M&A/MBO background – again, he says to “meet with the partners and associates so you are aware who will be working on the deal”.
He then outlines the many documents that will need to be drawn up. These include an investment agreement to govern the relationship between the shareholders of Newco, and new articles of association for Newco and subsidiary articles of association for the target company.
There’s also the matter of “banking and other loan documents that govern the terms of the debt arrangements entered into by Newco to enable it to fund the acquisition of the target company”.
Similarly, there’s the need for a share purchase agreement relating to the acquisition by Newco of the target company. “This details the form and structure of the consideration paid for the managers’ and other shareholders’ shares, warranties relating to the shares, and importantly, a tax indemnity.” This, for the record, is broadly, a promise by the sellers to pay to Newco any unexpected tax liabilities that arise in respect of any pre-completion transactions.
The small matter of payment
It’s understandable that in a trade sale, as Blake says, the exiting party is normally focused on a full exit on day one, with 100% of the sale proceeds payable on completion. However, he says that “in MBOs, it is usual that a significant part of the sale proceeds will not be paid on completion, but instead, the seller will act as a lender to the buyer and be repaid over a number of years”.
As a result, he thinks it fair to tie in the exiting party for a time post completion through deferred payment. Where this happens, the seller will “gain on any increase in company performance during the repayment period or if the MBO business is sold on to a trade buyer before the original sellers have been repaid their full initial proceeds”.
Taylor terms this a ‘non-embarrassment clause’ which “readjusts the original sale price of the exiting shareholders’ shares in a situation where the remaining or new shareholders sell on those shares for a higher price within a specified time period”.
With all these imponderables, Blake emphasises that expert legal advice is essential when it comes to sale agreements so as to mitigate many areas of risk.
Sellers and the ideal funding
On payment, in Blake’s ideal world, buyers would in part or wholly self-fund the MBO without relying on third parties. But he says: “If there is a funder in place, it is important they fully understand the business and their priorities align with that of the ongoing owners.”
And where – this is quite common – sellers help the MBO by deferring a proportion of the purchase price – termed ‘deferred consideration’, this can often, says Blake “take the form of loan notes, which the buyer pays back over an agreed period of time”.
Lastly, sellers can finance the deal to reduce the amount of capital buyers need to raise upfront. For Blake, this provides evidence that the seller has confidence in the buyer’s ability to make a success of the business and repay them, which makes the MBO appear more favourable to other finance providers.
MBOs can be a simpler, but not simple, way for owners to exit a business. But as with any commercial transaction, good advice is essential. For buyers, the purchase of a ready-made business has distinct advantages, but they need to be alert to the fact that the buck will stop with them on completion of the deal.
Dealing with tax consequences
Depending on the MBO structure and funding, there may be tax consequences that both sides need to understand and plan for.
- Is the proposed MBO a share or asset purchase?
- Will a Newco be created for the purposes of the acquisition? If so, has there been consideration of the implications of Business Asset Disposal Relief (BADR, formerly Entrepreneur’s Relief) available to vendors; is there Venture Capital Trust eligibility for any private equity funders coming in as part of the deal; and are there any potential income tax liabilities for management?
- Are there any further restructuring requirements that form part of the proposed MBO? And is there an earn-out period for the vendors? How this is structured may have implications for BADR entitlements.
- Is Stamp Duty payable? Is any bank interest tax-deductible from the borrowed? And what are the VAT considerations?
- If external finance is sourced, who is receiving it – Newco, the target company or individual purchasers? And what are the expected exit options for the purchasing management team in the future that ensure they are not liable for income tax?
- It is advisable to seek a tax clearance from HMRC for any MBO to gain certainty as to the treatment for sellers and management.
Kevin Barron, director, Richmond Capital Partners
Barron sees MBOs happen for many reasons; some because owners have faith in their management team, others as a way of a business passing on to the next generation while securing a pension for the sellers.
But in his view, “undertaking an MBO because you cannot see any other exit route is due to a failure to plan ahead. Such a move usual results in a poor outcome”. He emphasises that “an ability to run day-to-day operations does not necessarily translate into the ability to strategically run a business”.
To make an MBO happen he tells sellers to “create a second-tier management team with the ability to take the business forward”; this he says can take years to achieve.
Once this tier is in place Barron says the owners have to agree a payment plan: “It can be difficult to agree the amount to be paid and the timing of the payments. There is also the issue of how much money each member of the new management team will have to raise to buy their shares - if any - and what shareholding each member will receive.”
He adds that many get vertigo at the prospect of becoming a director or shareholder: “Some prospective team members will withdraw at the final stages under pressure from worried spouses about the risks associated with being a director or the requirement to raise funds.”
In relation to funding, Barron says that most MBO’s have to be majority financed by the vendors with payment terms stretching over several years. Barron details that if a business has a solid asset base it may be viable to raise money on the assets of the company, “but the higher the level of debt loaded onto a business the more likely it is to fail.”
It’s worrying that Barron comments that there are unscrupulous vendors, but “this can be a lose/lose result with the vendor not receiving full payment because the business has gone bust due to the new management team’s lack of ability”.
As for classic mistakes made by sellers, Barron says that there are a few including picking a team that lacks strategic thinkers; not putting in place solid vendor protection clauses limiting what the new management team can do until the consideration for the business is paid in full; and “vendors sailing off into the sunset on day one thinking everything will be okay”.
Mark Nelson, director, Compass Business Finance
Nelson thinks that MBOs can offer greater strategic value to a business owner than other routes. “In some cases,” says Nelson, “the MBO is part of a long-term strategic plan where the sale of the business to employees, who may be family members, has been discussed and agreed over a significant period of time.”
He believes that “by selling to employees of the business, you’re potentially selling to the most competent management team possible, due to their in-depth knowledge of the business, along with their relationships with customers and suppliers.”
Overall, Nelson says that MBOs negate the need to pay an agent to sell the business and can provide the most straightforward option for the seller.
He says that a typical MBO will take three to six months to complete, with up to four weeks for the finance to be agreed and put in place. “Finance,” he says, “should be one of the earliest discussions, so that the business owner can gain an understanding of how their employees intend to finance the purchase.” He adds: “It’s also important for the employee group to understand what you’re looking for, including the period of time over which you’d like the buyout to take place and how much, if any influence or control you would like to retain over the business during the transition period.”
To make a firm more saleable Nelson recommends ensuring there is equity within the business for the buyers to leverage to facilitate the buyout: “Buyers will typically utilise a mixture of asset finance, invoice finance and commercial loans to raise the required capital - where the debtor book and assets have already been leveraged, it can be a lot more difficult.”
Nelson says that it’s important to consider the timing of putting up the ‘for sale board’ – “left too long the attraction that would have once existed, no longer presents itself”.
He comments that businesses can feel a false sense of security, especially if they have paid off the factory mortgage, and most, if not all, of their loans and hire purchase agreements and just count the cash coming in: “The sense of security can lead to a lower appetite for investment in the business, including its people, technology, marketing, and infrastructure… the business can quickly begin to decay.”
Allied to this is the concern for Nelson that during the sale process owners can be tempted to stop driving the business forward - “this can also have damaging effects”.
He also advises being realistic, thinking about timing, preparing the business, considering the hurdles buyers may face, and requesting a due diligence questionnaire from your solicitors which will outline all of the documentation that’s going to be required.
Paul Philbrick, joint managing director, Close Brothers Asset Finance Print division
Philbrick thinks that most MBOs happen because “handing over the reins of the business to people that may have been involved with in it for many years is a natural progression and allows the current management team to finally have a stake in the business”. Invariably, though, he sees outgoing directors remaining involved for a period of time to ensure that there is a minimum of friction during the changeover period.
As to the process, Philbrick says it’s important to start discussions early with a specialist finance company like his: “We can offer guidance on values and assist with serviceability and viability questions. We can also work on deals that work for all parties and structure them with a blend of asset finance, term loans, or deferred consideration.” Overall, Philbrick reckons that the process can take anywhere from one month to a number of years, dependant on how driven the buyers and sellers are.
Of course, there are going to be issues and Philbrick sees them as involving businesses being overvalued by owners and “significant to’ing and fro’ing to agree a fair price”. He also comes across funding issues where there may be less equity available than expected, “which may mean a higher term loan or increased deferred consideration”.
He says his company usually releases cash secured against existing profit and margin and consolidates debt. He also recommends invoice finance to secure additional funding against the debtor book along with other key assets.
As for mistakes, the biggest Philbrick comes across tends to be a result of not opening conversations with a specialist finance company early enough; doing so “can offer guidance and speed of turnaround that could be pivotal to the right deal being done and help set a realistic outcome”.
So, what tips would Philbrick offer to those looking to make an MBO go off smoothly? “Good communication right from the start, honest conversations and realistic expectations moving forward.”
Leslie Manning, Rapidity
Rapidity was founded by Manning and his business partner, Jim Barr, in 1986. Originally called Printflow 86, then Printflow, the name was changed to Rapidity by Leslie’s eldest son, Paul around a decade ago.
As Manning explains: “The company offered what we used to term as ‘inplant overload’ printing for both digital and litho. At the time many large companies in and around London had their own inplant print operations. We would go after the overspill from these companies from our original factory in Shoreditch.” Clients included BP, British Standards Institution, the Stock Exchange and Citizens Advice. The business moved to Clerkenwell in 1990 and the next decade, says Manning, “saw the company grow to offer a much bigger service including design and typesetting, colour digital printing and litho”.
Barr wanted to retire around 2001 so Manning bought his shares to enable this and also made it possible for two other directors to purchase shares; this left him owning 70% of the business. The directors eventually left to pursue other ventures and around 2009 Manning ended up as sole owner of the firm.
As he tells, “I never really saw the company as a family business. However, at this point I had two older sons – Paul and Ben in senior positions, and two younger sons - Jack and Sam, (twins) joining in more junior positions.”
Manning says that he was starting to think of an exit plan. Paul had been very successful in 2012 in winning business from the Olympics which, as Manning says, “started me thinking that maybe my exit could be accomplished and still keep the business in the family… to me this was a win-win situation. Discussions for the sale were mainly between myself, my accountant and lawyer”.
Interestingly, he says that his sons felt that the decision on what was paid, and how, was a matter for him and HMRC. It was agreed that the company was to buy his shares for a set amount that would be a mix of cash and pension payments - “most was paid before I retired in May 2014, but a series of pension payments and profit share payments continued for a couple of years afterwards - the amount paid was a fair amount, and my sons were happy with the outcome.”
Manning says that he didn’t stay beyond the agreed date but did attend board meetings for a couple of years in a purely advisory capacity.