After 20 years of working around management buyouts — whether it was funding them at a venture-capital firm, raising financing for them at an investment bank, or advising business owners directly in a CFO role — I know they can be difficult transactions.
For one thing, they are often emotionally charged, and understandably so. The most common MBO scenario I see is one or more founding partner(s) or manager(s) buying out one or more others, and how many of us have joked that we spend more time with our business partners than our spouses?
Indeed, anything that can affect a person can also affect a small to mid-sized business partnership and possibly lead to an MBO, including stressful events like divorce, death, illness, and personal financial distress, as well as disagreements in vision or resentment between the partners. Then add in that structuring an MBO can involve creative combinations of arrangements like seller carryback notes, personal guarantees, earn-out agreements, and recapitalization with new debt and/or equity financing. Whether you — a partner or manager of such a company and, perhaps, its de facto CFO — end up on the acquiring or selling side, you’re likely going to be in gut-check mode.
Lately at my practice, perhaps because of perceptions that companies have greater value since rebounding from a recessionary environment in the not-so-distant past, advisory engagements for MBOs at small to mid-sized businesses management have been on the rise. Rather than discussing the infinite possibilities of structure, I’d like to offer some tips for the intangible nuances common in management buyouts that could help the process go more smoothly:
- Take care of your personal self in healthy ways. From observing management during the MBO process, it’s evident that negotiating a change in ownership while still trying to manage the ongoing business is a pressure cooker. The spotlight from banks, investors, and employees is on new management to establish company culture and lead the way. The party who’s performing the buyout may wish to press “pause” on the existing company for a spell, but that’s not possible, as scrutiny of the new management begins before the transaction is finalized.
- Don’t neglect the employees during the transaction process. As rumors begin to fly, employees can feel stressed and worry that the company is unstable.
- Before getting a formal valuation of the business, make sure you have an agreed-upon process for what to do with the valuation after it’s obtained. Imagine spending tens of thousands of dollars on a formal valuation opinion that no one ever looks at except the partner that paid for it. In some cases, a formal valuation is overkill.
- Analyze and forecast the company’s and new ownership’s ability to operate past any proposed buyout, in addition to considering legal advice. A lawyer does not always take into account the entire financial picture. Most often, new ownership has personal guarantees regarding post-buyout liabilities.
- Tax strategy can and should influence your structure and negotiations. It’s important to understand what might be construed as income, expense, losses or gains from both sides in order to structure tax-advantaged transactions. For instance, a high interest rate and a lower face value on a seller carryback note can seem like a great idea, until the seller figures in the tax consequence of interest vs. note repayment or the buyer considers that it could hurt the company’s debt service coverage ratios with the bank.
- Before having valuations performed, attempt to get a sign-off from existing management and ownership on the current financials and basic assumptions that would be used for valuation purposes. If you agree on starting figures and assumptions, it’s a lot easier to discuss valuation strategy or settle on a mid-range buyout number. If all the numbers are in question, even after valuations are performed, it can be a frustrating exercise of “so what?” reactions to the result of the valuation.
- Remember that the buyer is buying the exiting owner out of the current business, not paying for what the business will be worth in the future. In the kind of buyout scenarios I’m describing the point of exit is often forced, because a partner needs or wants to leave the company and it’s possibly not at an ideal time for the company to consider such a transaction. The manager or current owner purchasing the exiting partner’s shares is not a strategic acquirer that stands to pay based on a higher valuation driven by expected improvements in efficiencies and synergies. Rather, the purchaser usually assumes all the risk for completing the transaction and running the existing company.
- Adjust value for reality. Transition can create decline. Rather than blindly accepting a valuation number, consider employee turnover and increased need for incentives, neglected yet necessary capital expenditures, liabilities not necessarily on the balance sheet, unsettled litigation, upcoming professional costs, negative trends in the industry, effects from a recent lack of attention to the business, the solidarity of key banking relationships, and customer and vendor relationships. Formal valuations don’t always consider items like that, but after once assuming a CFO role after a management buyout, I now consider them seriously. New management is often taking a risk that they can right the ship.
- If you are leveraging your MBO, a professional plan, forecast, and presentation should convey to your lenders and investors a great opportunity to back someone who already knows the business and is likely to succeed.
- Along with new ownership of the company, all of its intangible assets, like non-compete agreements, intellectual property, trademarks, and customer lists, should be seriously addressed. There is no right or wrong way to do it, but a comprehensive understanding of the new roles buyer and seller will have post-buyout, and that the new roles won’t hurt the business, is of utmost importance to the new ownership.
Kira Spivak is the founder of CFO Services, a boutique Denver-area firm specializing in transaction-advisory, finance and accounting services.