In a management buyout don’t let emotion cloud business sense

A management buyout (MBO) can be the best means of disposing of a business but there are funding pitfalls to avoid, for the seller and the management team.

“From a seller’s perspective it can be seen as an attractive method of disposal, as the knowledge base is retained and the business will be in ‘safe hands’ going forward,” says Colm Sheehan, corporate finance director at Crowe. “It can offer a very positive outcome on an emotional level, as well as being financially attractive for the seller. But, as with any deal, it is important not to let emotions override the commercial rationale for the deal compared with other alternatives.”

Typically, an MBO will require a level of debt funding and/or deferred consideration to make a deal work. This brings an element of risk to the seller’s exit.

“If the management team have been historically incentivised in the form of a profit participation, there is potential that this could be rolled up into any deal, creating a form of equity that could sit alongside other sources of finance,” says Sheehan.

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In recent years Ireland has seen an increasing number of private-equity players interested in investing alongside experienced management teams. The seller needs to be conscious of the management team’s capacity to transact.

“Is the funding structure watertight and is the deal contingent on all members of the management team committing to the transaction? If one member falls away, does this impact the appetite of the remaining members?” asks Sheehan.

“From a buyer’s perspective it will be important to objectively determine the level of reliance the business has on the seller – does the seller hold the knowledge base and commercial relationships that makes the business tick and, if so, how is that replaced?”

While speed of execution and cultural fit are the upsides of an MBO, both Brian Fennelly, debt and capital advisory partner at Deloitte and his colleague, mergers and acquisitions partner James Toomey, highlight the fact that an MBO robs a deal of any element of competition, a major driver of value. It’s important, therefore, to be sure you are getting the right value from the business.

“There is a misconception that the management team needs to fund it all themselves. Not so,” says Fennelly. “Typically there is a cash element but debt always plays a role, in the form of financing from banks and alternative lenders. Banks will typically lend up to 50 per cent of the value of the business.”

The amount of debt will be a function of how much debt the business can sustain.

While the seller is often happy to “leave a little value on the table” as a way to say thanks to the team, Toomey sounds a note of caution: “If external private equity sits alongside the MBO team you need to be culturally aligned. Make sure you know who you are getting into bed with.”

Equally, he points out, if a business owner is to retain a small shareholding, they should make sure they understand what their minority rights are, to save conflict later.

And just because the management team knows the business, that does not mean they should go in with their eyes closed.

“You should still do your due diligence, just as you would with any acquisition,” says Fennelly.

When selling to a management team, owners should be aware of the challenge of differing price expectations, “which can hurt the team’s dynamic if a deal cannot be completed,” says EY Ireland corporate finance partner Ronan Murray.

In other ways the risks are the same as under a third-party transaction.

“Sellers may be ‘leaving value on the table’ if they exit the business at the wrong time. From the management team’s perspective, they should consider the potential negative impact of the seller leaving the business. Do they hold key customer relationships that could be put at risk?” asks EY Ireland corporate finance partner Fergal McAleavey.

“A deal can also have a negative impact on the company’s performance with management and departmental resources being stretched, so the timing of any earn-out or performance-contingent payments should be structured carefully.”