Good news: A company's key management may become the company’s buyer.
Bad news: Management usually does not have the cash to purchase a company for cash. The seller often creates a note secured by the stock of the company.
Definition: A management buyout (MBO) occurs when an existing management team purchases all or part of the company in which they are employed. (Private Capital Markets, Second Edition, p. 441).
Emotional Involvement: Regarding the note secured by the stock of the company, the future collection of the note is subject to the ability of the buyer to run the company with enough profits and cash flow to timely pay the note. The seller may be able to take back the stock of the company upon a default on the loan, however, the stock may be significantly devalued from the original sales price. The seller also runs the risk of not being able to “get away emotionally” from the company due to the personal stress related for the company to grow and succeed in order to pay the note to the seller.
Possible Competitors: It is not unusual during the sale process to receive an expression of interest from a group of key employees. Indeed, you may, through feelings of loyalty and camaraderie, prefer your key employees to be the buyer, even though they are not necessarily the highest bidder.
The primary difficulty in selling to key employees is they usually lack the capital and require you to finance them. Moreover, once your key employees become active bidders, they will not necessarily be as cooperative with other potential buyers who are willing to pay a higher price and do not need you to finance them. (Valuing Your Business, p. 121).
Institutional debt: There may be enough cash flow in the company for an MBO to take on debt for some or all the purchase. This can become quite complicated because there are numerous types of lenders that might be interested in funding the transaction, such as (Valuing Your Business, p. 122):
- Bankers and lenders
- Institutional financing
- Senior institutional lenders
- Mezzanine lenders (typically unsecured creditors and subordinated lenders
- Private equity funds
Fraudulent transfers: There may be much more in stake than first appears in the sale to key employees. A seller might consider the worst-case scenario before making such a sale. There is a risk that the management team may not run the company profitably. If so, the company may need to file bankruptcy sometime in the future. This might cause the people in charge of the bankruptcy to call the original sale a “fraudulent transfer,” which might cause significant damage to the seller. (Valuing Your Business, p. 122).
Pros and Cons: Below are some positive and negative issues related to an MBO (Sell Your Business Your Way, p. 21):
Key relationships to consider
|Upside||Very employee-friendly and strong continuity, this also offers a smooth transition from the current owners to current managers|
|Downside||This requires high leverage; there is no new blood, so few new perspectives on the business, and no new resources to grow the business|
|EBITDA Multiple||5X-7X EBITDA|