The New Get Rich Quick Scheme

I recently got a call from two people writing a book about buying companies and doing it with no money down. They wanted me to help people that read their book, do exactly that. After talking to them I looked around on the web and found several (paid) ads selling this same system either through an online course or book.

To me this is the same old gimmick as the 'no money down' real estate schemes. I admit I have not bought any of these materials, but I believe my instincts that like any other get rich fast scheme, the vast majority of people never get these schemes to work and all they have done is lost time and money in the process. Here's some reasons why i question "no-money down" buyouts and acquisitions.

1) 'No Money' doesn't mean "No-Money." When buying a business you have to pay attorneys, accountants, and banks (at a minimum)and maybe advisers too. They may defer fees until closing but if the deal doesn't close, someone (usually the buyer) has to pay those bills, which can be $25,000 to $100,000 depending on the size of the deal.

2) These deals often don't 'sit right' with sellers - Sellers that figure out they are selling to someone not putting any money into a deal are almost always likely to back out. What then do they need you for? Why wouldn't they just sell to management.

3) No one will lie awake at night - if the buyer has no significant money invested in the company, what is going to happen if the business starts to lose money or suffer a downturn. Banks and other financing sources, like to know that someone is not sleeping at night if its not working out.

4) Why not just sell to management - When you think of it from the seller's perspective, why does the seller need that buyer. What value does the buyer really provide. If the answer is 'some management experience,' if I ere a seller I would stop immediately and sell to my company to management team.

So if you happen to be considering this and have no target acquisition already in mind, go on and think of another get rich scheme, like any Multi level marketing scheme, day trading or playing the lottery (which I do!).

If you happen to be someone that has found a company to buy and don't have the money to do it. Dwell on Pt #4, and consider helping management (and yourself) do a management buyout. Instead of you becoming sole owner, you become a key part of the team that buys the company. In the end, your chances of success go up exponentially and everyone, including both the owner and the team you expect to run the business can do something everyone can feel good about.

Creative Management Buyout Strategies

Abstract: Private equity firms particularly those that focus on buying smaller companies (less than $100 million in value), will often structure the financing of a buyout utilizing limited amounts of their own equity and aggressive debt structures. While such an approach can create spectacular returns for their investors, management and the sellers can often end up feeling shortchanged. Thankfully, owners and managers can use their own creative buyout strategies to create substantially more value for both buyer (management) and seller (owner).

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Typical Management Buyout Transaction

Most management buyouts are financed by an equity “sponsor”. A sponsor is typically a private equity firm that offers to purchase a company from the seller and give management a percentage of the ownership. For a smaller, profitable business (i.e. less than $100 million valuation) most buyouts are usually priced at around 5 X (times) free cash flow (i.e. earnings before interest taxes depreciation and amortization (EBITDA) minus capital expenditures). Management is typically offered the opportunity to invest some amount of capital for an ownership stake typically equal to 5% to 10% of the company stock. Through longevity and performance the management team may get the opportunity to double their ownership stake with additional options or stock. Total ownership, assuming all performance hurdles are met, rarely exceeds 20% of the company stock on a fully diluted basis.

For companies that are worth above $100 million, a 5% to 20% stake in a business can be very significant to each key member of management participating in the transaction. However, for a business that’s worth $25 million, the opportunity for three or four members of management to split 10% of the ownership is hardly a financial windfall.

In addition to their 80% ownership, buyout or private equity firms also collect significant fees at closing and charge additional advisory fees while operating a company they've acquired. They also typically take a share of the investment profits. The average annual management fee to do business with a private equity firm is about 1.5% to 2.5%. The average share of profits is about 20%.

Another Approach to Management Buyouts

For financially healthy businesses, there is another approach that utilizes the same financing and buyout techniques the pros use but management ends up gaining ownership and operating control. In fact, management can end up owning 85% to 100% of the company depending on the situation. These types of buyouts are called Non-Sponsored Leveraged Buyouts.

How they work
In a non-sponsored buyout, key members of management are asked to invest an amount of capital that is significant to them personally (this can range from $25,000 to over $1,000,000) depending on the collective personal wealth of the management team. What is most important to the financial partners is that management has some ‘skin in the game.’ The remaining amount of the initial proceeds to be paid to the owner comes from debt that is loaned to the company for the purchase of the business. Within the capital markets, companies that proactively shop aggressive funding sources should qualify for total debt financing of at least 4X cash flow.1 The proceeds from that debt (less capital needed for future working capital and growth) are paid to the owner in a one-time cash distribution. The difference between the amount paid to the owner and the total value of the company is the value and/or ownership retained by the seller. That retained ownership can come in different forms including common stock, preferred stock or subordinated seller notes or some combination of each. Table 1 illustrates different buyout scenarios at different valuations for a company with an annual EBTIDA of $5 million.

Advantages of Non-Sponsored Buyout

As the table suggests the amount of initial proceeds paid to the owner is capped by the amount that can be financed plus management’s own equity contribution. While that initial amount maybe less than a 100% sale, often the difference can be relatively small depending on the valuation of the Company. Further, the advantages for both management and owner can be very significant.

Higher Ownership Stake for Management - The primary benefit of a non-sponsored buyout for management is the opportunity to own significantly more of the stock than possible with a sponsored transaction. Even at higher multiples such as 6 X (times) or more, management is positioned to own more than 50% of the total common stock, which is far more than the total ownership in a typical sponsored buyout transaction (usually less than 20%).

Higher Company Valuation for Seller – As mentioned earlier most private equity firms value companies at around 5 X (times) cash flow (EBITDA) and many times less. When selling to management, owners can typically get a higher valuation even though their initial proceeds will be limited to the amount of financing available plus management’s contribution.

Greater Control for Both Management and Seller – With a non-sponsored transaction, control of the business is maintained between management and the owner(s). Provisions can also be made for control to pass as the debt is paid down or paid off under any scenario acceptable to both buyer and seller.

Highly Vested Management Team and Continued Role for the Owner – Management teams that have significant ownership stakes are much more likely to perform at high levels than those that have less of stake. Conversely, many owners feel remorse after selling their business and would have desired to maintain a role in the company. A leveraged non-sponsored buyout accomplishes both.

Significant Liquidity to the Owner – Even though the owner hasn’t sold 100% of the business, the liquidity can be significant and is ‘true’ liquidity because the debt should have no personal recourse to the seller (owner).

Requirements for Non-Sponsored Buyout

The process of completing a non-sponsored management buyout is similar to other kinds of business financing. The key requirements for a successful non-sponsored buyout include:

Quality Company and Team – An ideal situation is for the buyer (s) to already be running a profitable business. Common situations would be a CEO that buys a company from a passive owner or a limited partner buying out his or her majority partner (s). The key is for would-be lenders or investors to have confidence in the management team once the owner walks out the door.

Proactive and Committed Management Team – Many prospective buyers never ask for the opportunity to buy their owner’s business. They are unsure and worried about how to bring up the subject. The best way to start such discussions is to informally ask, either over lunch or at an impromptu meeting. I have heard managers use phrases like, “would you ever consider selling the business to key management.”? Or even more simply, “if you ever decide you want to sell the business, we would be interested to try to put together financing to buy it.” When phrased that way it’s difficult for an owner to feel threatened by such a question. Many may even say they have waited years to hear such words.

Once management has permission to pursue a buyout, they need to remain committed to doing a non-sponsored buyout. Most of the financial industry from equity firms to advisors to banks will try to encourage management teams to do a sponsored deal because it’s easier for them. Unfortunately, an easy transaction doesn’t help management get a large ownership stake in their company. Thus, it is important to remain committed and find advisors and financial institutions with experience and a desire to do non-sponsored transactions. Also, if the owner is already going through a process to sell the business, management can hire their own advisor and go out and put together their own offer. We have found that if management can put together a total package that is somewhat competitive to an outside offer the owners will pick management.
Target Purchase Price – Developing a purchase price can be complicated or easy depending primarily on whether the owner has a price in mind. Within the financial community a company’s sales price is analyzed as a multiple of EBITDA. As shown earlier any purchase price between 4 X and 6 X (times) is likely to give management a much greater stake in the business than they would working with a private equity sponsor. Simply put, if the seller’s desired purchase price is anywhere in this range, management should seek to pay it, especially since the owner is giving management a once in a lifetime opportunity.

Maintain Flexibility with Owners - Books and guides to management buyouts suggest that management formalize their buyout terms similar to an acquisition through a Letter of Intent (LOI). This approach can be difficult because owners are always moving targets. They typically do not know really what they want until they are presented with options and feedback on financing terms. We suggest the management team get the owners to disclose the target purchase price and expected initial cash proceeds from the buyout. Once you receive initial financing terms, owners may continue to change what they want. Some owners even decide to provide some of the financing themselves once they see the rates certain lenders will receive. Regardless, owners typically stay moving targets right up until the end of the transaction so it’s important to keep them in the loop, have them committed to a process, and let them adjust as the process unfolds.

Strong Business Plan – The basis for the buyout and its potential should be spelled out in a very high quality business plan. The better and more thorough the business plan and projections, the greater the interest from prospective financing sources and the better the financing terms and cost. A high quality plan is typically 40-60 pages in length with a concise well written explanation of the business, industry, history, competition and management. The business plan should also include historical financials and detailed projections including income statements, balance sheets and cash flows. Ideally, projections should be done for a 5 year period with the first two to three years projected on a monthly or quarterly basis. Those projections then outline how much capital the company will need both now and in the future. The projections should be optimistic yet achievable. Creating a quality business plan is often the most tedious part of the financing process, however advisors (such as our firm) will typically take on the role of drafting and distributing the business plan which allows the plan to get out to the appropriate financing institutions faster and with less fatigue for management.

READ MORE ABOUT MANAGEMENT BUYOUT STRATEGIES

Shaky Economy Creates Buyout Opportunities

In a shaky economy a logical strategy for management is to focus on just hanging on to the business you have. For proactive management teams and owners it can be a time to reconfigure the business or ownership in order to realize in greater benefits in the future. Such is probably the case in recently announced buyout of Landry’s Seafood (NSYE: LDY).
See (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aLzJzpgNuSuM).

Looking at the proposed buyout terms, which include buying out all the outstanding shareholders at $21 per share and assuming $885 million of debt, the most interesting aspect is the upside for the future majority owner, Company CEO and Chairman Tilman Fertitta. Under the shareholder approved plan, Mr. Fertitta will roll over his existing equity, (approx. 39%), invest another $90 million of cash and raise an additional $50 million of preferred equity. (Source: http://www.creditinvestmentnews.com/.) Making some assumptions, Mr. Fertitta will likely increase his ownership stake from 39% to 80% of the company stock.

It’s easy to look at such going-private transactions as a quick “flip” strategy of taking a company private only to take it public again when the economy or capital markets improve. But Landry’s buyout offer is $21 per share equating to a market value of the Company of $415 million and the highest market value for Landry’s in the last three years was a little over $35 per share (December 2006) equating to company market value of $565 million. The historical highs of the stock and the accepted buyout price do not lend themselves well to a company that can be easily ‘flipped’ back to the public market when the overall market improves. This buyout will work based on improving the business which means increasing free cash flow and paying down debt.

Market slowdowns or changing economies often uncover long held differences between owners within a company. During times of change, proactive owners to can take advantage of such situations and buyout shareholders that are now willing to sell in order to reduce their risk or put their capital elsewhere. Most important, it creates valuable opportunity for a co-owner to gain full control of his or her destiny and do the things they believe will create substantial value in the future.

Getting to First Base

Regularly talking to managers wanting do a management buyout or leveraged buyout, one of the most difficult parts of the process is approaching the owner to ask for that opportunity. While many have the endorsement of the owner from the beginning others have to go ask for it. Facing a ‘chicken and the egg’ scenario managers don’t know whether to seek a possible financing partner first or approach the owner to ask for the opportunity.

Most buyout or private equity firms encourage managers to seek them first by rationalizing that the private equity firm can better negotiate the purchase price and make managment look like a qualified buyer in the eyes of the owner. But for a variety of reasons it is far better for managers to talk to the owner first then seek possible funding altneratives.

First, it is much easier to bring up the subject of a buyout, if a manager can ask in passing and little real work has been done to that point. The key is for managers to get ‘permission’ to proactively look for funding alternatives. From that conversation managers will get a telling window into whether the owner wants to do a buyout or not. My experience has been that such discussions go bad or good depending more on the owner than whether a manager has lined up possible financing.

A much more important reason to start with the owner is to give managers plenty of time to competitively shop for financing. Assuming an owner gives permission, managers will want plenty of time to shop every possible alternative because the cost of the financing and most importantly how much ownership and value management ultimately receives will vary substantially from one financing source to another.

As an example, we had a client management team that sought financing and we helped them get seven financing proposals with management’s equity stake ranging from 49% to 100% of the company stock after closing. Clearly, management wanted 100%, but getting to that point, required a competitive shopping process to do it.

Ideally, doing a management buyout, like business, becomes a team effort with the owner’s input clearly taking a driver’s seat. But by starting with the owner's consent, management is then in a driver's seat to put the pieces together to get the best possible deal for themselves while giving the owner what he or she wants.

Management Buyout- How to Successfully Execute a Management Buyout

Private equity firms like the Carlyle Group, Kohlberg Kravis Roberts (KKR) and many others have made huge returns for investors through buyouts. Using financial engineering and a lot of debt these firms buy companies with little money down. While these types of transactions create spectacular returns for investors, they often shortchange the seller and management teams that drive the business. Thankfully, owners and managers can use these same financial tactics to buy and sell their business and have the benefit accrue to them.

How Most Buyouts are Done - Sponsored Leveraged Buyouts Vs. Non-Sponsored Buyouts

Private equity firms do hundreds of buyouts a year. Their typical approach is to offer to buy a controlling stake in a company using leverage they obtained from banks based on the financials of that company. Often times these firms commit very little of their own money to purchase the business. With little cash invested, these deals create spectacular returns for the buyout firm.
Buyout firms also collect large fees up front, as well as additional advisory fees while operating a company they've acquired, and a big share of the investment profits. The average annual management fee to do business with a private equity firm is about 1.5% to 2.5%. The average share of profits is about 20%. While buyout firms give management ownership, it’s usually less than 20% of the company. This type of buyout is the most common and is typically called a Sponsored Leveraged Buyout, where the equity player is the “Sponsor.”

For financially healthy businesses, there is another approach that utilizes the same financing techniques but management gains operating control. In fact, management can end up owning 85% to 100% of the Company depending on the situation. These types of buyouts are called Non-Sponsored Leveraged Buyouts.

Keys to Non-Sponsored Buyouts

The process of completing a non-sponsored management buyout is pretty much like any other kind of business financing. The key requirements for a successful non-sponsored buyout include:

Quality Company and Team – An ideal situation is for the buyer(s) to already be running a profitable business. Common situations would be a CEO that buys a company from a passive owner or a limited partner buying out his or her majority partner(s). The key is for would-be lenders or investors to have confidence in the management team once the owner walks about the door.

Proactive Management – Many prospective buyers never ask for the opportunity to buy their owner’s business. Many are reluctant because they are unfamiliar with the process or believe they can’t qualify for financing. Interestingly, it’s the financials of the company, not the individuals that drive the ability to perform a non-sponsored buyout. The best way to start such discussions is to informally ask if the owner is open to discussing it. Once you get a ‘yes’ (even a tentative ‘yes’), more homework can begin.

Agreement on Purchase Price - Agreeing on a purchase price can be as complicated or as simple as both parties want to make it. Still, most small to mid-sized companies are valued at a multiple of between 4 to 7 times cash flow (commonly called ‘EBITDA’ – for earnings before interest, taxes, depreciation and amortization). As an example a company that makes $2 million a year EBTIDA would be worth $10 million at a 5 multiple (5X). Knowing this, the most direct way to get a price is to ask the owner their price. Any purchase price within a 4 to 7 range will probably work. In fact, our experience has shown buyers will end up owning more through a non-sponsored buyout than a sponsored buyout even if they have to overpay some in order to buy the company.

Understanding Financing Options - Most companies know they can get debt from banks and equity from buyout funds. However, a there are a variety of lesser known funding sources such as subordinated debt lenders, insurance companies, corporate development companies, hedge funds and other specialty lenders that will lend beyond a traditional bank. These are the same institutions that buyout firms use. Depending on the economic climate many of these firms will lend up to and sometimes over 4 times cash flow (EBITDA).

Buyout Math: Putting It All Together
Following the math here, if a buyer purchases a company for $10Million (5X EBITDA) and can borrow $8Million (4X EBITDA) they end up owning 80% of the Company. Owners are satisfied because they get cash up front with no recourse. Buyers like it because they get control. Also, most of these specialty lenders do not require personal guarantees limiting the downside risk to new owners. Over time the owner’s remaining interest can be bought out, often at a higher valuation. Most important, the value to all parties is directly driven by the buyer’s performance rather than financial engineering by outside investors.