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.

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