Management buyouts (MBOs) can be an attractive option to both the management team looking to buy a business and the owner wishing to sell it.
As a management team already knows the business well, MBOs are usually the smoothest type of succession and can offer a quicker, easier completion.
Raising finance is a key part of the process. MBOs can require significant funding, and management teams rarely have enough capital themselves to cover the total amount. Therefore, financing an MBO usually involves pooling together funding from several sources – both personal and external, and usually a mixture of debt (loans) and equity.
If you’re part of a management team looking to embark on the MBO process, you’ll need to know about the different funding options available. Getting the right combination of finance for your needs is crucial and will help ensure the long-term success of the business.
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This brief guide summarises the main types of finance used for MBOs and should help you get a better understanding of which may be best for you.
While it’s likely that third-party funders will provide the majority of the finance, it’s important that each member of the management team makes a financial contribution towards the deal. This investment can come from a variety of sources, including personal savings, re-mortgaged property, or the sale of assets such as stocks. The amount may not be huge in the context of the overall transaction, but it needs to be meaningful enough to each individual. This demonstrates to other lenders and investors that the team is incentivised and committed to the growth of the business.
It’s common for the seller to facilitate the management buyout by deferring a proportion of the purchase price (deferred consideration). This often takes the form of loan notes, which the buyer pays back over an agreed period of time.
Seller financing is often a good option for management teams as it reduces the amount of capital they need to raise upfront. It’s also evidence that the seller has confidence in their ability to make a success of the business and repay them, which makes the MBO appear more favourable to other finance providers. In fact, some funding offers may even be conditional on the seller deferring part of the consideration.
Earn-outs are a type of deferred consideration, which are often part of MBO deals where the business owner and management team can’t agree on a valuation of the business. The seller may have more confidence in the business’ future performance than the buyers do. In this case an earn-out, whereby the buyer agrees to provide an additional consideration to the seller when certain financial targets are met, can be a solution for both parties. It allows the management team to avoid overpaying based on performance projections, and enables the seller to remain involved with the business post-sale and earn a bigger price if the targets are reached.
Bank loans are often the first stop for management teams looking to fund an MBO – particularly those who wish to retain as much equity as possible. The management team will repay the loan over an agreed period of time and with an agreed interest rate. The loan can be either secured or unsecured, though unsecured lending from mainstream banks is less common.
Whether the bank is willing to provide funding will depend on a number of factors. They will look at both the business’ current and projected financial performance, and also at the personal finances of the buyers involved. This may include credit histories, net worth, and the amount of management equity put up by each individual.
There is a higher level of risk associated with unsecured loans, especially if the business is trying to raise a substantial amount. Therefore in order to raise the funding they need, the management team will normally be required to provide personal guarantees. This is where individuals are personally liable for repaying the debt in the event that the business fails to repay it.
In the case of secured business loans for MBOs, the borrower can pledge business assets such as property or machinery, and/or personal assets, as security. This can be a better route for management teams who need to raise a greater level of funding. And because the provision of security reduces the level of risk for the lender, they will also generally lend at a cheaper rate.
Alternative and specialised lenders
It can sometimes be difficult for a business to secure funding from high-street banks. There are some organisations that exist to provide debt financing when banks won't. Many of these organisations are pitched directly at small businesses.
On the flip side, as these alternative lenders are taking on greater risk, their loans will usually be subject to higher interest rates.
Private equity companies are another source of funding for MBOs. They will typically provide finance in return for equity shares in the business. As the company then grows, their shares increase in value. Private equity investors don’t often want to wait more than four to five years to make an exit. As they tend to be more focused on seeing a short-term return on their investment, their interests may conflict with the longer-term view of the business taken by the management team. It’s therefore important to choose the right investors if you’re going to use this type of funding.
Equity investment is a riskier (and therefore more expensive) form of finance, as it ranks behind debt in order of repayment if the business fails. Private equity firms may only invest in MBOs which they think will grow significantly within a certain time frame.
A less common funding method for MBOs, mezzanine finance is a hybrid of debt and equity finance. It can be used in an MBO transaction to bridge the gap between the amount of debt and equity the management team is able to raise, and the purchase price of the business. In terms of priority of repayment, it ranks behind senior debt (the debt that is paid back first if the company goes under – often provided by banks), but before common equity (the investments made by common shareholders).
This means that it’s a higher risk form of debt than traditional loans but it offers higher returns for the lender – rates are typically within the range of 10% to 20% per year. It also comes with equity warrants, whereby the funder can convert debt into stock and benefit from the growth of the business.
The Development Bank of Wales manages the £25 million Wales Management Succession Fund, financed by the Welsh Government and Clwyd Pension Fund. From this fund, we provide loans and equity investments between £500,000 and £3 million to help ambitious management teams buy Welsh businesses when the current owners retire or sell up.
We have years of experience in structuring finance for MBOs and provide flexible finance to suit your needs. Our funding covers the vast majority of the finance, so only a small investment is required.