When planning for retirement, many business owners consider a management buyout. But is a management buyout the best way to sell your business? Often, if you can’t sell to your management team, you’ll likely get the most for your company by selling it to a strategic acquirer – usually a customer, supplier, or competitor.
Management buyouts are so popular because many business owners want to give their loyal employees a shot at owning the company. If you’re one of those owners – or one of those employees looking to buy a business – read on for a look at some of the key factors that make a management buyout possible and that are at least partially under your control. The two factors that supersede everything else are situational: timing and capability.
If you’re a manager working in a company you’d like to purchase, or if you own a company you’d like to sell to your management team, you must get the timing right. If you’d like to buy the company but the owner
isn’t ready to sell, they won’t sell. If that happens, you’ll probably get frustrated and look for opportunities elsewhere. Conversely, if you’re looking to sell but the management team isn’t ready or willing to buy, you’ll be looking for a different option.
If the timing is right and there is a willing seller and a willing buyer, the next question is whether the buyer can run the business without the seller. This is an obvious question to ask but the response has serious ramifications. This scenario has three potential outcomes:
a. Both the buyer and the seller believe the buyer is a capable manager. In this case, the seller will be comfortable selling the business and may even be willing to finance part of the sale. This comfort can lessen the requirements of the buyer to come up with cash up front, and the seller will be willing to step away from the day-to-day operations of the business faster – even if they still maintain a stake in the company.
b. The buyer believes they are a capable manager but the seller does not. This scenario makes it difficult to do a deal. The seller may not be willing to finance any portion of the sale. If they do finance the sale they will be less willing to cede control of the business during the transition because they will fear a loss of value as the incoming owners take control. The outgoing owners will likely demand a higher price for the business and want it all up front if they don’t trust the incoming buyers – they’ll want to get paid and walk away. This situation will require the buyer to source all the capital needed for the transition up front.
c. Neither the buyer nor the seller believes the buyer is a capable manager. This scenario rarely leads to a management buyout except in challenging circumstances such as the deteriorating health of the seller or some other life event that requires an ownership transition. In these scenarios there is typically an attitude of “being in it together” and the seller will work with the buyer to build their capabilities. This type of event typically pays the seller the least of the three scenarios and can require the seller to self-finance the entire transition and remain very involved in the business.
Timing and capability are clearly related. If you are a business owner who would like to sell your business and believe you’ll maximize value by selling to your employees, you should ask yourself whether you believe you’re in scenario a, b, or c.
If your answer is c, you’re not in a great situation. Get going, finance it yourself, and be happy that someone is willing to work with you. If your answer is a, you’re in the best possible position; start negotiating a price and the terms of the transition. If you answered b and you aren’t in a hurry to sell, you can work on this. You can either help the management team to learn and grow, you can bring in additional staff and support to fill any holes, or both. You have the time to fix the capability gap if you get started now. It is worth noting that if you fix the gap and have a management team in place that’s capable of running the business when you’re gone, you’ll likely sell your company for more regardless of who you sell it to (management or a strategic acquirer).
It is worth noting that if you fix the gap and have a management team in place that’s capable of running the business when you’re gone, you’ll likely sell your company for more regardless of who you sell it to.
If you’re moving ahead with a management buyout, another critical component is required to make it work: financing. The way your employees pay for buying you out can take a few forms:
SELF-FINANCE. The management team may have enough cash to buy the seller out of the business. Or, more commonly, the business owner can lend the buyers the capital they need to buy the business. Most sellers don’t like to finance 100% of a buyout but they are often willing to finance a portion, especially if they have a high degree of confidence in the management team (or there is no other way to get the deal done).
EXTERNAL-FINANCE. If a business is valuable enough, the management team may not have enough capital to buy it on their own and the seller may not be willing to finance the entire sale. When you can’t self-finance the entire purchase, you will need to go to external sources:
• Debt. You may or may not be able to fill the gap with senior debt. Typically, either through the company or personally, the buyers should use as much senior debt as is available (without impairing the business) to purchase the company because it is the least costly form of external finance.
• Subordinated debt. Subordinated debt can often be thought of as lending against the cash flow of a business. This type of financing tends to have a higher interest rate than senior debt because there is a higher risk of non-repayment.
• Equity finance. Sometimes a business is valuable enough that the only way to progress through a transaction is to bring in partners who can afford to cut a cheque to buy whatever portion of the transition cannot be self-financed. Partners can be financial or strategic and may bring different skills to the company. If the buyers have a skills gap, you may be able to fill it with a partner instead of an additional person on the management team.
External finance is often necessary, but whether you can get it or not depends on the same two factors we highlighted earlier, timing and capability. You can usually find a potential partner, regardless of timing, but depending on your industry it may be easier at certain times. On the other hand, if you cannot convince a potential partner that the management team is capable, they typically won’t invest. It all comes back to timing and capability.
If you’re considering a management buyout, make sure you have a capable management team when the time comes and you’ll increase the value of your business and the ease of the transition.
First published in the March 2019 edition of The Business Advisor.