Management buyouts – the simple option

At times like these many of us decide to re-evaluate our priorities and long-term goals. For many small and medium-sized businesses, succession planning is a challenge and not an easy one to resolve.

There are many different ways of approaching the issue, but one of the simplest, cheapest and most common is to strike a deal with your management group by which they purchase the business and fund the payments out of the profits of the business over a period of time.

We have put several variants of this structure in place for clients over the last few years, ranging from consultancy businesses to professional services firms and environmental groups.

It seems like tempting fate to say so, but all the arrangements we have worked on have (touch wood) worked well so far for both sides of the bargain.

What works

What we think is key to the success of those deals is:

• a good mutual sense of what each party wants;
• a willingness to accommodate those wants;
• realism about value and the time it will take to pay; and
• pragmatism in negotiating the detail.

While it isn’t a driver for the deal, one of the side benefits is that the legal fees are usually low relative to an arms’ length transaction, and the process itself, which many private sellers can find stressful, is relatively stress-free.

How to do it

At its simplest the deal will go something like this.

1. Management team form a company and take shares in it in agreed proportions. This could, of course, just be one person: it doesn’t have to be a team.
2. That new company (the holding company, or HoldCo) agrees to buy the shares in the target company (TargetCo) off the current shareholders, typically the founders, at an agreed price.
3. Payment is made via an upfront payment with the balance being paid over a period in instalments.
4. Often those payments are calculated on a basis which enables the HoldCo to finance the payments out of dividends from TargetCo. There can though quite easily be (and often is) an element of borrowing and/or of shareholder equity.
5. Sometimes all the shares are sold up front and payment is made in instalments. On other occasions the shares are sold in stages, with the founders continuing to own the shares until payment is received at each stage. The purchase price for the shares at each stage may be either fixed or one determined by a formula.
6. Because the founders are handing over control before they have all the money, the share sale agreement will include provisions which restrict what the management team can do without the founders’ consent, until the founders have been fully paid. This list might include paying dividends, increasing their own salaries, borrowing money, charging assets or issuing new shares.
7. Typically as well the deferred consideration will be secured by security given by HoldCo and TargetCo, and possibly also by personal guarantees from the management team.
8. Because all the parties are familiar with the business and because the founders are only receiving the bulk of their money over time and remain "on risk", the usual legal process is much more restricted, which is where the costs savings come in. Often there is little or no due diligence and few, if any, of the "warranties & indemnities" which are often a heavily negotiated feature of sales to independent third parties and a key driver of fee levels.
9. For those reasons too the stress of the process is much reduced and the timescale both more reliable and also more relaxed. Given the negative impact that a sale process can sometimes have on the management of a business and on the people involved, this is not an insignificant advantage.

That is an example of a simple, basic structure. There are multiple possible refinements depending on the context.

And it is true that this will not work for some people or businesses where either the risk appetite is different or the value cannot be reconciled to this payment system or where there is simply a desire for a clean break.

But this structure does have numbers of advantages:

• it is quick and cheap (relatively).
• it is simple to understand and not over-engineered.
• it is generally seen as fair by those involved: something which is not always the case.
• it is tax effective.
• it often involves little or no external borrowing.
• the process of sale carries little risk to the people or business.
• the outcome should carry least risk to the business (or those employed in it) of any change of control.
• the chances of after-the-event disputes are low and the prospects of resolving them if they do occur are high.

If you are thinking of something along these lines, or just want to mull over possible options, come and speak to one of our experts.