Management buyout (MBO) funding is often needed when a management team has the opportunity to acquire the business from its owner(s). But the process to secure MBO financing can be confusing, time consuming, stressful and costly, even for experienced transactors.

A successful MBO is akin to a three-legged stool in terms of balancing the interrelated interests of the vendor, the buyer and the third-party funder(s). It effectively entails two simultaneous transaction strands: buying a company and funding the purchase. Both strands have potential pitfalls, even when transacting between friendly parties or even family succession MBOs, where children are typically buying out their parents.

The complexity of MBO deals and funding arrangements is best handled with the help of an experienced corporate financial advisor, able to handle both strands of an MBO seamlessly and play the vital ‘circuit breaker’ role of keeping all relationships intact, whilst achieving a workable deal for all parties.

Assuming the sale of the business has been agreed, following are the four key funding avenues available for a management buyout (MBO):

1 - Debt Backed MBO

The management team will naturally want to retain as much equity ownership of the business as possible post-transaction, with any deal consideration (borrowing) repaid over time from the future earnings of the business. This obviously brings into focus the available debt capacity of the business, which is typically calculated on multiples of earnings (Ebitda). For example, it is not uncommon for the debt markets to offer 2.5-4 times Ebitda in a buyout.

In turn, lenders will seek a balance of risk when lending their capital, which typically means that they will advance no more than 70-80% of the total deal consideration. The remaining 20-30% is expected to be carried by both vendors, through deferred consideration, and buyers’ contribution or ‘Skin-in-the-game’ , which is a mix of cash equity, personal guarantees and/or temporary salary sacrifice. Buyer cash contribution is key and must be a meaningful proportion of the personal net assets of each member of the management team.

It is important to note that debt lenders and advisors are keenly focused on post-transaction affordability of an MBO loan and that the business can comfortably service interest and scheduled principal paybacks from the company’s earnings. In addition, businesses will carry loan covenants, a safety margin between performance and a level where the lender can take remedial action to protect their capital.

2 - Equity Backed MBO

Some businesses may not have enough earnings to afford sufficient debt or the management plan may require earnings to be reinvested for business growth rather than for simply servicing debt. Also, some management teams may have no cash equity contribution at all or may not want the risk of debt service and covenant constraints on their business.

In these types of situations, equity funding is required to cover some or substantially all of the purchase price. Equity funders will seek an alignment of interest with the management teams being required to invest meaningful amounts of their own money (‘hurt money’). In exchange, the equity funders will typically incentivise the management with a significant equity ownership of their business, substantially beyond their hurt money contribution to the total purchase price and in some cases a majority stake.

One particular advantage of equity-backed deals is that management teams can avoid spending cashflow earnings on debt servicing. However, they must accept a lower equity ownership and often a controlling financial investor with commensurate board presence, additional non-executive directorships, voting rights etc or other control and oversight features.

3 - Vendor Financed MBO

We have been involved in vendor financed MBOs where the vendors effectively step into the shoes of the funder and the purchase price for the business is discharged with vendors exchanging their shareholding for a loan note. Loan notes are a debt instrument with a schedule of interest and principal payments, which is often secured on the equity in the business. This means that failure to meet loan note payments results in a return of the shareholding into the hand of the original vendors.

It must be said, substantially vendor financed transactions are usually down the pecking order of preference behind other funding options and typically result from a failure to fund with debt or third party equity. These deals can often be at risk of conflict, for example where every pound needed for a worthwhile investment by new owners is seen by vendors as a pound that could have been returned to them.

4 - Hybrid Arrangements

We come across hybrid transactions where partial buyouts of a majority stake are supplemented by an arrangement where the remaining shareholding is purchased over time based on a fixed formula and funding may also be a blend of debt and third party equity.  

The key in considering any such blend is whether all parties have enough clarity of ownership, scheduled payments and where the new owners have clear executive control and resources to drive their growth strategy post transaction.

We work with UK SMEs and small-cap PLCs that have the ambition to grow their business by acquisition. We often act as an outsourced Corporate Development team helping clients meet their strategic goals through mergers and acquisitions. Our value lies in helping clients build rigour into the acquisition search and execution process. For a confidential, independent, no obligation discussion on how to buy another business, click the 'Let's chat' button.