Management buyouts (MBOs) have become increasingly common in recent years, especially in small business acquisitions, and particularly among tech companies. A management buyout is a business acquisition strategy where the management team of a company buys the firm, often in combination with an alternative lender. In many cases, MBOs are supported by debt financing, whereby managers with limited capital can minimize their initial outlay and maximize their returns.
MBOs are particularly common for small businesses, especially in the transfer of family businesses over generations. The older generation may receive the financial benefits of a buyout while the newer generation takes control of the firm. In tech companies, MBOs constituted 20 percent of buyout deals in 2018 alone.
Management teams often partner with alternative lenders, such as business development companies (BDC)s, to finance buyout deals. While traditional lenders like commercial banks may be a go-to lending source for larger companies with consistent cash flow and favorable debt-to-income ratios, small and middle-market businesses often don’t meet those narrow requirements. Instead, alternative lenders are typically a much more attractive option thanks to their flexibility, speed, and easy application process.
In this article, we’ll explain what management buyout financing is, provide some management buyout examples, and spell out what you should keep in mind as you’re considering securing financing.
What Are Management Buyouts?
A management buyout is a transaction, often financed through debt finance, in which the management team of a company buys out the existing owners, purchasing the assets and operations.
Managers who want to be owners of the business, rather than employees, often find the prospect of an MBO appealing. MBOs are a popular mechanism for small business transitions, but they can also be used to take public companies private for a thorough operational overhaul, streamlining operations, and increasing profitability. They can also be used to spin off large companies’ divisions into separate businesses.
The management team would typically pool personal resources to provide capital for the MBO while arranging debt financing, often through a business development company or another external lender. Seller financing is also often an important piece of the MBO package. The team’s personal stake helps to assure their incentive to grow the firm.
An MBO is often the best option for a successful company that lacks a clear succession plan because it ensures a smooth transition to people who know the business and are best-positioned to ensure its success. Companies, especially small businesses, often do not carefully consider their liquidity options. This type of internal succession plan can often be the best option for all concerned, especially because selling to management reduces the risk of exposing confidential information and ensures a knowledgeable, sophisticated buyer, often with a high level of commitment to the company’s success.
Management buyouts come with low transition risk and minimal disruption because the management team buyers are highly aware of the details of the company’s operations. On the flip side, however, the seller may not get an optimal price. MBOs involve a fair selling price based on independent valuations in most cases, but a dedicated strategic outside buyer could potentially offer more for the company. Of course, this option depends on the availability of such a potential buyer.
There are several steps in preparing for an MBO, beginning with the management team establishing a strong record and business plan for the future of the company. Both buyers and sellers would need to assess the opportunities and risks involved and move into the following process:
- Determine fair market value of the business: An independent valuation can provide pricing guidance and will often be essential for obtaining outside debt financing. Due diligence on the status of the company, its financial and legal situations, is an essential part of the MBO process.
- Negotiate the structure of the deal: This process will involve multiple members of the management team and aim to meet the objectives of both parties as well as understanding the legal and financial requirements.
- Prepare the key paperwork: Participants and their legal teams would develop a memorandum of understanding covering the key aspects of the transaction and the financial elements necessary.
- Determine the best financing options: Management team members would determine how much of their personal resources they would invest in the MBO, while the seller would consider seller financing options. Parties would then consider business development companies, traditional banks, and private equity companies, depending on the size of the deal.
- Raise the funding: An alternative lender like a BDC may be the right fit for the MBO. The purchasers and/or sellers would go to a business development company with their documents and buyout plan to discuss debt financing options and secure the management buyout funding necessary.
- Finalize agreements and complete due diligence: Ensure all parties, including lenders, have the information they need and finalize the definitive sale and loan agreements.
- Close the deal and transition the company: All parties follow the terms of the buyout to finalize the deal.
Examples & Situations Where An MBO Is Necessary
Many MBOs occur when a company seeks to go private in order to boost its profitability and potential. One particularly well-known example of a management buyout came in 2013, when Michael Dell, founder of the eponymous computer company, paid $25 billion to take it private, with the help of a private equity firm. After the MBO, Michael Dell was left with a 75 percent stake in the company, the world’s third-largest computer manufacturer.
By 2018, Dell’s estimated worth was $70 billion, nearly three times its value at the time of the MBO. It went public again in December of the same year.
A more recent example of a management buyout was completed in November 2020. Fuse Media CEO Miguel Roggero led an MBO of his company with undisclosed terms, following a 2019 bankruptcy filing that left it in the hands of a group of private equity firms and hedge funds.
In the same month, former PricewaterhouseCooper Director Michael Line led an MBO of PwC’s fintech division, then known as eBAM. Following the buyout, backed by two private equity firms, the company was rebranded as LikeZero.
Different Options For Management Buyout Financing
Option 1: Debt Financing
There are several forms of debt financing, including the following:
- Non-bank cash flow lending, based on the company’s growth potential, which can be determined by algorithms and advanced software used by lenders, including business development companies
- Recurring revenue lending, based on income from subscription services and especially common for cloud-based or SaaS-focused tech companies
- Home equity lines of credit, or borrowing against the value of your home — which is easy, but also carries some risk, if the business doesn’t do as well as hoped
- Debentures, a bond or debt instrument backed by the company’s reputation and performance rather than collateral
Option 2: Seller/Owner Financing
Seller financing is a particularly popular source of management buyout funding and often involves a term loan amortized over a period of years following the buyout. Sellers tend to finance 5% to 25% of the total MBO value as part of a funding package. In essence, seller financing is a delayed payout for the business and shows the seller’s confidence in the buyout process.
Option 3: Mezzanine Financing
Mezzanine financing combines features of debt and equity financing. Mezzanine debt typically ranks below senior debt in priority but also comes above equity and may take several forms, including private securities, junior debt, subordinated debt or convertible debt.
Mezzanine financing is sought by management teams seeking flexible repayment terms and a higher return on equities. In return, mezzanine investors have a say in corporate growth strategies and develop repayment schedules in concert with the company’s cash flow.
What Else Should I Know About MBOs?
There are several factors to keep in mind when considering an MBO for your company, including the overall feasibility of the deal, other members of the management team who may come on as partners in the deal, and future plans for employee and customer retention throughout the transition period. Of course, your plans for financing the transaction are particularly important. Alternative lenders like business development companies can offer strong partnerships throughout an MBO due to their extensive experience and innovative, flexible approach to management buyout funding.
MBOs can be an incredibly successful way to transform a company and ensure a positive succession. However, there are some common mistakes that can undermine the process. Some of these are the difficulties that can come from moving from a non-owner/manager to a business owner or partner, while others involve dealing with the wrong mix of financing or an insufficient understanding of the financial partners involved in the transaction.
Due diligence is paramount in completing any transaction. When seeking a lender for your MBO, it is important to seek an experienced one with a proven track record. At Saratoga Investment Corp., for example, we pride ourselves on our reputation for meeting the financial needs of small and medium-sized businesses with speed and flexibility.
Management teams can review Saratoga’s investment profile to determine whether their company is a good fit to move forward with management buyout financing.