MBO Guide - Turning Executives into Owners

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This guide is designed for managers who are considering a management buy-out (MBO). It provides background on management buy-outs, how to spot an MBO opportunity, outlines the typical buy-out process, funding and legal structures, highlights many of the key issues that management will face and explains how DVR Capital can assist in negotiating value for the management team.

MBO Guide - Turning Executives into Owners

  1. 1. DVR Capital Corporate finance for progressive businesses. The key to buying your business An insightful guide to MBOs DVR Capital Limited 5th Floor, Portland House 4 Great Portland Street London, W1W 8QJ United Kingdom Tel: +44 (0) 20 3371 7248 www.dvrcapital.com
  2. 2. DVR Capital An insightful guide to MBOs Table of Contents 1 MBO Fundamentals ....................................................................................................................................................... 3 1.1 What are MBOs, MBIs and BIMBOs? ............................................................................................................. 3 1.2 Why do management teams undertake MBOs? ....................................................................................... 3 1.3 Where do MBO transactions go wrong? ...................................................................................................... 5 1.4 What transaction costs are incurred undertaking an MBO?............................................................... 6 2 MBO Market Context ..................................................................................................................................................... 7 2.1 How common are management buyouts? .................................................................................................. 7 2.2 Where do MBO opportunities come from? ................................................................................................ 8 2.3 What makes an attractive MBO opportunity? .......................................................................................... 9 2.4 What does a MBO team look like?.................................................................................................................. 9 3 Raising Money for the Management Buyout .................................................................................................... 10 3.1 How much funding is required? .................................................................................................................. 10 3.2 How is the purchase price established? ................................................................................................... 10 3.3 How are MBOs structured financially? ..................................................................................................... 11 3.4 How much money does the management team have to invest? .................................................... 12 3.5 What are equity investors looking for? .................................................................................................... 12 3.6 How do performance ratchets incentivise management? ................................................................ 13 3.7 How should MBO teams choose an equity provider? ......................................................................... 13 3.8 What are debt providers looking for? ....................................................................................................... 14 3.9 How should MBO teams choose a debt provider? ............................................................................... 15 4 Dealing with the Vendor........................................................................................................................................... 16 4.1 Do we need to approach the vendor before pursuing a buyout?................................................... 16 4.2 How should the management team approach the vendor? ............................................................. 16 4.3 How is management’s conflict of interest addressed? ....................................................................... 17 4.4 What advantages does a MBO offer to vendors? .................................................................................. 18 5 MBO Process and Timeline...................................................................................................................................... 19 5.1 What is a typical buyout timescale? ........................................................................................................... 19 5.2 Which professional advisers should the MBO team appoint?......................................................... 20 5.3 What should be included in the business plan? .................................................................................... 20 5.4 How are MBOs legally structured? ............................................................................................................. 22 5.5 What due diligence is undertaken? ............................................................................................................ 22 6 DVR Capital: Your MBO Partner ............................................................................................................................ 22 © DVR Capital Limited 2009 Page 2
  3. 3. DVR Capital An insightful guide to MBOs This guide is designed for managers who are considering a management buy-out (MBO). It provides background on management buy-outs, how to spot an MBO opportunity, outlines the typical buy-out process, funding and legal structures, highlights many of the key issues that management will face and explains how DVR Capital can assist in negotiating value for the management team. 1 MBO Fundamentals This section covers definitions of a management buyout and its variants, the motivations of management teams, the economics of a buyout for the MBO team, the typical legal structure of a buyout, industry data on buyout transactions and how to spot a buyout opportunity. 1.1 What are MBOs, MBIs and BIMBOs? For most management teams, MBOs are a once-in-a-lifetime opportunity to obtain significant rewards for a small investment: • A management buyout (MBO) is the purchase of a business by its management, usually in co-operation with a venture capital firm and supported with bank debt. The management team gains a substantial equity stake in the business usually for a relatively modest personal investment. The management team creates value by paying down the debt and growing the business. Upon sale of the business, typically in 5 years time, the management team realizes significant gains. • A management buy-in (MBI) is the purchase of a business by a new management team, usually in co-operation with a venture capital firm and supported with bank debt. • A BIMBO is a combination of management buy-out and buy-in where the team buying the business includes both existing management and new managers. MBOs, MBIs and BIMBOs are all very similar in nature in that a management team is purchasing a business with the assistance of financial backers. The key difference between these lies in the familiarity that the management team has with the business and the ability to demonstrate that the management has a track record operating together. MBOs are considered the least risky, followed by BIMBOs then MBIs. For sake of simplicity, throughout this document, MBOs, MBIs and BIMBOs will be referred to as MBOs. 1.2 Why do management teams undertake MBOs? There are many reasons why management teams undertake MBOs including an ability to shape strategy, gaining more control over the business, obtaining freedom from group constraints and reducing the fear of redundancy or a new owner. The most important reason why management teams undertake MBOs is to obtain a significant equity shareholding in a business that can be grown to yield a significant capital gain within a three to five year timeframe. © DVR Capital Limited 2009 Page 3
  4. 4. DVR Capital An insightful guide to MBOs Illustrative Deal: Acme Limited This example shows how a modest investment by the management team in an MBO can reap large returns. The management team running Acme Limited agreed to purchase the business from its owners for £20 million. In addition, the business needed an additional £1 million for working capital and the transaction fees for the investment banking, legal, tax and accounting advisers totalled £1 million. The £22 million total funding requirement was raised from a variety of sources: • £13 million of bank debt [£12m senior debt + £1m overdraft] • £8.7 million of venture capital funding [£8m preference shares + £0.7m ordinary shares] • £0.3 million commitment from the management team (‘skin in the game’) The management team and the venture capital firm agreed to split the shareholding 30% / 70% in favour of the venture capital firm. A summary of the funding requirements and sources of finance is shown here: Following the MBO, the management team spend the next few years building Acme Limited, growing revenues, improving operating margins and revitalising the company’s competitive position. Four years after the buyout, the management team sells Acme Limited to a trade buyer for £60 million. At the date of trade sale, Acme Limited had paid down half of the bank debt. Assuming transaction fees of £1.5 million for the sale of Acme Limited, the sale proceeds would break down as follows: As can be seen, management’s investment of £0.3 million generated a capital gain of £12.3 million (£12.6 million less £0.3 million). Note: The above example ignores the effects and use of vendor financing, share options, equity ratchets and tax.
  5. 5. DVR Capital An insightful guide to MBOs 1.3 Where do MBO transactions go wrong? Unfortunately, MBOs can and do go wrong for lots of different reasons – most of which are avoidable with proper transaction management. Common reasons why MBOs never materialise or do not achieve the desired result for the management team include: 1. The MBO opportunity is never initiated • Management is not aware that an MBO opportunity exists • Management is too afraid to initiate discussions with the vendor due to unknown vendor reaction, heated political circumstances or fear of loss of employment 2. The MBO opportunity is blown • Management fails to convince the vendor to allow the management team to bid for the business or cannot agree a first shot before the business is put up for auction • Management discloses confidential information to third parties without first obtaining approval of the vendor • Management cannot secure funding from equity investors and debt providers (team not credible, unclear business plan, timelines too tight, not right investors, etc.) • The vendor becomes suspicious that management is deliberately underperforming so that they can purchase the business at a knock-down price • The window of opportunity is lost and/or management does not meet deadlines agreed with the vendor • Management loses its cool in negotiations with the vendor and destroys the trust built up between management and the vendor • Management cannot get the vendor to agree to pricing on realistic terms • Management cannot agree on who should be in the management team, commitment to the process, level of personal investment and equity structure 3. The MBO is agreed on suboptimal terms • Management overpays for the company and/or assumes onerous terms • Management leaves significant value on the table with equity and debt providers • Equity investors become very controlling and unsupportive of management • The business environment or opportunities change and equity investors refuse to invest further in the business and prevent management from seeking other sources of finance Your financial adviser can help you avoid many of these pitfalls. © DVR Capital Limited 2009 Page 5
  6. 6. DVR Capital An insightful guide to MBOs 1.4 What transaction costs are incurred undertaking an MBO? The costs incurred in a management buyout typically include: • The MBO team’s financial, legal and tax advisers • The institutional investor’s legal and due diligence advisers • Bank arrangement fees While transaction costs vary from deal to deal, the total cost ranges anywhere from 4% - 10% of the value of the company and varies based on the size and complexity of the transaction. The good news is that most financial advisers and some legal and tax advisers will structure their fees to be only payable upon legal completion of the buyout. This reduces the risk to the management team that if the buyout fails, they are not out-of-pocket. Nevertheless, the deal-abort costs should be agreed in writing as early as possible to ensure that the management team is not personally liable for fees in the event that the deal is aborted. Equity investors often agree to pick-up the deal-abort costs related to the management team’s legal advisers and tax advisers as well as their own costs of due diligence and legal advisers. In some circumstances, vendors may also be prepared to assume the deal-abort costs where the vendor may withdraw from the sale of the business. © DVR Capital Limited 2009 Page 6
  7. 7. DVR Capital An insightful guide to MBOs 2 MBO Market Context This section covers market data on volume, value and sources of management buyout transactions and the factors that make an attractive MBO opportunity. 2.1 How common are management buyouts? You may be surprised to learn that in the UK there are over 600 MBO transactions a year and that MBOs represent about half of all M&A transactions – a ratio that has held constant for many years as shown below. Overview of UK MBOs and MBIs (2006) General M&A Activity MBO/MBI Totals MBO/MBI % No. Deals Value (£m) No. Deals Val (£m) No. Deals Val (£m) 2000 587 106,916 623 23,963 51.5% 18.3% 2001 492 28,994 644 19,548 56.7% 40.3% 2002 430 24,236 639 15,500 59.8% 39.0% 2003 558 18,679 715 16,308 56.2% 46.6% 2004 741 31,408 709 20,490 48.9% 39.5% 2005 769 25,134 694 24,169 47.4% 49.0% 2006 777 28,501 683 26,542 46.8% 48.2% Source: CMBOR/Barclays Private Equity/Deloitte MBOs take place in all sectors, regions and size ranges. In 2006, the breakdown of MBOs by sector was as follows: Sector Distribution of UK buy-outs / buy-ins (2006) Total Avg No. Of Value Value Sector Group Deals (£m) (£m) Business & Support Services 87 2,438 28.0 Financial Services 32 1,511 47.2 Food and Drink 28 3,279 117.1 Healthcare 21 1,130 53.8 Leisure 39 5,494 140.9 Manufacturing 163 2,522 15.5 Paper, Print, Publishing 17 91 5.4 Property & Construction 31 2,436 78.6 Retail 52 3,228 62.1 Technology, Media & Telecoms 83 2,135 25.7 Transport & Communications 19 1,049 55.2 Others 86 1,007 11.7 Total 658 26,320 40.0 Source: CMBOR/Barclays Private Equity/Deloitte © DVR Capital Limited 2009 Page 7
  8. 8. DVR Capital An insightful guide to MBOs 2.2 Where do MBO opportunities come from? MBO opportunities originate from many sources. According to research from CMBOR/Barclays Private Equity/Deloitte, between 2001 and 2005, family and private companies topped the source of deals in the UK. Sources of UK MBOs and MBIs by volume (2001-05) MBO Deal Source % Family & Private 29% Local Parent 28% Receivership 10% Secondary Buyout 10% Unknown / Other 10% Foreign Parent 9% Public to Private 4% Total 100% Source: CMBOR/Barclays Private Equity/Deloitte Behind the numbers, there are usually situation-specific factors that indicate the potential for a management buyout. • Retirement Sale: The owner of a family business may wish to retire and has no successors • Sale of a Subsidiary: A corporation or group may decide that a particular business or geography is non-core and wishes to sell off the business • Unwanted Acquisition: A major corporate acquisition results in unwanted subsidiaries or businesses that must be sold to comply with regulation • Conflicting Shareholder Interest: Divergent shareholder aspirations create the need for some of shareholders to be bought out • Public to Private: A public company is better suited to be run as a private company • Need to Realise Investment: Institutional owners (e.g. VCs / PEs) need to exit its investment • Company in Receivership / Administration: A receiver or administrator may wish to sell a business as a going concern © DVR Capital Limited 2009 Page 8
  9. 9. DVR Capital An insightful guide to MBOs 2.3 What makes an attractive MBO opportunity? To evaluate whether a particular company is suitable for a management buyout, the existing business must be analysed and several factors must be considered and evaluated holistically. These include the following: More Attractive Less Attractive • Vendor with reasonable pricing • Vendor with unrealistic pricing expectations expectations • Track record and visibility of generating • Development stage companies or free cash flow companies with erratic cash flows • Proven management team • Newly formed management team • Defensible market position • Cyclical industry • Stable industry sector • Significant capital investment or R&D • Secure contracts requirements • Spread of customers and suppliers • Highly concentrated supplier or • Commercially-viable on standalone basis viable customer base • Integrated group business It is often the case that the business is partly-integrated into a group with a moderate amount of he integrated inter-company trade and capabilities such as information technology, operations and marketing company shared across several group companies. These interdependencies create both risks and costs cost when pursuing a management buyout and thus need to be carefully assessed. 2.4 What does a MBO team look like? A typical MBO team will comprise the 3 or 4 senior executives from inside or outside the pical business: • Chief Executive / Managing Director • Finance Director • Sales Director • Production / Operations Director It is quite common that the management team is incomplete and external executives need to be recruited. What is important to financial backers is that there is a core team with a balanced range of skills and a track record of success that can be built upon. Equally, the management team will need to provide prospective financial backers a compelling strategic plan for the business and convince them that the management team has the skills and track record to deliver against the plan. o
  10. 10. DVR Capital An insightful guide to MBOs 3 Raising Money for the Management Buyout Most management teams will not have sufficient funds to purchase their business outright and will need to look to a variety of outside sources for funding. This section covers the amount and composition of funding, how much the MBO team needs to contribute, what debt and equity investors are seeking and how MBO teams should evaluate different debt and equity investors. 3.1 How much funding is required? The funding requirements for a management buyout will typically include: • the purchase price of the company • working capital requirements • transaction costs and; • any existing debt transferred with the business. Depending on the type of company and situation, additional funding may also be needed for organizational restructuring, capital investment programmes and/or bolt-on acquisitions. The amount of funding required, risks and rewards will all need to be estimated. For capital investment programmes and bolt-on acquisitions in particular, it may make more sense to phase capital raising into two stages: the first to secure the business for the management team and the second to raise expansion capital. Your financial adviser can assist you with determining whether funds should be raised in one or two stages. 3.2 How is the purchase price established? The purchase price of the business is established through negotiation between the vendor and the management team and its advisers. Occasionally, the management team will be invited to an auction for the business alongside other prospective buyers. The vendor will typically be aiming for the highest price for the business and will consider an offer from the management team in light of what the vendor believes the business is worth and/or any other competing offers for the business. The management team will need to determine how much the business is worth, what the maximum price they should offer to pay for the business and what the bid strategy should be. The management team may be guided by the vendor’s pricing expectations but should also undertake a valuation of the business to ensure that they do not overpay for the business. Company valuation is not an exact science. Typically, several methods of valuation are used for arriving at the worth of a business including: • Public-Company Comparables. The market capitalisation, price-earnings multiples, revenue multiples and cash-flow multiples of similar, publicly-listed companies can often be used to establish the valuation drivers for the business. Typically, these valuation comparables are backward looking as they will rely on © DVR Capital Limited 2009 Page 10
  11. 11. DVR Capital An insightful guide to MBOs • Transaction Comparables. Where similar businesses within the same sector and size have been bought, sold or invested in recently, a comparable can be established. Utilising similar valuation multiples and drivers, perhaps adjusted for the business, can then be used to arrive at a valuation for the business. • Discounted Cash Flow (DCF). Under DCF, future cash flows for the business are projected out several years and then discounted back to their present value based on the weighted-average cost of capital. Arriving at a valuation of the business using DCF is more involved than using comparables, however, DCF analysis typically yields significant insights into the valuation drivers for the business and thus assists significantly in assessing strategy. • Net Asset Value. The net asset value of the business is simply the value of the assets less any liabilities on the balance sheet. For most management buyouts, net asset value has very limited application as balance sheets are both historic in nature and only capture goodwill of the business that has been acquired but not created. The management team and the advisers are likely to have different views regarding the worth of the business and the walk-away price. Equally, investors will also have a view as to the worth of a business and this is typically more conservative than the management team’s valuation. 3.3 How are MBOs structured financially? MBO’s are funded from a variety of sources including the management team, venture capital investors, mezzanine providers, hedge funds, banks and vendors themselves who provide vendor financing or deferred compensation. Typically, acquisitions are funded as follows: • 40% - 60% Debt providers • 5% - 15% Mezzanine providers • 25% - 45% Equity investors • 5% - 10% MBO team • 0% - 30% Vendor finance / deferred compensation The funding composition of each transaction varies dramatically based on the size of the transaction, the profitability and risk of the target company and thus the amount of debt that the company is able to support, the amount that the management team can contribute and the willingness of the vendor to part-fund the acquisition. As debt has historically been cheaper than equity, management teams and venture capital providers would seek to obtain as much leverage as possible for the acquisition to maximise the returns to the equity holders. In 2008, the availability of acquisition finance from debt providers has tightened considerably forcing management teams and venture capital providers to rethink the highly-leveraged approach to value creation. In turn, for MBO transactions to proceed, more conservative levels of debt and more creative funding solutions, such as increased vendor finance, are needed in order to meet funding requirements. © DVR Capital Limited 2009 Page 11
  12. 12. DVR Capital An insightful guide to MBOs 3.4 How much money does the management team have to invest? Equity investors and debt providers want to ensure that management is absolutely committed to delivering on the business plan and will require that management personally invest. Some management teams ask if salary sacrifice is enough and generally the answer is no, it is not enough. When a manager invests, they think more like an owner than an employee and as a result are typically more successful in building the business and making difficult decisions. While the amount of investment varies by deal and personal circumstance, as a rule of thumb, each member of the management team is typically expected to put up one year’s salary as their ‘skin-in-the-game’. The funds for this investment may come from cash, remortgaging the home or quite commonly a loan from a bank. 3.5 What are equity investors looking for? Equity investors that back management buyouts include venture capital and private equity firms, family offices and occasionally hedge funds. Financially, equity investors target a 25% - 35% return on capital invested with a 3-5 year exit horizon. To achieve their financial objectives, equity investors are typically looking for: • A proven core management team • A stable, cash-generative business with defensible market positions • Products and services that generate higher predictable margins • Realistic opportunities to exit the investment within 3-5 years • A wide customer and supplier base • Few major risks to the business (e.g. regulatory hurdles, technological obsolescence, etc.) • Control of the board of directors (but operational control rests with the management team) To ensure that the MBO team delivers against its objectives, equity investors will typically seek several controls including: • Monthly financial reporting • Board representation and/or board control • Equity performance ratchets • Restrictions on acquisitions • Purchases of other services • Change of auditors Your financial adviser can assist you with introductions to suitable investors and negotiating the term sheet between the MBO team and the equity investors. © DVR Capital Limited 2009 Page 12
  13. 13. DVR Capital An insightful guide to MBOs 3.6 How do performance ratchets incentivise management? Performance ratchets are common arrangements in MBO transactions designed to incentivise the management team to achieve certain targets. Equity investors use ratchets to reduce downside investment risks and share upside potential. If agreed targets are met, the management team receives a larger stake in the business. Reverse ratchets are structured inversely to normal ratchets in that if targets are not met, then management’s stake in the business is clawed back. Putting this all together, an illustrative deal structure between investors and the management team incorporating ratchets could be: 1. At management buyout, the management team owns 25% of the common shares of the business. 2. Performance Ratchet: If the capitalised value of the business upon sale or flotation is £40m or better, then the management team shall receive 30% of the common shares of the business. 3. Reverse Ratchet: If the capitalised value of the business upon sale or flotation is £20m or less, then the management team shall receive 20% of the common shares of the business. The targets underpinning ratchets are usually based on profits or capitalised value upon sale or flotation. Where ratchets are to be used, it is very important to precisely define the terms of agreement regarding the targets and trigger mechanisms to reduce any legal issues later on that can result from different meanings, eventualities and accounting methods. 3.7 How should MBO teams choose an equity provider? The relationship between the equity investors and the MBO team can significantly enhance or limit the business’ success. The MBO team should consider a number of criteria when selecting equity investors including: • Shared vision – product, service, geographic focus, approach to growth • Demonstrated ability to partner with management team during early discussions • Deal structure, incentives and rewards for the management team • Personal chemistry – support of vs. control over management • Bolt-ons - funding availability, terms and timeframes • Exit timeframes • Track record with other management buyouts © DVR Capital Limited 2009 Page 13
  14. 14. DVR Capital An insightful guide to MBOs 3.8 What are debt providers looking for? Debt providers include banks and other asset-backed lenders. In providing acquisition finance, debt providers are looking for companies that have a track record of generating positive free cash flow for at least 3 years. Asset-backed lenders will take first charge against specific assets while banks provide senior debt, subordinated debt and overdraft facilities and may take first charge against all other assets. Banks are typically looking for: • Loan size no more than 3X EBITDA and comprising no more than 60% of the total acquisition value • 2X – 3X times interest cover • 5 - 7 year loan repayment period • Tighter covenants to restrict management’s ability to make decisions that pose material risk to cash flows Banks may also seek to charge arrangement fees and apply other fees when financing needs change. As part of the acquisition financing arrangement, banks will also strongly encourage the MBO team to move all of its day-to-day banking to the bank. Financial covenants that banks may include as part of their agreements include: • Cash flow to total debt service • Cash flow based interest coverage • Dividend restriction • Minimum net worth • Level of gearing • Net current assets / borrowings • % of good debtors below certain days outstanding Non-financial covenants that banks may include as part of their agreements include: • First charge over specific assets • Audited annual accounts • Monthly management accounts • Restrictions on ownership change • Restrictions on additional borrowings • Restrictions on acquisitions • Restrictions on asset disposals • No capital expenditure beyond certain limits without approval • No redemption on preference shares while loans outstanding • No undisclosed tax liabilities • Requirements for certain accounting policies • Restrictions on directors remuneration Your financial adviser can assist you with introductions to banks and negotiating financial and non-financial covenants. © DVR Capital Limited 2009 Page 14
  15. 15. DVR Capital An insightful guide to MBOs 3.9 How should MBO teams choose a debt provider? The management team should consider a number of criteria when choosing a debt provider including: • Loan size and price • Flexibility for additional finance (e.g. for bolt-on acquisitions) • Tightness of covenants • Experience and personal chemistry of bankers © DVR Capital Limited 2009 Page 15
  16. 16. DVR Capital An insightful guide to MBOs 4 Dealing with the Vendor This section covers various aspects of how the management team should approach the vendor and proceed through the buyout process. 4.1 Do we need to approach the vendor before pursuing a buyout? In pursuing a management buyout, the management team needs to ensure that they are not in breach of: 1. Any fiduciary responsibilities as a director or officer of a company and/or 2. Any non-disclosure or employment agreements that restrict management’s ability to disclose confidential information to third parties. Thus, before sharing company confidential information with third parties, the management team needs to first obtain approval from the vendor to pursue a buyout. If the management team is approached by an investor who wants to buy the business, management will have a fiduciary duty to inform the vendor. At the same time, the management team may take general advice before pursue a buyout as long as it does not breach any of its fiduciary or employment obligations. 4.2 How should the management team approach the vendor? Obtaining approval for a management buyout may just be a formality if the management team has already discussed a management buyout with the vendor or if the vendor has put the business of for sale and invited the management team to bid for the company. In other situations, the prospect of a management buyout has never been discussed and the management team may feel that the vendor may be unreceptive to an approach. Vendors may perceive that management have been covertly working against them which could cause irreparable damage to relationships. Thus, the initial approach is often the most difficult issue that management teams face. Before making an unsolicited approach, several matters should be carefully considered: • Who should be approached? Who are the decision-makers and influencers? What is their rationale for selling – money, strategic fit, management overhead? Are the owners looking to sell the company at all? Are they in need of cash or retiring? If part of a group, is this business non-core? What are their key issues – price, confidentiality, speed? • Who should make the approach? Should this be the business head, the team, the financial adviser or a particular investor? If the management team and the vendors are close, vendors tend to be more receptive to management making an approach than to outsiders. If the business is already for sale, vendors will typically feel obliged to allow management to bid for the business. • What type of approach would work best? Formal or informal? Written, verbal or both? Enquiring or direct? One-stage or many? If the business is for sale, the management team may ask the vendor for a first shot at making acceptable offer for the business before other bids are invited. © DVR Capital Limited 2009 Page 16
  17. 17. DVR Capital An insightful guide to MBOs • When should the approach be made? Is there a specific event or window that works best? Your financial adviser can assist you with determining how to approach the vendor. 4.3 How is management’s conflict of interest addressed? When a vendor agrees that a management team can pursue a buyout, a conflict of interest is created between the fiduciary duties of the management team to the shareholders and management’s personal interests. At the outset, the management team and the vendor should openly discuss the conflict of interest and the best way of handling it. The management team and the vendor should agree how the management team may pursue its buyout bid. If the sale process is not competitive, then the vendor and management should agree on certain rules of engagement: timelines and deadlines for an offer or pre-emptive offer, what an acceptable offer is, amount of time management may spend on the buyout, information that can and cannot be disclosed to third parties and at which stage, continuing management responsibilities, etc. If management is bidding for the company alongside others in an auction, then the vendor or its advisers will stipulate the rules that management must follow to ensure a level playing field among all bidders. During the buyout process, negotiations can pit the vendor against the management team and strain historic relationships. The vendor pays a lot closer attention to management performance, behaviour, policies and practices and the management team may become critical of the vendor. Otherwise promising buyouts can fail at this stage because of breakdowns in communication, personality clashes and misunderstandings. During negotiations, it is important that the management team rise above their personal interests and make an extra effort is paid to the relationship with e vendor and that management continue to perform to the best of their abilities. The most sensitive item during negotiations is almost always pricing terms. During pricing negotiations, it may be helpful for the management team to take a back seat and leave negotiations between investors and the vendor and communicating to the vendor that it is the investor who is in fact purchasing the company. The management team can emphasise the advantages of a management buyout over other forms of sale. © DVR Capital Limited 2009 Page 17
  18. 18. DVR Capital An insightful guide to MBOs 4.4 What advantages does a MBO offer to vendors? It is often assumed that trade buyers can and will offer a significant premium over financial buyers for the business. This however is not always the case. A competing MBO bid for the business often deters trade buyers from bidding for fear that a failed MBO bid will result in an unmotivated management team. MBOs can offer many of advantages over other forms of sale: • Speed. Management can often act much quicker than other buyers because of its understanding of the business. • Confidentiality. There is reduced risk that sensitive commercial information will be passed on to competitors. • Management Continuity. Management is less likely to leave if they own a stake in the business. Moreover, the workforce is often more accepting of a MBO than a trade sale. • Vendor Continuity. Vendors can often retain a stake in the business • Loyalty. Vendors often prefer the business be sold to management. • Risk Mitigation. Vendors often prefer the business be sold to management. © DVR Capital Limited 2009 Page 18
  19. 19. DVR Capital An insightful guide to MBOs 5 MBO Process and Timeline This section covers various aspects of the process and timeline of a typical management buyout not covered elsewhere. 5.1 What is a typical buyout timescale? Management buyouts typically take between 3 and 6 months to complete but vary significantly based on the willingness of the parties, the extent of negotiations, the readiness of information and the complexity of the transaction. A well-planned transaction increases the likelihood of the MBO team securing control of the company as early as possible and mitigates the controllable risks associated with the transaction such as not deadlines agreed between management and the vendor. An outline timetable of a typical management buyout is illustrated below.
  20. 20. DVR Capital An insightful guide to MBOs 5.2 Which professional advisers should the MBO team appoint? The MBO team should appoint a financial adviser early on, then subsequently tax and legal advisers. Financial Adviser The financial adviser coordinates the transaction and ensures that it stays on course, provides advice to the management team, offers a network of financing and advisory contacts and negotiates with other stakeholders on behalf of the management team, in particular: • Vendor: The price of the business is fair and on the right terms • Banks: Lending is cost-effective and with appropriate covenants • Equity investors: The risks and rewards are favourable to the management team While the financial adviser will take lead responsibility for co-ordinating the acquisition, specific activities typically undertaken by the financial adviser include: • Assessing the feasibility of the MBO before entering into discussions with the vendor • Valuing the business and determining the maximum purchase price • Outlining the returns available to the MBO team • Identifying financial backers with an appetite for the deal • Arranging and attending meetings with financial backers • Negotiating and structuring the financing with financial backers • Advising on the format and content of the business plan and presentations • Advising on how to approach and negotiate with the vendor • Project managing the activities, resources and timelines • Monitoring and minimising deal costs • Identifying external executives for the management team • Introducing the management team to other advisers Tax Adviser The tax adviser provides expert guidance and planning advice to the management team to ensure that at both a corporate and a personal level the initial purchase and subsequent proceeds from sale attract as little tax as possible. Typical tax issues include: • Minimising capital gains tax and inheritance tax (IHT) liabilities • Income tax relief on the interest paid on borrowing for personal investment • The structure of the transaction and the requirements for any tax clearances • Payment of stamp duty • VAT registration for the new company and advice on the recoverability of VAT in relation to deal costs • Tax indemnities from the vendor Legal Adviser The legal adviser is primarily responsible for preparing and negotiating the myriad of legal agreements. 5.3 What should be included in the business plan? © DVR Capital Limited 2009 Page 20
  21. 21. DVR Capital An insightful guide to MBOs The business plan is primarily a sales document used to secure financial backing from equity investors and banks and comprises planning documents, presentations, financial projections and overviews. Typically, the management team will write the core of the business plan and the financial adviser will constructively critique the plan and assist in further drafting. The business plan must convey how the business will be managed after the buyout with financial projections that are credible and specific. A typical business plan would include: • Overview of the business and rationale for the transaction • History of the business • Profiles of the management team • Overview of business lines, products and services • Market assessment and competitor analysis • Company operations – locations, employees, systems, processes • Marketing and sales plan • Operations and technology plan • Financial projections and assumptions • Key risks and mitigating actions • Management accounts and key performance indicators (last 3 years) While both equity investors and banks require a business plan, occasionally slightly differing business plans are written for each which emphasise what each are looking for. Equity investors make money through appreciation of the value of their shareholdings and thus are interested in understanding the market, the growth of the business, changes to the competitive position, investments in operations and technology, etc. By contrast, banks make money by acquisition loans being repaid without interruption and thus are primarily interested in the stability and security of and risks to future cash flows. Banks will be more interested in worst-case scenarios, while equity investors will be interested in a more balanced view of the business. © DVR Capital Limited 2009 Page 21
  22. 22. DVR Capital An insightful guide to MBOs 5.4 How are MBOs legally structured? While each MBO transaction is unique, most MBO transactions share a common common set of basic legal relationships between stakeholders. As shown below, a Newco is created that is subscribed to by the shareholders: equity investors, the MBO team and occasionally the vendor where a vendor wishes to retain a stake in the company post-acquisition. Newco purchases the target company for consideration as is stipulated in the Sale and Purchase Agreement. Shareholders typically enter into a shareholders’ agreement to ensure that the interests between investors and managers are aligned and cover key commercial matters such as voting rights, equity ratchets, management authorities, information sharing, dividend policies and confidentiality. Debt providers provide acquisition finance to Newco whose terms and conditions are covered in the loan agreement. Typical MBO Legal Structure 5.5 What due diligence is undertaken? After the heads of agreement is signed, equity investors and lenders will start their due diligence enquiries to ensure that the current state and the potential of the business is as agreed. Due diligence may include: • Commercial due diligence. The equity investor or a consultant engaged by the equity investor researches the products and services, competitors, markets and economics to better understand market demand. • Financial due diligence. The equity investor and lender typically engage an accountant to review the company’s historic accounts, balance sheet, asset and tax positions and the management team’s financial projections. • Legal due diligence. The equity investor typically engage legal counsel review title to property and other assets, intellectual property issues and the implications of any litigation. 6 DVR Capital: Your MBO Partner
  23. 23. DVR Capital An insightful guide to MBOs We hope that our insightful guide to MBOs has provided you with some practical advice and insights into management buyouts. Management teams will undoubtedly find themselves under immense pressure and severe time constraints during the management buyout process. As your financial adviser, DVR Capital can help you and your management team avoid the many pitfalls of MBO transactions and increase your chances of success. Why should you consider DVR Capital? • Best deal terms. We will achieve the best possible deal for you and your management team. • Well-networked. We are in regular contact with a variety of MBO investors, lenders, legal advisers and tax advisers as well as senior executives from a wide variety of industries. • Reduce pressure and time constraints. We will ease the burden of severe time constraints and immense pressure on management. • Pragmatic, operationally experienced, responsive, and understated. In a world of big egos, we are very easy to work with and take a client-specific approach to each MBO transaction. We keep MBO transactions on track by planning and executing iteratively emphasising quick turnaround in all we do. • Research-driven. Our MBO advice draws heavily on facts gathered from a wide variety of research sources, internal reports and insights from industry luminaries. • Success-based fees. The majority of our fees are paid upon legal completion of the management buyout. I invite you to contact us for an exploratory meeting in absolute confidence, without any cost or obligation. Marco Del Carlo DVR Capital Limited Managing Director 5th Floor, Portland House 4 Great Portland Street Tel: +44 (0) 20 3371 7248 London, W1W 8QJ Mob: +44 (0) 7866 361 157 United Kingdom marco@dvrcapital.com www.dvrcapital.com

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