This is the second of a five-part blog series on transferring your business to key employees. Business owners that wish to exit their business and leave that business in the hands of key employees have four options available to them. In the previous blog, we discussed the option of the Long Term Installment Sale, which leaves one or more employees of the business with a promissory note to make installment payments over a seven to ten year period with a reasonable interest rate.
Now, we’re going to look at another option available to exiting business leaders:
LEVERAGED MANAGEMENT BUYOUT
This transaction structure draws upon the company’s management resources, outside equity or seller equity, and significant debt financing. This structure can be an ideal way to reward your key employees position the company for growth and minimize or eliminate your ongoing financial risk.
To effectively execute a leveraged management buyout, your business should possess the following characteristics.
- A management team that is capable of operating and growing the business without your involvement.
- Stable and predictable cash flow.
- Good prospects for future prosperity and growth. The growth of the company should be described in detail in a management-prepared business plan.
- A solid tangible asset base, such as accounts receivable, inventory, machinery and equipment. Hard assets make it easier to finance the acquisition through the use of debt, but service companies without significant tangible assets can obtain debt financing, albeit at higher cost.
- Have a fair market value of at least $5 million (probably $10 million in order to attract the interest of private equity investors).
The prerequisite for a management-led leveraged buyout is that you, as the seller, and the management team agree on a fair value for the company. The parties then execute a letter of intent giving management the exclusive right to buy the company at the agreed price for a specified period of time (typically 90 to 120 days).
The management team and its advisors subsequently arrange the senior bank debt to fund a portion of the transaction. This bank debt usually requires management to arrange to make an equity investment prior to closing. It is at this point that the management team and its advisors seek an equity investor. They offer the equity investor a complete package of price, terms, debt financing, and management talent. The equity investor need only weigh the reasonableness of the projected return on his investment.
There are many professionally managed private equity investment funds that actively seek management leveraged buyouts as a preferred investment. These private equity funds control billions of dollars of capital for investment which they may structure as senior debt, subordinated debt, equity or some combination thereof. This investment flexibility enables the private equity investment firms to be much more nimble than your local commercial banker. The investment philosophy of these private equity investors is captured in the slogan of a successful buyout group: “We partner with management to create value for shareholders.”
From management’s perspective, a significant advantage to working with a private equity firm is that most will continue to invest in the company after the acquisition to fuel the company’s growth. These private equity firms will also allow management to receive a “promoted interest in the deal.” This means that management can earn greater ownership in the company than it actually pays for.
To help you better understand the mechanics of this process, let’s look at one highly-profitable medical device manufacturing business with revenues of approximately $5 million. The owner wanted out of the business and was willing to sell it to management under the condition that the transaction be completed within 60 days. The agreed upon sale price was $8 million, payable in cash to the owner at closing. The management team’s biggest and only problem was that it had only $750,000 collectively from second mortgages on their homes. Consequently, they hired an investment banking firm to help them arrange financing to close the transaction. With the clock ticking on their exclusivity period, management was motivated to make the deal.
The transaction was ultimately structured as follows:
In this transaction, management owned 20 percent of the equity ownership, despite investing only nine percent of the equity funds needed to close the transaction. Six years later, all of the debt that had been used to buy the company had been repaid. The outside equity investors received five times their initial investment and the management team reaped their initial investment ten-fold. Another advantage of the management leveraged buyout is its flexibility. If an outside private equity investor cannot be located under acceptable terms, the seller can elect to maintain an equity position in the company, or subordinate a term note to the bank.
As you can see, a management leveraged buyout may enable a business owner to accomplish the majority of his original objectives.
In Part III of this blog series, we’ll examine another option available for business owners – the ESOP, or Employee Stock Ownership Plan.