Selling to Your Employees: Common Pitfalls of the MBO

The time has finally come, a generation is moving on and baby boomers are retiring. To facilitate this transition one of the most popular, and often the only option for some business owners, is a management buyout (MBO).

Baby boomers have spent years working with their executive teams and managers, and now these same employees have the goal to own the business they have put so much time and effort into. Often times, this is a dream situation for both parties, however it is remarkably risky and usually difficult to close.

Unfortunately, compromise is difficult to achieve with out-going owners and in-coming management, and a stalemate ensues. But why is it so difficult to find agreement here? Don’t both parties want the same thing, after all?

Generally, there are two primary flaws that lead to a stand still and freeze in the transaction process. The first of these issues, is inexperience. Neither party has ever been a part of a deal like this, regardless of their achievements. This can lead to a symptom called “deal-fatigue.” This happens when both sides of the transaction get tired of negotiating and simply say, “This isn’t worth it anymore.” The second common issue is that one or both parties dig in too deep on their side of the fence. They stack lawyers, accountants, advisors and egos, and refuse to budge. Too frequently this leads to the management team either quitting or being fired, and the owner losing their buyers. Both scenarios are bad for the owner, and bad for the managers.

Moreover, unrealistic expectations exist on both sides of the transaction. Sellers are typically unaware of the business valuation and usually error significantly high in their price expectations. Owners also often fail to understand the uniqueness of the situation. As the final say so on most everything in the business, a different dynamic is involved when managers are negotiating against their boss for their best interest. Management teams are often out of their league with the process of buying a business and don’t have legal and investment banking resources in their pocket to guide them.

Valuation:
Business value is a large element of a successful transaction, largely that it is fair market. Besides being good for the buyer and good for the seller, fair market means that it is acceptable to the parties and is financeable with the right capital structure. When a price is too high, the buyers usually cannot finance it, leading to the end of the deal. Furthermore, a high price may seek vengeance years down the road when the business is unable to repay the loans, once again leading to the untimely end of the company.

Financing:
Once the value of the business is agreed upon, the next element of the transaction comes into play. Commonly, managers do not possess the initial liquid cash required to support the equity needed to result in an acceptable level of debt. This concept seems somewhat confusing but is relatively simple. If a $20 million enterprise value business could support up to $14 million in debt financing, then the incoming managers needs $6 million in equity in order to complete the deal. Naturally, this is a difficult number to reach for a manager. He will be trading in the paycheck he has regularly received for 10 to 20 years, then remortgaging his house, selling his investments, and borrowing money just to gain the $6 million he needs in equity. By the time he gathers the $6 million, will he still have confidence that owning this business is the best choice? Will his family? These impending issues frequently necessitate the owner to provide seller financing which, if not received, can impale the owners retirement goals.

Creative strategies to address this issue are needed if a deal is to be done and fortunately there are options.

Roles and Control:

Defining roles post-close is essential, not only for the exiting owner, but for the current management team. A common practice is to negotiate and execute a shareholder operating agreement concurrent with the Purchase Agreement. The shareholder operating agreement should address roles and responsibilities as well as provide agreed upon methodologies regarding termination, selling the business, operational ethics, etc.

This step along with a buy-sell agreement funded through life insurance on the principals usually go hand-in-hand.

The MBO Requires a Coordinated Exit Plan:

MBO’s can provide an ideal outcome for owners and buyers alike, if the risks are navigated well. As with any exit plan, coordinating all aspects of the transition should involve a team of experts to address each segment of the transition.

To be successful, the MBO requires more planning than would a sale to a third party and the need for an Exit Plan should not be minimized. A typical MBO would still need the financial advisor, insurance professional, estate planning attorney, CPA, tax attorney, valuation expert and others, but also require coordination of these specialties for the management team as well to ensure the successful continuation of the business.

As a Certified Exit Plan Advisor, our approach is to place and coordinate the team of specialists to execute the strategic objective of the transitioning owner and we rely on advisors like you to assist us in succeeding in this exit strategy.

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