March 01, 2012

Middle market businesses often overlook MBOs as viable liquidity alternatives. However, for certain industries, businesses, and capital structures, an MBO may represent the best option for maximizing shareholder value, ensuring business continuity, and creating investment opportunities for management.

Stout: As MBOs tend to be one liquidity option of many for a business owner, perhaps we should start off with a definition and an understanding as to its place relative to other options.

Michael D. Benson: An MBO is simply an acquisition of all or a large part of a company by the company’s existing management. In order to understand its appropriateness and usefulness, we first need to examine the concept of strategic alternatives. At a basic level, there are really two objectives inherent in each company: corporate and shareholder. In an equilibrium state, both objectives are synchronized. But that is rarely the case. As an example, the corporate objectives pursued by a management team may be to aggressively grow the business, which requires capital and forays into other markets. Alternatively, the shareholders may possess different objectives related to future capital commitments and their risk tolerances. Think of a first generation owner approaching retirement. His or her appetite to follow some logical corporate objectives may be diminished. An examination of this imbalance between corporate and shareholder objectives is the first step in exploring an MBO.

Stout: Can you describe some of the other liquidity options besides that of an MBO?

MDB: In general terms, the continuum measures the degree of equity which is sold or effectively sold, and ranges from, at its lowest level a stock repurchase or special dividend, to a partial sale involving an ESOP (“Employee Stock Ownership Plan”) or a negotiated transaction, to that of a total sale or merger. This last level on the continuum may involve a strategic or a financial buyer. An MBO is by definition a financial buyer as there are no synergies existing subsequent to the transaction. And by stating that no synergies exist, I do not mean to imply that no benefits exist. MBOs may indeed bring a number of benefits to a company.

Stout: What are some of those benefits specific to the selling shareholder?

MDB: An MBO provides continuity and certainty to the sellers. Think of a family owned business. It may be very important for the owners to maintain some continuity. They want to see their business continue without being subsumed by some larger strategic buyer. Maybe they want the family name of the business kept on the door, and an MBO is the best way to ensure that the new owners will retain that. They may want to see their employees continue with their jobs. Also, the opportunity for an MBO is a powerful incentive for management. It may be set up to reward management for past performance and dedication. Discussing the likelihood of an MBO years before the current owners exit the company facilitates the attraction and retention of quality executives and, ultimately, the financial performance enjoyed by the selling shareholder years before an exit.

Stout: What are some benefits specific to the transaction?

MDB: An MBO will require less due diligence as the buyer is already running the business at the time of the transaction. That is an advantage for both the buyer and the seller (assuming the seller was active in the company), as both sides already know what they have here. You also potentially have fewer representations and warranties which cuts down on the complexity of the documentation required in a transaction – which means there are fewer points to negotiate which may trip up a deal. However, this may be less of an advantage depending on what the entities providing the financing demand.

SRR: Let us talk about the disadvantages.

MDB: Disadvantages certainly exist; otherwise an MBO would be a feasible alternative for every business owner. For example, the seller may not be able to realize full liquidity. That is, any group financing the MBO – a bank, private equity group, etc. – may likely require the selling owners to retain some portion of equity within the business in order to assist with continuity; probably around 10 or 20 percent.

Stout: What problems exist if the business is already being marketed for sale and then management steps up and wishes to pursue an MBO?

MDB: That can create a clear conflict of interest, which may complicate a sale. Obviously, the greater management shows – a.k.a. presents their capabilities and opportunities – the higher a potential buyer may make their offer, which competes with management’s own desire to acquire the business. Maybe their projections become less aggressive. Maybe the risks they see down the road become amplified. This potential conflict needs to be managed. This is especially so if management anticipates the loss of their jobs in an acquisition. In this situation, they have nothing to lose.

Stout: That is clearly a risk for the selling owner. Are there any risks for the management team pursing the sale?

MDB: As in any acquisition process, there will be some up-front costs and fees that need to be paid - and this cost must typically be borne solely by management. These costs may be significant to management on a personal level and obviously may be permanently lost if management is unsuccessful. And it is very possible that management may not be successful. Remember that an MBO is a type of financial buyer, and financial buyers (besides competing among each other) frequently have to compete against strategic buyers who may be able to make significant offers due to potential synergies. Beyond this, management will need to invest in the company itself, so there are some additional, and potentially relatively significant, personal expenditures to be paid by management.

Stout: What does an MBO process entail?

MDB: Before initiating any steps, management should consult with legal counsel since, as we discussed, numerous conflicts of interest may exist which need to be successfully navigated. The first step is for management to develop a business plan and projections because they will need these to secure financing and to assist their investment bankers in negotiations. Next, management would submit an indication of interest. This is a high-level document – maybe just one or two pages – that lays out how they think they could put the deal together and what the purchase price would be. If this is acceptable to the selling owner, then management next needs to work with their advisor to raise capital. After this, a letter of intent can be offered. If accepted, management possesses exclusivity in their pursuit of an acquisition and can begin their due diligence, which hopefully culminates in a close.

Stout: All of this, obviously, assumes that an MBO is feasible. What factors determine feasibility?

MDB: Determining feasibility starts off with looking at the industry from a very high level. Depending on the economic situation, there are some industries that are out of favor, there are some industries that are in favor, and there are some situations where the industry is just in the wrong point in a cycle, regardless of the economic situation. All of this affects the ability to finance an MBO. The automotive industry is a pretty good example. It is very cyclical and three or four years ago it would have been impossible to get an MBO done. Today it is fairly possible, but not easy. In addition to a debt and equity raise, there may need to be a seller’s note, but today’s environment is much better for all than it was three or four years ago. This is just an example of starting with an assessment of the industry to determine whether a deal can be done.

An examination of competitive dynamics is also required. How is the company situated vis-à-vis its competition? For example, is it a much smaller competitor? What is the company’s market niche? How are its facilities relative to competitors? This last issue also relates to future capital expenditures and, thus, how much financing may be required. Funding sources are really going to pay a lot of attention to the stability of the business and the potential to grow the business going forward.

Stout: What about management?

MDB: An MBO is a bet on management. It needs to be well rounded. It needs to have a strong player in each key area. If there is weakness in terms of strength or depth, it needs to be addressed. As much as these other financial or competitive factors are key to raising capital, we hear over and over again that it ultimately comes down to management.

Stout: Is the lack of financing the reason we are not seeing a large number of MBOs right now, and how do you anticipate this changing?

MDB: Right now, most companies possess really only one and a half or two years of steady revenue and profit margins. An MBO needs significant financing, and until the financing markets opened up and companies could demonstrate steady or improving financial performance over time, the money just was not there. My guess is we will see a significant increase in the number of MBOs in the near future.

Stout: How many times is an MBO performed as a stand-alone process versus as being a part of an overall marketing process?

MDB: A lot of times, management initiates a sale of the company by pursuing an MBO. In a lot of situations, management may approach the owner, who then hires a financial advisor. As part of an assessment of the attractiveness of management’s offer, a process to market the company may be initiated. Interestingly, even if management is unsuccessful in performing an MBO, they may end up with a fairly similar ownership structure. That is, if the company is ultimately sold to a financial buyer who requires or desires the current management team, equity incentives may be offered. So, in the end, management ends up owning a part of the company.

Stout: How would the terms or potentially the process change if you had a sole shareholder looking to sell the company versus some type of other structure?

MDB: It depends. There are probably three main types of ownership attractive to an MBO: closely held, private equity owned, and a corporate orphan. The closely held situation will likely be less formal. You will probably have had conversations between the owner and management years in advance, and operationally the company may have evolved to the point where the owner is effectively absent from the business. In contrast, the other two situations have owners who will primarily seek to maximize their return on investment – that is, the overall sales price. So they will very likely look at an MBO as one of many options available.