What I really want to talk about this month is Management Buy-Outs (“MBO’s”), in particular, the unique aspects of MBO’s. And, there are some curious differences.
In a MBO, one or more of the existing operational management team buy the shares or assets of the division or subsidiary from the owner/operator or parent corporation. This article contains my observations on the unique aspects of these transactions. Family buy-outs are not addressed: they are a whole different animal.
Creating the Ophan
The idea for a divestiture usually comes from the vendor/parent, and not from the management buyout person or group.
In a fit of focus, the vendor suddenly discovers that the subject division or sub “isn’t part of the core business” anymore! Yikes! Imagine that! Just a short time ago, the same people were probably bragging about the “great advantages of diversification, horizontal or vertical integration”.
But this corporate flip-flop is advantageous to the MBO team: the Vendor is essentially admitting that the division or sub is not a success; not desirable; not part of the Mother Corporation’s future. An “Orphan” is created.
Ideally, some individual within the vendor is front and centre as the advocate for the sale of the Orphan. I’ll call that person the “Champion”. A Champion is much preferred over a Task Force or involuntary delegatee. A Champion has a personal interest of some kind in making the deal happen.
Especially in a very large organization, a divestiture can whither and die if there is no Champion. Also, big companies are bureaucratic, filled with legions of CYA artists who will nay-say your MBO if they have no stake in closing it. No one wants to take responsibility for a failure of something which is “not their deal”.
I’ve seen cases where the Champion is attacked by the “CYA artists” who scream that the Orphan is being “given away”. The MBO team must nurture and support the Champion.
As Time Goes By
Maybe it’s my obsession with getting on with things, or maybe I’m just getting-on myself, but it seems like it takes far too long to settle the business terms of some MBOs. I have seen deals take over 12 months from germination to draft agreements. This is ridiculous, and likely happens because the Orphan has no Champion.
It is crucial to obtain the vendor’s written agreement evidencing its intention and desire to sell the Orphan. This can be in a one paragraph letter of intent, or a 10 page letter agreement. The deal will move more quickly if the structure, as well as key issues like employees, valuation and payment terms, are fleshed out in the initial document. If you can’t reach a consensus on the major terms for an informal agreement, you have a hint what it’s going to be like to complete the formal transaction documents.
Never ignore red flags.
Is Your Boss Actually Your Superior?
Well, he thinks so. You will be reminded of this many times during the course of negotiations in an MBO. Don’t be too insulted: it’s standard operating procedure.
Your boss will be skeptical that you can really pull this off, doubting your negotiating moxy, your ability to make the business work without the vendor’s benevolent hand, and your moral character in paying off the vendor take-back financing.
Typically, the primary negotiator for the vendor is your boss. I do mean “is”, not “was”. This makes it somewhat awkward to tell him to “Go to hell!” or similar epithets. After all, if the deal doesn’t go through, you still want your job, right?
I suggest that once you commit to the MBO, you must determine your “Plan B”: what you will do if the deal falls apart, and you want to leave/are canned from your job.
Otherwise, your boss/vendor will take advantage of this strategic advantage (your insecurity) in several ways:
- beat you up on price
- refuse to give you reasonable representations and warranties
- change the deal as he sees fit
- insist on ridiculous default terms on vendor take-back financing, like forfeiture
- try to work around your lawyer on key issues
There are three ways to deal with this syndrome:
- hire an independent intermediary (financial, not legal) to do all negotiating;
- take a strong stand right away on important outstanding issues; and
- get on with the deal: the boss thing worsens the longer the deal takes.
Deal of the Century
I’ve said before that dealmakers are characterized by their perseverance in getting deals done. The buckets of perseverance required by MBO’s is usually richly rewarded by the pot of gold at the end: a damn good deal.
Let’s return to the origin of the MBO: the creation of the Orphan. The vendor determines that the business is not part of its core business. Rarely is it orphaned because it’s not profitable. The Orphan may have been underperforming relative to the rest of the vendor’s businesses, but even then, it may generate a good return and/or cash flow.
At the outset, it is essential to identify why the Orphan is being orphaned, and to establish with certainty that the problem or factor will be (not can be) overcome when you buy it.
Local operational management should be in the best position to evaluate the strengths and weaknesses of the Orphan. The vendor often undervalues the Orphan, mainly through ignorance of the business and market. The MBO purchaser typically places a higher value on the business due to his superior knowledge or potential synergies which he can exploit.
I realize this is a self-evident truth in any deal: each party must think he is getting a good deal, or the deal won’t be made. I think that MBO’s accentuate this equation, so that the MBO group can end up with quite a bargain.
Value can be enhanced and risk lessened with vendor take-back financing, as well. High leverage, if it works, can enable a management group with little capital to carry out a larger transaction than would be the case with conventional financing.
Importantly, a vendor is going to be far less intrusive in the business post-closing than a bank or third party investors. If the business hits a rough spot, the vendor might be more understanding than a financier.
MBO’s can be the opportunity of a lifetime for the management group or individual. With perseverance, and preparedness for certain idiosyncracies, you can acquire a wonderful business which you already know how to operate and grow.