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MBOs: Typical Troubles

Why Read This Article?

·     you’re an owner & thinking about selling a key employee some or all of your shares

·     you’re a key employee & you want to acquire ownership

I’ve dealt with both perspectives – owner and employee, because I act for either side, and, it’s vital to understand the other side’s position to get a deal done.

Background Points:

 A.  “MBO” means management buyout, ie, one or more employees acquire all or some ownership  in the business from the owner(s) or from the corporation (treasury issue)

B.   The owner/employer invariably has more knowledge of the business, more money and more legal & accounting advice at their disposal

C.   Conversely, the employee has little knowledge of the business, and much less legal, deal, tax and accounting experience

D.  The employer is the employee’s boss, so she/he has a strategic advantage in negotiations (it’s not easy to tell your boss they’re unreasonable or wrong)

E.   The MBO will be the biggest, most important business transaction of the lives of the owner and the employee!

MY TIPS FOR TYPICAL MBO ISSUES:

1.    I Don’t Need No Friggin’ Lawyer! 

 OK, maybe you don’t need to hire a lawyer, as employer or as employee –

A. if you’re an employer who has done lots of these transactions and can put together legally effective documents, go for it!

B. if you’re an employee who is prepared to totally trust your boss to do the right thing, now and for the next decades, and, you are familiar with MBOs, EBITDA, shareholder agreement issues, financial statements, tax reorganizations and employment law…

then, hey, never mind getting your own legal counsel to do an MBO. Never mind that 90% of the time, the employer has used the company CPA & lawyer to structure the deal and table an agreement, and that the company lawyer can’t protect both parties due to the conflict of interest. No, the company lawyer cannot and will not take care of the employee in an MBO.

Very often, employers try to persuade employees not to hire their own lawyer for an MBO. They assure the employee that they have no worries, that lawyers just make things complicated and adversarial. That’s not altogether false. One thing for sure though, it is in the best long term interest of both parties to have their own qualified legal counsel. A lot is at stake.

And, the practical problem is that employees rarely have a pot of cash to pay a lawyer to protect them and negotiate a fair deal. When I act for employers, I always recommend that the company reimburse the employee for her/his legal expenses in the MBO. After all, the company usually pays the employer’s legal expenses, directly or indirectly, so it is only fair to do so.

Not all employers are so beneficent however; indeed, some are quite prepared to exploit their position of authority to push thru a one-sided MBO, sometimes under the premise that they are being generous in “giving” the employee the shares. Well, it depends on the deal. I believe that fair deals work better and last longer for all parties.

I think both employer and employee should use their own separate qualified legal counsel, paid for by the company. No, there is no guarantee that the counsel will act reasonably and charge reasonably, and I have seen things go off the rails by overreaching employee counsel, but that is usually because the employee doesn’t have a clue how to instruct and control their counsel – they just go along with whatever such counsel recommends. So let’s talk about controlling your advisors on an MBO next.

2.  Keeping Your Lawyer on a Short Leash

As noted above, I’ve suffered some MBOs or partial MBOs (where an employee is buying shares over time) that have been catastrophically derailed by overreaching employee counsel. That is, one lawyer has killed the deal.

The definition of “overreaching” is in the eye of the beholder. It depends on the deal. These are the main factors justifying employee counsel taking a vigilant approach to the deal:

·     if the employee is paying fair market value (“FMV”) for their shares

·     if the shares being bought represent a substantial stake in the company (say, more than 33%)

·     the employee pays cash on closing, ie, the purchase price is not generously financed over a long time, or paid by means of special dividends or bonuses to the employee,

then, in my view, such employee and their lawyer are more than entitled to get all of the protections and assurances that a third party buyer would demand.

However, where the employee is getting the deal of a lifetime because the share price is way below FMV and/or is paid out of extraordinary dividends or other subsidized financing over a long time period (thereby discounting the price), then I believe the employee should show some good old fashioned, rarely seen, judgement and not ask for the sky and moon.

I’ve seen deals where my client, usually the owner, is effectively making the employee into an overnight millionaire with very little financial commitment or risk, and yet the employee’s lawyer negotiates like it is a battle to the death over paranoid concerns.

Fine you say, but how do the parties keep their lawyers on a short leash? Owners have a big advantage in this area because they have usually worked with their counsel on other deals. Owners frequently know how to control their counsel.

For employees, I suggest that the first step is to keep the deal simple in structure. Next, ensure that the employee fully understands the business terms being offered. The owner should not expect the employee to fully grasp the sophisticated tax planning and other maneuvers done in the past, but they will very likely get spooked if the MBO terms are laden with multi-step tax oriented actions and inscrutable documents.

Finally, I recommend that there be a meeting of all of the parties early in the deal process. It is all too easy and common for lawyers to be more aggressive in emails and on phone calls than in person. I find that meetings are few and far between, often at the cost of developing any relationship among the parties or their counsel. Positions are polarized instead of compromised.

Conversely, the owner is wise to be respectful of employee’s position if the deal is at FMV and/or involves serious business risks and a lot of money. In that situation, the owner should, in my view, be prepared for the typical third party negotiations and comments from the employee’s legal counsel: it’s not appropriate or reasonable for the employee to ‘just trust the owner’ and go along without a peep. An informed employee/shareholder is a happy shareholder.

3.   Getting the MBO Done

Deals don’t get done without there being willing, able and engaged parties. Every deal needs a quarterback – and in an MBO, this means the owner, or the owner’s legal counsel or financial advisor – to coordinate and push the deal along. If there is no quarterback, invariably, the deal will flounder, even die.

I tell clients that almost any deal can get done in 6-8 weeks if all parties are engaged and the deal is fully and finally negotiated. Agree to reasonable, ie, attainable target dates for the share purchase agreement and then closing. Do get a letter of intent, aka “LOI”, signed as soon as the deal terms are resolved, but don’t fuss over details in the LOI. It is important to get the deal process going, to evidence the moral commitment of both parties to do the deal.

Never, ever negotiate by draft unless you want to delay the deal and pay a lot more legal expenses. I caution employees not to allow their boss to bully them into submission on legal and key business points – let your lawyer deal with the boss’s lawyer. That is, assuming that the deal is fully negotiated, not subject to change on the key business terms. If you’re still in negotiations, then the business parties should settle the deal themselves, not thru the lawyers who will polarize and extend the discussions.

Perhaps you will find this piece useful if you are considering a succession plan with one or more employees, or if you are a key employee that wants to buy into your employer to enhance job security and participate in equity growth.

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