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M&A Alternatives in a Time of Market Disruption

May 13, 2020

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When we started writing this piece, we were only vaguely aware of COVID-19 and had, frankly, never heard of Wuhan, China. A lot can change in a month and so here we are nearly six weeks into a country-wide quarantine, with little to no end in sight. While no one can predict how the COVID-19 crisis is going to play out, we are confident that any damage caused to the economy will eventually be resolved.

Having said that, we cannot ignore the reality of the marketplace. COVID-19 has rattled the business community and has created a significant amount of business uncertainty. In times like this, investors generally take stock of their internal business issues and often pause investment activity or try to find acquisition targets at bargain prices.

While the best response might be to “ride it out until things stabilize and business returns to normal,” this is not always possible or even desirable. Let’s look at some cases where you can not or do not want to postpone a business transition:

  • Health or family issues are driving the agenda;
  • COVID-19 has highlighted weaknesses in your capital structure;
  • It is an appropriate time to hedge future business risk; or
  • You are ready for a transition and want to explore all options available.

If you are reluctant to postpone your transition, now might be a good time to consider a Management Buy-Out (MBO) arrangement.  

Management Buy-Outs

An MBO transaction is where the existing, or new, management group acquires an ownership interest in the business.

An MBO is often overlooked as a succession option due to pre-conceived notions that the current ownership group would be leaving money on the table, employees are unable to raise capital or they do not possess the necessary skills. It is our view that an MBO can achieve both financial and non-financial objectives for the current owners. Let’s outline a few of the benefits:

  1. Allows current owners the opportunity to take money off the table without retiring;
  2. Enhances business value by demonstrating management continuity;
  3. Increases management engagement and commitment; and
  4. Provides for a smoother transition of ownership.

While the MBO process can sometimes be messy, with proper planning and preparation, it can yield great results. Let’s take a high level look at the steps one should undertake to evaluate a possible MBO.

Step 1 – Discovery

Ultimately, the MBO process must be worth the time and effort to do it. So, before you start the heavy lifting required to close a transaction, you need to understand the different options available and the pros and cons of each. The discovery process is designed to show you what your organization would look like post MBO.

If one is willing to divest some of their equity and agree to a more structured governance model in exchange for immediate cash, continued earnings and the opportunity for another pay day down the road, then an MBO process might be the answer.

Step 2 – Analysis

The analysis phase is where we lay out the operational, financial, tax and governance components of the MBO. This is the road map that will ultimately lead to a completed transaction. While the analysis has many facets, there are several key components, including:

Pricing Analysis – All the stakeholders in the process must agree on a pricing range that they find acceptable given current market conditions. The pricing analysis is prepared with the help of an independent advisor to provide a basis to agree on the business’s enterprise and equity value. The enterprise value is the underlying value of the business after considering expected cash flow, business risks and actual market transactions. The equity value is arrived at by adjusting the enterprise value for redundant assets, a reasonable level of working capital and current debt.

Financing Structure – Typically, if the MBO involves current employees, there will be little outside cash available to invest. It can sometimes take some creativity to structure the deal, but it has been our experience that there is a variety of capital sources to fund most MBO transaction as they are viewed as less risky by lenders.

Governance – We use the term governance to describe the set of policies and agreements that the future shareholders abide by post transaction. Many of the issues related to governance should be dealt with early in the process to avoid wasting time if there is no appetite to give up some degree of control to the governance system. A good governance system will address the following issues:

  • The Role of the CEO vs. the Board
  • What decisions require shareholder approval
  • Decisions that require the unanimous approval of all shareholders
  • Shareholders agreement
  • A mechanism to buy or sell shares
  • The valuation of equity
  • Day-to-day responsibilities

Step 3 – Offering

Once again, it is best that a third-party advisor prepares the offering materials and underlying supporting data before presenting to potential future employee shareholders. The MBO is not unlike a normal M&A process where you are offering to divest 100% of your shares. In the case of an MBO, there is added complications related to financing and governance.

Also, the addition of new employee shareholders should not be limited to current employees. There might be talented individuals at other organizations whose abilities can take the business to the next level.

Step 4 – Closing the Deal

Completing the deal involves a considerable amount of work and frankly, there are no short-cuts. The shareholders, financial advisors, lawyers, tax advisors and bankers all must work together to ensure the deal is structured in a manner that reflects the agreed upon business terms.

In closing, we would like stress that a successful MBO is not an easy process, but in our experience, it is worth the time and effort to put in place. After all, some of Canada’s most successful businesses are employee-owned.

MBO arrangements can be challenging, but there are many situations where they make sense. If you have any questions, or want to discuss this topic further, please do not hesitate to contact me (Mike Berris) directly, or reach out to another member of our Advisory Team.

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