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Management Buy-Outs and Business Transitions

July 11, 2017

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While there are many different paths to financial security, it has been our experience that owning and operating your own business offers the best hope for financial success. Granted there are risks associated with being a business owner, they are, for the most part, overstated when compared to the risks associated with being an employee. As an employee, being fired generally results in a total loss of income.

Another issue that keeps people from operating their own business is the fear that they are risking the base salary that their family depends on to pay the bills. We agree this is a scary proposition, but with proper planning, a good understanding of the businesses sales cycle and some management ability, the risks are manageable.

Once you are in business, you should always be considering how you’re going to get out. Selling a business can be a messy process, as there are many financial, personal and timing issues to consider. Most advisors will recommend that you auction your business to achieve the best price and terms. Although we agree this is usually the case, there are circumstances where you want to transition your business over to new owners, while still maintaining an active role for a designated period of time.

We have traditionally been wary of management buy-outs because the attempt to negotiate the deal often fails. This leaves the employee feeling under-appreciated and the owner vulnerable to losing their best employees. While every case is different, there are some general issues that cause most of the problems. These are:

  • Valuation – neither the owner or the employees have a good understanding of the fair market value of the business;
  • Owner Commitment – the owner claims to want to transition from the business without putting forward a workable plan to get it done;
  • Employee Commitment – employee is a passive participant and does not invest the time and energy required to make the deal happen;
  • Terms – the parties can’t work out the financial and deal terms that will ultimately create a win-win; and
  • Lack of Process – the parties just don’t know how to proceed.

For example, one of our clients is interested in a phased retirement with a sale to an employee. He has a business that has been successful for over 20 years and, based on our valuation report, was willing to sell 40% of his business now at fair market value, and the remaining 60% when he retires in two years. The final payment would be pegged to the current valuation with an adjustment for growth. The client agreed to finance the second purchase tranche, but wanted cash for the first payment. He offered to guarantee the loan for the employee. The employee’s net compensation after making the loan payments was expected immediately to go from $80,000 to $120,000.  The business owner currently earns more than $400,000 per year, therefore there was no reason to believe that the employee would not also earn this much or more and be able to pay for the business in four years.

Unfortunately, the employee balked at the deal, stating the price was too high. Typically, this is attributed to cold feet, but we came to learn that the employee was not able to understand that the deal had to be viewed in terms of expected return on the investment after considering the risk. Instead, the employee felt the price was too high based on some market information he had. In the end, a deal was made, but not without hard feelings being left on both sides.

In addition to this example, there are plenty of other cases where the business owner may want to transition the business, but is not prepared to give up any meaningful ownership or even commit to a time frame for their exit. For a management buy-out process to work, it should be structured very much like an actual transaction process without the auction piece.

Understand all parties’ motivation and commitments

It is not unusual for a business owner to start the process of business succession and then back out when faced with acting on the deal. Therefore, it is important to work with both parties by outlining the process, related costs and alternatives available right from the beginning. If there is going to be a change of mind by any of the parties involved, it is good to have it happen early.

Determine a price

With an auction, the market determines the price and related terms. With a management buy-out, the price must be negotiated. Chartered Business Valuators are well trained to help you determine a fair market value of your company.

Develop a process

Ensure everyone understands the process, the milestones that need to be achieved and agree to a timetable.

Use an intermediary

We suggest that both the buyer and seller have an intermediary handle much of the sensitive parts of the negotiations. This can help keep good relationships both during and after the deal.

Negotiate the terms and financing

Lawyers are well trained to help you negotiate the terms of the deal. This should be done in conjunction with the financing. A win-win approach is very important especially if the owner is maintaining an equity interest.

Flexibility

The ability to be flexible can make a significant difference in making the deal work or not. For example, you might have a long-term employee that is key to the business’ success, but has little financial acumen. This might be an appropriate time to look for a private equity investor that requires management continuity and wants management to retain some equity. You can sell part of your interest to the manager and part to the private equity firm.

Management buy-out arrangements can be challenging, but there are many situations where they make sense. If you have any questions, or want to discuss management buy-outs or business transitions further, please don’t hesitate to get in touch with one of the members from our Advisory team.

 





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