MBO Definition

The process of buy-out realization is particularly complicated and usually long-lasting. It is because of the necessity of solving many problems and answering many questions. They concern following issues:

How to inform the company owner about buy-out plans?

If the buy-out idea appears among the management group, and it is not vendor's proposal, then a question raises, how and when inform the owner about the buy-out? What his reaction is going to be? Because this matter is one of the sensitive ones, it is advisable not to ask the owner in a formal way (official letter, official inquiry on the supervisory board meeting), but to do it in an informal and very cautious way. It is going to be very important, if there is no certainity, whether the possibility of seeling the company to the management has ever been considered by the owner. The transaction success is to a large degree dependent on the owner favour. Obtaining his permission will have a fundamental importance for the buy-out process.

When should the work on buy-out begin?

A great importance to that issue are the relations with the owner and his plans to the shares he possesses. If the owner clearly signalize the will to sell the shares, work on the buy-out should start immieditely. We have to remember, that making a reasonable and real offer, takes from two up to three months of preparation.

Optimally is to have the owner's permission and smoothly work on the buy-out to realize it with out problems. But what should we do when an owner who is favourable to the management asks the managers to make an offer in the context of a competitive, already placed offer? To stay in the game it will be necessary to place an offer, however buyers will not be sure of the possibilities of its realization, because of the lack of prior preparation.

Buy-out is a very complex process and at the same time requires time commitment from the management group. When working with an advisor, making an offer should be proceded by a 2-3 month-long preparation period. When realizing the buy-out alone, this period will definetely extend because of the necessity of managing the company.

Who should be the part of the management group?

One of the success factor in the buy-out process is the proper lineup of the management group. After the buy-out, this team will be the owners as well as the managers, therefore the division of the authorities should be well matched. The best way to collect a proper management group is to choose managers responsible for the main departments in the company (president, financial director, production director). If the finacial director is not at the same time the main accountant, it is good to include him to the team preparing the buy-out. In the case when one of the managers is not in the management group, it will cause in a significant weakness of the group. It is also hard to imagine a buy-out without the president of the board taking part in it.

What should we do in case of competition appearance?

In case of a competitor appearance, who wants to buy the company, situation of the management complicates. It creates a peculiar conflict, because of the management positon as a buyer and on the other hand as a representant of the vendor. A peculiar problem arises, because of the management position as a buyer and on the other hand as the vendor representant towards other buyers.

Often the owner has concerns, that during the company analisys by the competitor (due diligence), the management will not be willing to give exhaustive answers. From the management point of view a concern exists, that information provided to the competitor may be used against the company in the long term. It may lead to a conflict between the management and the potential buyer. In that case the owner usually decides to introduce "his man" into tha management, who will watch over the transparency of the sale process.

Summing up, if the competitors appear the whole process becomes much more complicated. It is necessary to be very careful, not to be suspected of a lack of cooperation with the vendor, at the time of examining the company by the competitor. The best solution is a good preparation to negotiation with the vendor in order to close them and make the payment as soon as possible. It is also important to judge the chance for the cooperation with other buyers. In many cases it is known that the new ownership is going to result in management changes.

In such situation it is necessary to negotiate in a quite aggressive way, taking into consideration all the consequences resulting from that. There is also often a chance to cooperate with other buyers, what can be much better solution for the management than a high purchase price.

How to negotiate with the owner?

There is no "best solutions" in that matter and everything depends on specific conditions You negotiate differently when the owner refers the offer only to the management, than when the sale is realized in a tender formula with many others investors.

Regardless of the situation negotiation should be:

•  Short in time
In order to negotiate effectively, the management group should be very well prepared. It involves a lot of work, that needs to be done before the negotiation process begins (company analisys, evaluation, transaction structure, financing arrangement). The more time is spend to prepare the transaction, the more effective and less time consuming the negotiation process is going to be.

•  As less aggressive as possible
Because the management group is dependent on the buyer, it is often on a worse negotiation position. The owner's good will and prior relations are fundamental for the good course of the negotiation;

•  Transparent and clearly defined
In order to avoid the accusation of lowering company results or blocking the competitors, it is very important to operate in a transparent way with clearly defined operating time period.

When should we arrange the finance?

Raising finance is one of the most important element in the buy-out transaction. When realizing the transaction we deal with some kind of a vicious circle. On one hand the vendor would like to sign the offer and recieve the payment, on the other hand the buyer is unable to raise the finace, because the main elements of the transaction, such as price, has not been established yet. Banks often require negotiated agreement with the owner covering the price issue.

Situation changes when the offer has been negotiated and placed, however, even than handing in the documents to the financial institutions in order to search for the finance, takes usually around 2 months, since the buy-out transactions are considered as untypical. Such a long time period is usually unacceptable by the vendor.

A solution to this problem is to start searching for the finance before placing the offer. It is possible at that time to determine the main parameters of the transaction and based on them place the inquiry in the bank about possible finance arrangement. Usually bank is able to reply within 14 days, specifying if it is interested in financing and what kind of information are needed to make the decision. If, after placing the inquieries, we have at least two positive replies, it is very possible, that at the time of placing the offer and establishing the key elements of the transaction, raising finance is not going to take much time. It is very risky first to sign the agreement by the buyers, that is often connected with the advance payment, and than searching for the finance under the time pressure.

Management Involvement Issues and Concerns

In simple terms, almost invariably an employee cannot begin putting together a management buyout without the consent of his employer. This flows from a number of standard terms in a contract of employment, notably the misuse of confidential information, whole time and attention and no other business interests.

Putting together a management buyout without consent may well be gross misconduct, entitling the employer to terminate the contract of employment. This is particularly likely where a member of the management team has been using confidential information without the employer's consent. As the management will need to use confidential information such as business plans and management accounts to raise funding it is nearly always the case that the management team will need to use confidential information at an early stage. Summary dismissal for gross misconduct, as well as avoiding any compensation claims has the advantage that any restrictive covenants in the employment contract are preserved.

If a company discovers that a member of its management team has been trying to put together a management buyout without permission the company should seek to establish immediately to whom confidential information has been disclosed. The company is entitled to recover confidential information from anybody to whom it has been wrongfully supplied, such as corporate finance advisers, private equity houses and other advisers, and may well be entitled to an injunction against use or further disclosure of the confidential information.

Any sensible or well advised management team will therefore approach the employer for permission to begin putting together a buyout. The employer should record its consent, with any limitations, in a formal letter. The terms of such a letter vary with particular circumstances but key features include:

• permission for the employee to spend a certain amount of his time in putting together a buyout;
• permission to create a business plan using confidential information such as management accounts;
• limited consent for the business plan to be disclosed to potential financiers. Most employers insist on seeing the business plan before it is disclosed and also require an agreed list of recipients for the business plan.

Lastly, it is quite common for management teams to be incentivised to maximise the sale proceeds, even if a management buyout is one of the options, through sale bonuses. Great care needs to be taken to ensure that a sale bonus does not constitute illegal financial assistance. An agreement by the target to pay a sale bonus will be illegal financial assistance if the amount of the bonus constitutes a material reduction in net assets. As the level of materiality is generally construed quite strictly (a one percent of net assets test is a commonly used rule of thumb) the sale bonus is often best offered by the seller and not the target.

Conduct of Sale Process

Selling to a private equity backed buyer brings its own problems to the sale process. This is particularly the case where the seller is conducting an auction and several private equity houses have expressed serious interest. In this situation access to the management team should be strictly controlled and the management team suitably constrained so that they do not favour one private equity house over another (often the private equity house which is offering the management the largest equity stake).

A private equity house will be keen to be granted exclusivity at an early stage. Most purchasers are naturally wary of granting exclusivity unless they are confident that the buyer has funding. This can often be a chicken and egg situation as in a leveraged buyout funding is never committed until completion. However, at a minimum, purchasers should insist upon a good faith letter from the private equity house that it has expressions of interest from senior and junior debt providers sufficient to fund the proposed purchase price.

Sellers may also find themselves being asked for a fee underwrite commitment. Private equity backed acquisitions are very expensive in terms of fees, largely driven by the complex funding structure. The private equity house will be seeking to minimise its costs exposure and whilst many of its advisers will work on a contingent basis most financial due diligence providers will either not be contingent or will have agreed a discount rather than a full contingency.

Divided Loyalties & Warranties

In any MBO process the management team find themselves with conflicting loyalties. As employees/directors of the target (and perhaps the seller) they have obligations to assist with the sale process. However, they are also potential owners of the business if the acquisition goes through and have a vested interest in acquiring the target on the best possible terms. Divided loyalties are manifested in the hotly contested issue of the extent of warranties that the seller should be giving on a management buyout.

The seller will often take the opening position that management has the most knowledge of the business and that any private equity house should seek warranty cover from management rather than the seller who may have very limited knowledge. Such seller warranties would be limited to “head office” type areas such as tax and insurance.

The private equity house will counter that management has little in the way of assets to support a warranty claim and that the seller is being offered full value for the business and should give warranties accordingly. In leveraged buyouts it will be the bank and the venture capitalists who are risking the greatest investment and they will not be prepared to acquire a business without normal full commercial warranties. It may be possible to write a purchaser's insurance policy to cover this insurance risk (see the recent Dealpoint feature on insurance in M & A transactions) but more commonly the seller will be prepared to give warranties provided that it is comfortable with the disclosure process and vendor liability limitations.

The following are some of the options for a seller:

• closely involve all the members of the management team in the disclosure process and be alive to the risk that management are not being full and frank. Management may need to be reminded of their employment (and perhaps fiduciary) duties. It is very common for management to be required to sign a comfort letter certifying that, so far as they are aware, they have participated fully and openly in the disclosure process;
• Sellers would usually like the purchaser to be deemed aware of all matters within the knowledge of the management team and for the warranties to be suitably qualified. This is not usually a position which is acceptable to the private equity house as it undermines the benefit of the warranties to an uncontrolled extent. One possible alternative is for the purchaser to acknowledge it cannot bring a warranty claim if at completion management were actually aware of the possibility of such a claim. This means that management must be aware of the act/omission which gives rise to the claim and be aware of the implication that a warranty claim is possible.

Deal Structure

Sellers need to be alive to some of the peculiarities of MBO's. Many sellers are nervous that management have kept back good news so as to deflate the purchase price. One alternative is for the seller to seek an "anti embarrassment" arrangement. This covers a situation where the purchaser exits in a relatively short period after completion (perhaps 12 to 18 months) generating what might be perceived as excess profit. There are various ways of structuring an anti embarrassment clause, from a form of earn out to some form of equity instrument in the purchaser.

Generally speaking it is usually advantageous from a tax perspective for sellers to sell subsidiaries rather than the assets of the business because of the substantial shareholding exemption. This does mean that financial assistance will be an issue in any management buyout. Whilst this is predominantly an issue for the purchaser and its funders it can be an issue for the seller if there is deferred consideration for which the seller requires security. Almost invariably the financial assistance in an MBO is dealt with under the whitewash provisions of the Companies Act so any additional financial assistance comprising security for any deferred consideration can be dealt with under that whitewash procedure with little additional cost.

Sellers should beware of any intercreditor agreement if there is deferred consideration on a sale to an MBO. Banks view deferred consideration as a form of additional equity to provide comfort for the senior debt provider. The terms of the intercreditor agreement produced by the bank's lawyers will reflect this with the seller only being able to recover its deferred consideration in very limited circumstances. We recommend that the seller makes clear the extent to which it is prepared to be postponed behind the bank at an early stage in negotiations. We have seen situations where an intercreditor deed is produced at quite a late stage and then a fundamental disagreement arises between the seller and the bank which cannot be resolved, leading to the transaction collapsing. There are a variety of nuanced alternatives to achieve a compromise between sellers and their debt providers.

Conclusion

While an MBO sale is in some respects a normal corporate sale a seller must be alive to the special consideration of an MBO sale and seek to address potential dealbreakers at an early stage.