Selling your company to management sounds like a good idea, but…

by Dave Kauppi, CBI, principal at MidMarket Capital Advisors, LLC

Many owners think that selling their company to their management team is a great way to reward loyal employees for years of service. This article discusses difficulties the owner’s exit planning team will have implementing a management buy-out and puts forth an alternative approach which accomplishes many of the same goals.

Showing gratitude to loyal employees is a noble desire that often leads to the exploration of a management buyout. The thinking goes: who better to buy the business than the management team that is familiar with the procedures, the customers, the suppliers, the industry and the intellectual property?

From a practical standpoint, however, unless the potential management buyout team already owns a meaningful percentage of the company, it is unlikely they have the financial resources to complete the acquisition. In addition, though these managers may be great employees, seldom will they have the risk tolerance to expose their personal assets in order to finance an acquisition.

Employees may at first naively think they will be able to secure financing to make the acquisition, but when they begin to peel back the layers, experiencing first-hand the detailed level of skepticism expressed by today’s financial institutions, their enthusiasm likely will begin to crack. Banks today are not going to finance an acquisition based on a competitive market price for the business. They will probably make loans based on a percentage of the asset value of the equipment, receivables and inventory that exceeds the company’s debt level. This will likely result in the buyout group getting financing at, perhaps, 40-50% of the investment value of the company.

Where does the remainder come from?

Mezzanine financing? Mezzanine financing offers a way for privately held companies to attain financing without relying on public markets and potentially ceding ownership of their company. It is a blend of traditional debt financing and equity financing. Like equity financing, mezzanine financing is an unsecured debt, requiring no collateral to be put up unlike traditional bank loans. Like debt financing, mezzanine financing is very fluid and does not necessarily involve giving up an interest in the company. When the management buyout team explores the effective rate of mezzanine financing – 12% interest rate with warrants that drive the cost to 25% – they usually eliminate that option.

Personal assets? When the banks start asking for personal guarantees, individuals drop out pretty quickly.

This process sometimes evolves to the owner being asked to settle for a purchase price closer to the secured financing level available rather than the market value of the company. On a company with a $10 million fair market value, this could result in a discount of $5 million or more. Is this what you want?

Unforeseen and unintended consequences occur once a very excited management team realizes that their dream of ownership has been knocked off the track. Many times key players will blame the owner for not acquiescing to the lower acquisition price; they can turn from loyal to disgruntled and may even leave the company. This can result in true erosion in company value. The original plan has blown up in the owner’s face. The exit planning team has to be aware of this possible scenario in advance and work to create solutions.

Another approach would be for the owner’s team to seek competitive bids from both strategic buyers and private equity groups. This process would give instant visibility to value that would presumably be far superior to the financing value of the assets minus liabilities. The owner could grant key employees a cash award based on years of service, salary, or other criteria of his choice. Of course, this deviates considerably from the employees-will-take-over ideal.

If the buyer is a Private Equity Group (PEG), the owner has another option that may be even more attractive to key employees and the owner. PEGs encourage sellers to invest some of their equity back into the business. They get to invest leveraged equity along with the PEG.

So let’s say that the selling price of the business was $10 million. The PEG would borrow $7 million and need $3 million in equity. If the seller invests $1 million of his (or her) proceeds back into the business, he would own 33% of the new entity. If the owner was planning on distributing $500,000 to employees, he could reinvest that $500,000 along with his $500,000 back into the business and he would then own 16-½% and the employees would own 16-½% of the new entity.

The employees will be highly motivated to stay and to perform at a high level for their eventual exit and cash out. The PEG gets to keep a performing management team in place that is highly motivated. The owner gets the investment value for his business because of the soft auction business selling process. Finally, the owner gets to reward his loyal employees with a powerful investment in their future.

The second payoff for the owner and a powerful payoff for the employees comes five years later when the PEG sells the company now valued at, say, $50 million to a strategic industry buyer. This second bite of the apple values the owner’s retained 16-½% stake at $8,250,000. The loyal employees cash out at that same level from the original $500,000 bonus, and a creative solution pays off for all.

Our thanks to Dave Kauppi and MidMarket Capital Advisors, LLC. for permission to use exit planning and exit strategies content and ideas on businessvaluation.com!