Funding an MBO
Management teams can be under the illusion that a buyout is not possible because collectively the team members do not have sufficient funds to meet the consideration. This is quite a common misconception.
It is true to say that members of the buyout team are required to invest a sum of personal money into Newco in return for an equity interest (“a Stake”) in the business. However the vast majority of the consideration is usually provided by third party financial institutions such as banks, venture capitalists and even the vendors themselves by way of deferred consideration.
Sources of finance for a buyout and their key features are summarised below.
The personal investment required by members of the buyout team needs to be meaningful to each individual taking into account their own financial position and personal circumstances. The sum need not be vast but will typically represent around 6 to 12 months salary.
The investment made by management serves to demonstrate their belief in and commitment to the MBO to third party funders.
Banks obtain their return on investment by way of interest on the sum advanced. The availability of bank finance is therefore reliant on the ability of the business to service the future capital and interest repayments following legal completion of the buyout.
Funding from a private equity or venture capital investor will always be conditional upon their taking an equity stake, usually as a minority shareholder, in Newco.
The investment returns on a private equity investment are twofold: interest income on the funding provided and capital growth in the equity stake.
Private equity providers make the majority of their money on the sale of their shareholding when Newco is sold, usually within a period of around five years after the MBO. Consequently this type of finance is typically only available in support of those buyouts where substantial capital growth and a relatively fast exit is anticipated.
Vendor deferred consideration
Vendors, as you would expect, prefer the consideration to be paid to them in full at legal completion of a transaction. However, this is rarely feasible and vendors usually need to defer a proportion of the consideration in order for an MBO to proceed. Indeed funding offers are normally conditional on a proportion of the consideration being deferred.
Business cashflows may be insufficient to support capital and interest repayments on the amount of debt which would otherwise be needed; furthermore, funders gain comfort from the vendors’ financial endorsement of the management team.
An earn-out is a specific type of vendor deferred consideration whereby additional consideration is payable to the vendors contingent on the future trading performance of the business following completion of the buyout.
The vendors may believe that the business is worth more than the MBO team does or more than can be funded based on its past financial performance. An earn-out structure may lead to additional consideration being payable to the vendor if the business achieves or surpasses specific financial targets following completion of the buyout.
An earn-out helps to maximise the value of the business for the vendors and eliminate uncertainty for the MBO team.