When is an MBO the right answer?

MBO or not MBO? Not quite Shakespeare I know, but bear with me. I’ll make an equally famous literacy reference at the end of this article.

We are seeing increasing numbers of Management Buy Outs (MBO) at the moment and with such transactions getting increasing coverage there is always a risk that businesses and indeed some less informed advisers will think that an MBO is always the right answer. So the question I want to address is ‘When is an MBO the right answer to the business succession challenge?’

To add some clarity, an MBO is a strategic business move where the management team of a company acquires ownership from the current owners. This process allows for a smooth transition of leadership, continuity of operations, and often leads to increased employee morale and performance. A transfer to an Employee Ownership Trust (EOT) is a very different animal and does have some complexities that do not arise with an MBO. You can find more information on EOT’s here.

Firstly, let’s consider the MBO from the Sellers point of view. Prior to even considering whether to enter into an MBO the seller holds all the cards. They have an asset in their possession that they will, often without any particular rhyme or reason, have placed a value on.  More often than not owners have an inflated opinion as to the value of their business, though I have seen the reverse.

Anyway, let’s say Mr Jones, having met with his professional advisers, has concluded that his business is worth £5 million.

It’s important to note that typically, but not something that is always clear, most valuations are on a ‘cash on the completion’ basis. Cash on completion deals are increasingly rare, I have never seen an MBO that is cash on completion and trade sales will more often than not include an element of deferred consideration, certainly in the current climate.

Offers on the table

So back to Mr Jones who is expecting £5 million, he then goes to market and gets the following offers.

A reputable trade buyer with rapid expansion plans has offered £3m on completion and £750,000 per year for 2 years. So total consideration of £4.5 million.

Mr Jones has also approached the management team who have accepted the valuation of £5 million and have offered payment of £2.6 million on completion (primarily funded by existing cash in the business) and then £600,000 a year for 4 years. So total consideration of £5 million.

On the face of it, taking into account the time value of money, they are fairly similar offers; 11% more money, but a longer payment period.

So it’s decision time for Mr Jones – key factors to consider

The key factor to consider is Mr Jones’ assessment of the ability of the current management team. He is relying on the quality of that team to settle the amount due to him as the exiting owner. If the management team have approached him that’s always a good sign. If he has approached the management team and, after months of discussion, they have come back to him along the lines of ‘we think we would like to give that a go’ then that’s not a particularly positive signal from the management team. Mr Jones is effectively lending the management team £2.4 million, so he needs to be confident that repayment will follow.

Oddly the ability of the new management team, and therefore the ability for them to repay the debt, is something that is often overlooked by exiting shareholders, they forget that they will no longer have control or influence over the running of the company.

A further consideration will be Mr Jones’ view on what might be termed legacy. Does being welcomed every year to the Christmas party, being recognised in the street as the man who did good by his employees, and his own view that he is giving a life changing opportunity to the management team that helped him to generate his wealth carry a value to Mr Jones. This is always an important consideration when considering an MBO but very hard for an accountant to place a value on.

Final consideration, which is equally difficult to place a value on, is ease of the process. To put it another way, how important is it that you can sleep at night. With an MBO exit strategy the due diligence (financial, commercial and legal) is ordinarily a lot more straight forward. There will be a significant amount of deemed knowledge within the MBO team. With a trade sale the due diligence process is long, costly and mentally draining. From my experience, a sale is more likely to fall over when a trade sale process has started as opposed to an MBO. Having said this, it’s difficult to place a value on it. If it was me, on say a sale value of £5 million, a discount for the ease of the due diligence process may well be worth it. £250,000 might feel like a huge discount but taking into account the Sellers own savings in fees, a faster transaction time with an MBO and simply an easier process (encompassed in that a good night’s sleep), I think an MBO discount of 5% on comparable terms would usually be acceptable.

So – back to the beginning – when is an MBO the right answer to the business succession challenge?

As I have outlined above there are key factors to consider and in order of priority.

1. Potential cash consideration and certainty thereof

This has to be the key consideration, no business owner, however benevolent, wants to give away their business. If the management team are not driven and clearly up for the ride, then this should be a red flag.

2. Legacy

Only the current owners can tell you how important this is. Most that I come across consider this to be really important. We then talk about cash and risk and suddenly legacy becomes less important.

3. Sleep

How much do you want it? At its worst going through a full due diligence process can be like …… we all have our worst fears. so add your own. Mine would be stuck on a never-ending theme park ride.

Can’t make up your mind?

To paraphrase another Mr Jones, ‘don’t panic’. As always in these instances, come in and see us, with an open mind. Life changing decisions take time and are not easy, we are here to help. If you are considering exit strategies for your business or considering a Management Buy Out, feel free to get in touch for a confidential chat by calling 0330 058 6559 or emailing hello@scruttonbland.co.uk