Date 1 October 2005
First Published October 2005 in Business in Hertfordshire Winter Edition.
A management buy-out can be a very exciting and rewarding business venture. It can also be one of the most nerve-racking! Chris Wilks of SA Law demystifies the process.
In concept, a management buy-out (MBO) is very straightforward. The existing management team of a company purchases that company – or the business and its assets – from the current owners. Often, the management team will form a new company through which the purchase takes place.
In practice, even the seemingly simple and amicable MBOs can become a headache. Invariably the management team will need to raise finance in order to make the purchase – that means wooing investors or banks and guaranteeing their returns. The existing owners will also be pushing for the most financially rewarding deal – usually in the shortest possible time frame. The more parties involved = a more complex transaction = a greater risk of the deal going wrong.
Who’s involved?
Over and above the seller of the business and the management team purchasers, an MBO does require the services of other specialists.
Sadly, yes lawyers are a necessity! Risk is inherent at every step of an MBO and the only way to limit that risk is to use a specialist corporate/commercial lawyer to protect your interests. For a start, you want to be sure of the business being purchased and that there aren’t any ‘skeletons in the closet’. You also want to be sure all contracts are watertight – to be held accountable for something that wasn’t considered at the time can easily prove costly for the management team purchasers further down the line. Usually one firm of lawyers will act for the seller(s) and one will act for the purchaser. There are many other legal considerations in an MBO such as employees, property, intellectual property and good old solid contract law.
It is likely that the management team will require investors. These will either be private ‘equity’ providers such as business angels or ‘debt’ finance providers such as banks and other financial institutions. Some MBOs may require a mixture of the two.
Accountants are also necessary – they advise both the management team and the private equity investors on financing aspects of the deal. The management team and the seller may also require the services of an actuary if it is necessary to value a pension fund.
Debt or Equity?
Raising debt finance from a bank or other financial institution could be the more straightforward option but not necessarily the best deal. These organisations tend to keep the risk to themselves low, which invariably results in the risk being higher for the borrower. Debt finance usually comes in the form of a bank loan or debt security. A common example of a debt security are ‘vendor loan notes’ where the seller(s) offer a loan to the management team purchasers instead of receiving cash on completion.
Raising private equity will require a private equity provider who will provide funding if satisfied with the competency of the management team and the plan for the business. The equity investor will usually require shares in return for their investment. The transaction will normally be structured in such a way that both the management team and the private equity provider pay the same price per share. The equity provider may require ‘redeemable preference shares’ which give them preferential dividend rights and the right to cash in shares after a certain period of time and be repaid before ordinary shares in the event of the company being wound-up.
Equity investors will also want to protect their investment and will usually request that certain provisions are made. For example, they may wish to vet new shareholders and directors. The Articles of Association may be drafted in such a way as to restrict the management team from transferring their shares (bar any negotiated special circumstances such as transfer to a family member). Other provisions commonly required by equity investors include ‘ratchets’ – a method of increasing the value of an investment if targets have been exceeded.
Business Plan and Due Diligence
The solid foundation for any MBO is the management team’s business plan. A clear statement of the company’s background, financial state and aspirations for future growth is a vital component to encourage banks and equity investors.
An agreement to proceed will be quickly followed by a thorough investigation of the company. Known as ‘due diligence’, this will cover (or uncover!) aspects such as the company’s statutory books, finances/accounts, employees, property, intellectual property, any insurances and important third party contracts.
Negotiations and Documents
Negotiations will normally open by considering and agreeing the most important points such as the sale price of the business. These will then be set out in a document known as the ‘heads of terms’.
Following this, all parties will then negotiate and prepare the principal documents. These include the following:
- An Acquisition Agreement containing warranties (assurances by the seller that a true picture of the company has been provided). These give contractual protection to the management team and new company by providing a remedy if any fact disclosed against a warranty by the seller turns out to be incorrect. Typically there will be fewer warranties in an MBO than an acquisition by outsiders.
- An Investment Agreement to govern the terms of investment and the process of share allotment between the management team and any equity investors.
- The seller will prepare a Disclosure Letter to disclose any important facts about the state of the business. This can include the status of any contracts with third parties or whether the company is currently being sued. The disclosure letter will seek to limit the management team purchasers from making claims for breach of warranties in the acquisition agreement.
- A Tax Deed will protect the buyer from existing and potential tax liabilities of the company.
- Assignments and Licences for intellectual property.
- Documents relating to property.
- Banking documents such as a Bank Facility Agreement (terms by which the debt finance is being lent), Security Documents (guaranteeing the bank’s debt) or an Inter-Creditor Agreement (specifying the order in which each party is repaid in the event that the business is wound up).
In the case of purchasing the business or assets through the formation of a new company, there will also need to be:
- Documents transferring contracts to the new company – also known as ‘novation’.
- Documents transferring any pension scheme to the new company.
- Articles of Association governing the internal management of the company.
- Service Agreements for the directors.
It is always difficult to predict how long negotiations will last – the more complex the situation in terms of the number of parties involved and the special considerations, the longer it will usually take.
Protect Against the Unforeseen!
MBOs shouldn’t be attempted without legal and accountancy advice from experienced experts (and I’m not just saying that because I’m a lawyer!). Obviously the advice and representation will carry a cost, but the service provided will be invaluable. Business lawyers and accountants will help you with the two most important aspects of an MBO – getting the most out of the deal and ensuring you remain as protected as possible from risk both now and in the future.
For further information contact the Corporate Department at SA Law by telephone on 01727 798000 or by email chris.wilks@salaw.com.
© SA LAW 2005
Every care is taken in the preparation of our articles. However, no responsibility can be accepted to any person who acts on the basis of information contained in them. You are recommended to obtain specific advice in respect of individual cases.