Management Buyouts

Contents

1. What the term means
2. How the purchase is paid for
3. The buy in that becomes a buyout
4. When the numbers do not work
5. The seller who stays

Brent O’Mara works with business owners and multigenerational families, and in business succession, a subject that work reaches often, the buyer is sometimes already inside the building. The New York Times described such a building in 2015: a castings plant in Dayton, Ohio, where two men had gone to work while still in college, joined full time as manufacturing and engineering executives, and eventually teamed with a third employee to buy the company. Nearly three decades later, with 40 employees and about $5.5 million in annual sales, the two were in their sixties and facing the same question their former employer once had, and they answered it by selling to an outsider.⁶ Their first transaction, a purchase by the company’s own managers, is this entry’s subject.

What the term means

Accounting Today defines a management buyout as the existing management team, or a group of managers, purchasing an ownership stake in the company, and lists it with family succession, an employee stock ownership plan and a sale to a third party as the four main routes out of a private company. The advantage it names is continuity: experienced managers take ownership and responsibility for the company’s future while the departing owners get liquidity.³ A Kiplinger adviser column groups it under internal successions, alongside ESOPs and transfers between generations, and sets those against outside sales to strategic or financial buyers; internal sales, it argues, are driven mostly by a wish to see the business carried on by known hands rather than by the largest possible check, while outside sales are more often a matter of necessity.²

Figure

Internal succession against an outside sale

	Internal succession	Outside sale
Who buys	Managers, family members or an employee plan	A strategic buyer, a financial buyer or the public market
What drives it	A wish to keep the company in known hands rather than the largest check	Often necessity: the company has outgrown an internal buyer or needs capital
Continuity	Leadership stays in place, which is the chief advantage	Culture, operations and direction can change considerably
Price	Frequently lower, because the buyers borrow or pay over time	Set by competition among bidders

How the purchase is paid for

Managers rarely have the price in cash. A second Kiplinger column, addressed to an owner whose buyers are key employees, calls the installment sale the common form where the company is stable, with steady cash flow, good management, capable staff and consistent processes. Owner and buyers settle on a value; the owner then holds a promissory note, repaid in installments with interest over a stated term and backed by the company’s assets and stock as well as the buyers’ personal collateral. Employees seldom have the liquidity or the financing for a single payment, the columnist cautions, so the price tends to come in below what other buyers would offer.¹ The Wall Street Journal traced the wider habit to the years after 2008, when bank loans no longer covered the full cost of an acquisition and owners fell back on financing their own buyers.⁷ The mechanics of the note, and how installment payments are taxed, are set out under earnouts and seller financing.

The buy in that becomes a buyout

In professional practices the buyout often arrives in stages. The Journal of Accountancy describes the structure for accounting firms: a successor, often a smaller firm or a single practitioner, buys a partial equity interest in a firm whose owner is several years from slowing down, with the date and terms of the full buyout agreed up front. In its example a firm with $800,000 in fees merges with a practitioner billing $200,000, who becomes a 20 percent partner on relative volume and buys another 30 percent, paid over years, to reach half; a merger leading to a buyout works the same way without the up front purchase, and is the usual approach when both sides are multipartner firms. A straight sale, in which the seller walks away the day after closing, is rare, the authors write, because clients are asked to change hands with little transition and retention suffers.⁵

When the numbers do not work

A buyout can fail on arithmetic. University of Minnesota Extension collected the stories of eleven Minnesota owners, among them a wood products company in Cohasset whose leaders first considered a management buyout and found the business had grown to a value that made it difficult; an ESOP gave the employees an ownership stake instead and kept the company in its town. A St. Paul consulting firm in the same set went to a worker cooperative.⁴ Both alternatives are described under employee ownership and ESOPs. CPA Practice Advisor makes the point from the other end: a management buyout is one of several exit routes an owner should identify early, because each requires different preparation, and a company whose sales, relationships and decisions all run through the owner is not one a management team can readily buy.⁸ The value that has to be financed is the subject of how a business is valued.

Figure

Selling to key employees, step by step

1. 01
   The whyRetirement, a changing industry, a disability or divorce, a need for cash or a loss of interest
2. 02
   The buyerKey employees, as against family, partners, an ESOP or an outside third party
3. 03
   ValuationAn independent professional valuation, since what the owner thinks it is worth and what a buyer will pay differ
4. 04
   StructureUsually an installment sale, with the owner holding a note paid over a set period with interest
5. 05
   FinancingEmployees rarely have the liquidity for a lump sum, which can mean a lower price
6. 06
   MessagingCustomers, suppliers and the employees not buying hear it from the owner first

The seller who stays

In Dayton, the engineer who bought the castings company kept both former owners on as vice presidents and said he intended to keep them as long as he could, for their institutional knowledge; his financing was typical, 13 percent down in cash, 12 percent carried by the sellers on a note, and the balance from a bank loan.⁶ A seller who is still owed money has every reason to remain in the building, and the Wall Street Journal’s reporting describes exactly that: former owners lingering for years to help the new ones succeed.⁷ Kiplinger’s columnist notes a complication peculiar to selling to one’s own staff, which is that the buyers know the seller well enough to ask for leniency if the business hits a rough patch, and that reworking the terms is sometimes the sensible course for all concerned.¹ Whether a buyout, an installment note or another structure fits is a matter of individual circumstances, with its tax and legal terms left to qualified professionals.

The vocabulary is short. A management buyout, or MBO, is the purchase of an ownership stake by the managers already running the company. An internal succession is any sale to insiders, whether managers, family or an employee plan; an external sale is a sale to a strategic buyer, a financial buyer or the public market. An installment sale is one in which the buyers pay across several years, under a promissory note that spells out what is owed and when, with collateral behind it. A buy in is the purchase of a partial interest, and a buy in leading to a buyout is the staged version in which the full purchase date is fixed in advance. An earnout is a part of the price paid later if the company meets stated targets. A feasibility study is the professional analysis of whether the buyers’ financing and the company’s cash flow can carry the deal, and the buy sell agreement, covered in its own entry, is the standing contract that may have fixed the price and the buyers long before any of this began.