You’ve slaved away, built a successful enterprise and now the time has come to decide which exit strategy you will take.
So is it better to pass the business on to your management team or sell to a trade buyer? We investigate the pros and cons of these two exit strategy options…
Every entrepreneur selling their business wants to obtain the best combination of price, form of consideration, deal structure and compatible purchaser within an agreed timescale. The type of exit chosen determines much of this and two popular methods of disposal are selling to another business or being bought out by your management team. In both cases, there are many players involved; the buyer, the seller, investors, professional advisers, management, employees and even family members.
In addition, there’s an array of competing ideas of how the business should be run in the future, what its growth prospects are and, crucially, what it’s really worth. With all this complexity involved, it’s not surprising entrepreneurs find it difficult to choose an exit strategy.
The UK buyout market has rebounded strongly since the Brexit vote, according to data from the Centre of Management Buyout Research. 167 exits were completed in 2017 and their value doubled year-on-year to £34.7 billion.
Phil Adams, CEO at investment bank GCA Altium says, ‘The fundraising climate at the moment is particularly positive, and this has led to a broader range of private equity investors. One key difference is the diversification of finance, with credit funds now often providing funds in place of conventional banks.’
In 2017, management buyout activity (MBOs) jumped to 91 in 2017, up from 76 in 2016.
So why are MBOs so popular? One obvious answer could be the emotional advantage they have over other exit strategies, fulfilling an entrepreneur’s natural instinct to pass on the enterprise they’ve nurtured to worthy successors.
Mark Wignall of Mobeus Equity Partners, an active backer of management buyouts, says, ‘It’s quite common for human sentiment to make an MBO a preferred route. The perception is that the current management team are uniquely placed to understand the business, and perhaps it’s also a case of “better the devil you know”.
‘We recently backed a buyout of a company called Pasta King where the family owners had deliberately groomed their management team rather than considering selling to an outsider. There was a sense that “keeping it in the family” was preferable.’
However, one of the downsides with MBOs is that it’s not always easy to nurture talent from within the business quickly enough to meet the exit plans of the owner, nor is it straightforward to find talent from outside to bring in as heirs to the business throne. ‘For an MBO to succeed, you’ll need to sell to an identikit management team, so start putting that together far in advance of when you’d like to exit,’ says Jeremy Furniss, partner at independent corporate finance house Livingstone Partners.
Ideally, this would include an obvious leader or CEO-elect and a strong finance brain. ‘Even for small transactions, financial backers of MBOs will want the reassurance that a finance director or similar exists as the principal contact for key financial information,’ he says.
Adams, who advised B2B supply solutions company IESA on its £88 million sale to Electrocomponents, says securing the right exit meant finding a buyer that could offer the highest valuation, whilst also instilling confidence in the shareholders that the transaction would be successfully delivered.
‘A deal needed to be structured to enable a full exit for Gresham Private Equity, which held a 75 per cent majority shareholding in IESA. Achieving this involved exploring both a secondary buyout and a sale to a strategic acquirer,’ he said.
He continues, ‘Creating competitive tension amongst bidders is also a key tactic in avoiding opportunistic low offers.’
‘During the sale of IESA, we included the possibility of an IPO as a third exit strategy whilst letting the bidder pool know that all options were being considered, to maintain tension.’
Further reading on exit strategies
Laying the groundwork
Few directors can afford to buy a business outright with their own cash, so the buyout team will need to convince finance providers they are competent to take over the reins in order to get backing.
“Typically, private equity providers will want to realise their investment by achieving an exit, generally within three to five years after backing an MBO”
They usually desire a 30 per cent return on investment by that time, so effectively will only back businesses that are likely to grow quickly in terms of profitability and turnover.
It’s therefore a good idea for owners to help the MBO team illustrate how the private equity backer might realise their investment in a few years, as this will increase confidence in the deal and optimise the price paid now.
Another option is for a ‘vendor-initiated buyout’ to take place. This is where an owner looking to sell a business first approaches a range of equity providers to find out what funds would be available to back an MBO and, if the sums discussed constitute an agreeable purchase price, only then is the idea of a buyout raised with the management team and they are introduced to the equity lender.
Furniss says, ‘This can offer a business owner greater certainty of realising the value for the business they desire, as well as giving the MBO team a head start when it comes to securing financial backing.’
However, Iain Mackinnon, senior partner and founder of Mackinnon Corporate Finance, argues, ‘If the MBO team cannot put together a compelling business case to secure funds without the vendor’s involvement, they’re not the right people to buy and run the business.’
He continues: ‘You shouldn’t be the one getting the private equity backing for your management team to buy you out. Ask yourself this: If you’re doing all the hard work and still being the pivotal player, how have they proven they’re capable of taking the business forward successfully without you? And if they’re not competent, how likely is it that you’ll get any payments you’ve deferred in expectation that the company’s value will go up?’
Secrets and lies
A major advantage MBOs have over trade sales is increased confidentiality. Dealing with external buyers can alert the outside world to the fact the business is up for sale.
“Trade sales can therefore expose you to ‘fishing trips’ by competitors, who feign purchasing interest in order to gain access to trade secrets”
All potential purchasers who examine your business, whether they eventually buy it or not, will walk away having looked at your crown jewels.
‘There’s a general belief that selling to an existing management team reduces the risk of information leaking to the market,’ says Luke Ahern, director of broking at smaller company specialist stockbrokers Corporate Synergy. ‘It’s understandable shareholders might feel reticent to open the company books to all and sundry and expose themselves to corporate buyers who are competitive.’
Vendors should be aware, however, that MBOs present other risks associated with confidentiality and trust, which can be just as commercially damaging for a business. For example, during any acquisition process, directors have ongoing responsibilities to the company and its shareholders. However, if they are also potential owners of the business, they have a vested interest in acquiring the target on the best possible terms. Divided loyalties are clearly going to be an issue. At some point during the MBO process, you’ll have to face the fact that your management team is no longer your own and has its own interests.
‘When we back MBOs we typically see a drop in the company’s performance because management have taken their eye off the ball and are busy organising their bid,’ says Mark Wignall. It’s easy to become resentful if your management team is neglecting the business, particularly if that’s seen as a cynical ploy to get a good deal by driving down profitability and, consequently, the value of the business. Performance may dip for logical reasons prior to sale, but vendors may still suspect the worst.
‘The degradation of trust between a business owner and management team can be rapid in these circumstances – even irreversible,’ believes Jeremy Furniss. And, as Ahern warns, ‘A spurned management buyout team is a very dangerous beast. They’re invariably pissed off and uncooperative in future trade sale situations.’
So only choose the MBO exit strategy if you’re confident the deal will be successfully concluded. One way round this is to appropriately incentivise your management team for the successful completion of the transaction, whether MBO or trade sale, so either way they ‘win’. It’s also worth reminding them of their fiduciary duties.
Maximising your return
MBOs typically offer more flexibility than trade sales when structuring the deal. Purchase agreements usually comprise three stages of payment: an initial lump sum, loan notes or similar, followed by an earn-out contingent on a number of targets being met. Only then may the owner get the final portion of the buyout settlement and achieve a complete exit.
Therefore, when selling up you must make several decisions early on that will affect the balance between these stages of payment. Do you want a large lump sum for the business now or more money in the future, when the value hopefully goes up? To what extent do you want to stay involved in the business? Do you want to walk away completely and, if so, when?
‘For example, more cash can be taken out as a lump sum from a business with large chunks of property on the balance sheet,’ explains Mackinnon. ‘Any business owner seeking a large upfront payment should plan far ahead and be thinking how to gear up the balance sheet and load debt to maximise return.’
Minimising your tax liability should be a key concern of any exiting entrepreneur. MBOs and trade sales are both transactions incurring capital gains tax, but you should always try to preserve your ten per cent business asset taper relief by structuring the deal accordingly.
For instance, you might decide to take a portion of your payment in the form of loan notes. ‘This usually enables you to defer capital gains tax, but not always, as it depends exactly what sort of loan notes they are,’ argues Frank Haskew, head of the tax faculty at the Institute of Chartered Accountants in England & Wales. ‘And the last thing you want to do is end up sacrificing ten per cent tax relief upon selling your company as a result of the payment method you’ve chosen.’
Mackinnon adds, ‘You might even be able to get your loan notes guaranteed by a bank or insured. In that way, you’ve changed a capital interest in the business into a more secured interest. It can be prudent to minimise risk in this way.’
Getting the best price
There are clearly many good reasons for choosing the MBO route, yet being acquired by a trade buyer offers its own unique advantages, particularly for serial entrepreneurs looking to maximise return and move on to their next venture. What matters most when considering a trade sale is whether is the market is interested in your business. The answer will depend on what sector you’re in.
‘Large software corporates are keen to snap up smaller software enterprises at the moment,’ says Mackinnon, ‘so owners can demand greater sums when selling up. Construction companies, on the other hand, are notoriously difficult to sell to trade buyers because of contract fluctuations, very little brand power and there are relatively few barriers to entry in that industry. There’s not much demand for printing companies either, since it’s a capital-intensive business and there’s vast over-capacity in the market. These are the kind of factors that might push a small business vendor down the MBO route instead.’
If you’re lucky, a strategic trade buyer desperate to get access to a new customer base or assume geographic advantage, either domestically or internationally, might be able to justify paying a good price for your business. However, warns Mackinnon, ‘there’s a lot of ill-informed thought about the valuation of businesses.
‘I’ve had some difficult conversations over the years with vendors about the amount they are expecting,’ he adds.
There are no hard and fast rules for determining what a business is worth, particularly a private firm. Some people start with a crude measure of annual profit multiplied by the number of years’ earnings, others are guided by stock market valutions applied to companies in the same sector. ‘The trouble is,’ says Mackinnon, ‘it’s not an accurate guide to apply the stock market valuation method for a company like Microsoft to a private business with, say, one office and five staff.
Alternatively, some vendors approach valuation by thinking the lump sum paid for the company should produce an interest income equivalent to the current lifestyle-maintaining income extracted from their company. Jeremy Furniss says, ‘In a low-interest environment, this can produce an inflated price expectation as, in contrast, the market’s valuation will always be based on what buyers think the business is worth to them. That can be 25 to 50 per cent less than the business owner is expecting.’ If you’re considering taking the trade sale route because you believe an outside buyer will pay more for your business than a management buyout team, think again.
‘The extent to which private equity houses backing MBOs can financially engineer their deals gives them huge flexibility when valuing the businesses,’ argues Furniss.
MacKinnon agrees: ‘For owners of small businesses that perhaps aren’t attractive to potential trade purchasers there’s plenty of capital out there to fund buyouts. Now is a good time for owners to exit and management teams to take control.’
Having made the difficult decision to sell, owner-managers tend to want a quick resolution, and sensibly so, since a process that drags on can be quite bruising. As a general rule, management buyouts tend to be executed more quickly than trade sales because, explains Mackinnon, ‘MBOs don’t involve time spent getting to know the purchaser or marketing the company externally.’
Issuing sales memorandums to the market, dealing with competitive bidding situations and undertaking the auction process for trade sales all take time. Based on his experience advising small and medium-sized businesses on many types of merger and acquisition, Mackinnon reckons the average management buyout takes around three to four months, whereas trade sales take at least six months to complete. It’s another reason why MBOs are so attractive to business owners.
But in your haste to sell up, don’t overlook the importance of preparation, warns Furniss. ‘You can add significant value to your business by proactively “grooming” it several years before you intend to sell. This involves taking a deeper look at your business and making some key decisions that can add real value to the proposition in the eyes of potential purchasers. It’s not just a case of buffing up the family silver for display.’
Due diligence dangers
A common myth among business owners is that MBO teams will spend less time on due diligence than trade buyers before agreeing on a deal. It’s assumed that because management is already familiar with the business, some questions are already answered and that speeds up the process. Trade buyers are believed to be more thorough and intensive, leaving no stone unturned in their investigation of a potential acquisition from a commercial, financial and legal perspective.
But, argues Furniss, don’t be fooled that the level of due diligence is any less with an MBO than a trade sale. He says, ‘Any private equity backer of an MBO values their cash as much as a trade buyer does. Venture capitalists are, by nature, preoccupied with the numbers in order to justify the value paid for the business.’
Trade buyers tend to be more interested in the client base, product technology and so on, in order to realise value through synergies with the existing business. In fact, a trade purchaser might already have market research and commercial awareness, which will shortcut some of the due diligence process. In comparison, a private equity house would usually be obliged by protocol to undertake a thorough investigation before backing an MBO. As a result, they may be more cautious than a trade buyer and the whole process could take longer than you think.
Scoring big when selling up
Shrewsbury Town Football Club chairman Roland Wycherley has just been through what he calls the ‘emotional trauma’ of selling the business he’s built for 34 years. He founded The Midshires Group, based in Shrewsbury, in 1972 and it became one of the largest independently owned vending companies in the UK. It was sold for an undisclosed sum in 2006 to Bunzl Plc, the international distribution and outsourcing group.
‘Every entrepreneur instinctively knows when the time is right to sell, but it’s still an emotional trauma even if you’re ready for it,’ says Wycherley. He says his management team weren’t inclined to take on the financial burden of borrowing to buy the company, besides which, ‘two powerful players’ in the trade made offers to buy him out. ‘I chose to sell to Bunzl because I believed them to be an ethical operator that understood the business. Acquisitions are a sensible option in this industry, and organic growth is very difficult to achieve in present economic conditions. Times are tough, despite what the Government says.’
He was determined to crystallise the value he’d built up in the business during three decades by securing a lump sum payment. ‘It was a cash sale done on the day, I didn’t want to take a stake in future earnings or shares and the like. ‘One of the best decisions I made was to get advice and expert help selling my business. I had a perceived value of its worth and I’m happy to say that Mackinnon Corporate Finance helped me receive 15 per cent more than that from the sale. It’s not always easy for business owners to trust advisers, but I’m glad I brought in expert help. I’m very pleased indeed with how it all turned out.’
And although he’s no longer running his own business, Wycherley is gainfully employed in the not exactly small project to build Shrewsbury Town’s new £1.5 million stadium. ‘It’s keeping me busy,’ he confirms.