A common exit strategy: The MBO ...

If you're an owner looking to sell your business or an employee thinking of buying the company you work for, you should be familiar with the term management buyout (MBO). In its simplest form, an MBO involves the management team pooling resources to acquire all or part of the business they manage. A Leveraged Management Buyout (LMBO) is similar to a MBO, except that the buyers use company assets as collateral to secure financing.

Most of the time, the management team takes full control and ownership, using their expertise to grow the business. An MBO/LMBO acquisition, which can be sizable, is usually funded by a mix of personal investors, external financiers and the seller.

For a business undergoing a change in ownership, the MBO/LMBO offers advantages to all concerned. Most obviously, it allows for a smooth transition. Since the new owners know the company and its business, there is reduced risk, other employees are less likely to be apprehensive and existing clients and business partners are reassured. Furthermore the internal process and transfer of responsibilities remain confidential and are often handled quickly. Once a business owner has agreed to sell his company to members of his staff, there are usually a series of common steps in the transfer of power:

• Buyer and seller agree on a sale price.
• A valuation of the business confirms the agreed-upon price.
• Managers assess the portion of the shares they could purchase immediately, and then draft the shareholder agreement.
• Financial institutions are approached.
• A transition plan is developed that incorporates tax and succession planning.
• Managers buy out the sellers' interest with financial support.
• Decision-making and ownership powers are transferred to the successors; this can take place gradually over a period of a few months or even a few years.
• Managers pay back the financial institution. This is done at a time and pace that will not unduly slow the growth of the business.

Buyers will need to ensure that the venture is profitable or at least has good potential to be. Keep in mind that the MBO/LMBO requires substantial financing, which will have an impact on company cash flow. To compensate for the repayment, the buyer will need a strategy to increase cash flow through cost-cutting, improved productivity or building revenue.

A thorough financial analysis should reveal cash flow, sales volume, debt capacity and potential for growth. This will provide valuable information on the fair market value of the business and on management's operating flexibility.

How to finance an MBO/LMBO
The buyer(s) will need to develop a strong business plan to prepare for the acquisition. The forecast should be credible and realistically attainable. Personal and business contacts and referrals can also help a successor secure confidence from bankers. A small buyout usually involves only one institution. In larger transactions, several institutions may handle the financing.
In an LMBO, business assets are evaluated to determine the equity available for financing. The lender will use the assets as collateral. The financial institution will adjust interest rates according to the risks associated with the transaction.

The financer may ask the seller to finance a portion of the sale as a form of commitment to the venture, and as a sign of confidence in the management team. Be sure to shop around for the best terms.

Any of these types of basic financing may be combined to achieve a successful transition.
Personal funds can help secure confidence from a financial institution, add equity to the transaction and share risk. Buyers often need to invest a significant amount of personal money — which may involve refinancing personal assets — to demonstrate their commitment. Loan or credit notes from banks are often used to purchase owner shares in the business. This type of financing is attractive because of its simplicity—assets are used as collateral—and because interest rates are lower.
Seller/owner financing can extend payments over a number of years. This form of financing is tied directly to the seller and may include credit notes, loans or preferred shares. This may reduce cash outflow at time of transaction and make the transition easier.

Similarly, an installment purchase of stock allows the seller to maintain a level of control until he or she is completely paid off.

Selling stock to employees can be used in conjunction with an MBO/LMBO to finance the remaining portion. The Employee Share Ownership Plan Association explains how this type of financing enables other employees to purchase stock options in the business. This can give incentive to existing employees while the management team retains control of the business.

Subordinate financing can complement a management team's equity investment by bringing together some features of debt financing and equity financing without diluting ownership. If a profitable business maximizes the financing on its assets, and the management team's personal funds are insufficient, then subordinate financing may take on a higher risk to participate in the venture. Repayment terms are established at time of transaction.

For more information: http://www.bdc.ca/EN/advice_centre/sell_your_business/Pages/RelatedArticles.aspx?PATH=/EN/advice_centre/articles/Pages/succession_mbo.aspx

BDC Perspective: Subordinate financing - a lesser known financing alternative

You may have heard it called "mezzanine financing", "junior debt", "structured equity" or "quasi-equity financing" but as Anthony Esposti, Manager of Subordinate Financing at BDC explains, the myriad of names all share a common principal - subordinate financing is basically a hybrid of debt and equity financing.

"It shares some of the characteristics of debt financing because the borrower has the obligation to repay," emphasizes Esposti. On the other hand, subordinate financing also mimics equity financing because repayment is based on cash flow rather than depreciating company assets. "What's important to remember is that the word "subordinate" basically refers to the fact that the security of BDC, for example, ranks behind or is secondary to senior lenders." Ultimately, the risk is shared.
So what's the key advantage of this type of financing for a small or medium-sized business? "Subordinate financing provides the capital necessary for a business to fuel its growth or secure its continuity. Repayment is not based on diminishing asset value but more on cash flow potential." emphasizes Esposti.

Expected cost
Entrepreneurs can expect part of the cost to be in the form of fixed interest, which is a deductible expense. The remaining cost comes in the form of a variable component such as a royalty, bonus payments or options to purchase shares in the company at a discount. "It's a higher risk so naturally a investor is looking for a higher return," he says.

Right now, if you're considering subordinate financing as an option, Esposti believes that talking to organizations such as BDC is important. "The industry is typically focused on larger transactions at $5 million and over. The Business Development Bank is a dominant player in the market for smaller transactions under $3,000,000," he says. "As Canada's small business bank, we truly understand the needs of SMEs."

Who's eligible?
Essentially, BDC would consider a small or medium sized business eligible if they have a sound management team, a record of profitability and an established line of credit. This means that start-ups are not considered for subordinate financing "We're looking for companies that have a proven track record and want to move to the next level."

However, he emphasizes that subordinate financing is not a formula-driven solution and can be customized to specific needs, depending on factors such as business seasonality, working capital requirements and the repayment structure. "The first step is to sit down with your lender, bring in your transaction and explain exactly what you're looking for. After that, a customized deal can be worked out," he says.

Typical investment scenarios
So what are the most typical scenarios when lenders consider subordinate financing as an option?

Management buy-outs/buy-ins
With an aging population, many 50+ business owners are looking for ways to exit their companies. Subordinate financing can provide the necessary funds for an existing management team to invest in the company. "Basically, we're helping entrepreneurs fill the financing gap in a transaction ," says Esposti.

CASE
Company X is an insurance adjuster in business since 1986, one of the fourth largest in Canada, showing $22 million in sales and very profitable. 14 senior managers in the company want to buyout owners who are 60+ and are looking to retire. The lender structured a deal that involved an equity injection by the new owners, a loan provided by the exiting owner and subordinate financing to round out the financing.

Mergers & Acquisitions
Mergers & Acquisitions naturally involve both fixed assets and more difficult-to-finance and intangible assets such as "goodwill." Subordinate financing can help companies purchase the goodwill while preserving their cash flow during a period where some uncertainty may exist.

CASE
An online research company has been in business since 1973 but has postponed its IPO due to market conditions. The company has expanded into the US and acquired businesses that will drive 25% growth over the next two years. The company has proven profitability, a strong management team and is a market leader with consistently retained earnings. The deal involves subordinate financing with payment at maturity, allowing the business to preserve cash flow.

Working capital for growth
Subordinate financing is often used to finance working capital for growth, which enables companies to increase revenues and profits. Entrepreneurs looking to invest money in market penetration, improve product R &D or finance additional headcount can take advantage of subordinate financing without compromising their regular cash flow used for daily operations.

CASE
A hardware company in business since 1981 has recently completed development of a proprietary technology. Financing was needed to help the company market this technology to existing clients and a broader market. This business needed to react to the market on a timely basis and to pre-build a one-month inventory of its products. The subordinate financing deal enabled this company to do just that.