Many owners think that selling their privately held company to their management team is a great way to reward loyal employees for years of service. This post discusses why that seldom works and puts forth another approach that is a better alternative for owners, employees, and the buyers.
Many business owners want to thank their loyal employees that have helped them build their businesses when they exit. It is a noble desire that often leads to the exploration of a management buyout. Who better to buy the business than the management team that is familiar with the procedures, the customers, the suppliers, the industry and the intellectual property?
From a practical standpoint, however, unless the potential management buyout team already owns a meaningful percentage of the company, it is unlikely they have the financial resources to complete the acquisition.
These managers may be great employees, but they generally do not have the risk tolerance to put their personal assets at stake in order to finance the acquisition.
They may originally think that they will be able to secure financing to make the acquisition. When they begin to peel back the layers they find that their enthusiasm begins to crack. Banks are not going to finance an acquisition based on a competitive market price for the business. They will make loans based on a percentage of the asset value of the equipment, receivables and inventory that exceed the company's debt level. This will likely result in the buyout group getting financing at 40-50% of the true value of the company.
Where does the rest come from? When the management buyout team explores the effective rate of mezzanine financing - 12% interest rate with warrants that drive the cost to 25%, they usually eliminate that option. The next option is the personal assets of the team. When the banks start asking for personal guarantees, individuals drop out pretty quickly.
This process sometimes evolves to the owner being asked to settle for a purchase price closer to the secured financing level available rather than the market value of the company. On a company with a $10 million fair market value, this could result in a discount of $5 million or more. I am sure the business owner is grateful to his loyal employees, but this is just not practical.
The problem occurs after this process unfolds and the once very excited management team realizes that their dream of ownership has been knocked off the track. If some of the key players blame the owner, they can turn from loyal to disgruntled and may even leave the company. This can result in erosion in company value in the eyes of the eventual buyer. The original noble plan has blown up in the owner's face.
Another approach would be for the owner to engage an investment banker to seek competitive bids from both strategic buyers and private equity groups. This process will establish the true market value that will be far superior to the financing value of the assets minus liabilities. The owner could grant key employees a cash award based on years of service, salary, or other criteria of his choice.
If the buyer is a Private Equity Group, the owner has another option that may be even more attractive to key employees and the Owner. PEGs encourage sellers to invest some of their equity back into the business. They get to invest leveraged equity along with the PEG.
So let's say that the selling price of the business was $10 million. The PEG would borrow $7 million and need $3 million in equity. If the seller invests $1 million of his proceeds back into the business, he would own 33% of the new entity. If the owner was planning on distributing $500,000 to employees, he could reinvest that $500,000 along with his $500,000 back into the business and he would then own 16 ½% and the employees would own 16 ½% of the new entity.
This works out for everybody because the employees will be highly motivated to stay and to perform at a high level for their eventual exit and cash out. The PEG gets to keep a performing management team in place that is highly motivated. The owner gets the maximum selling price for his business because of the soft auction business selling process. Finally, the owner gets to reward his loyal employees with a powerful investment in their future.
The second payoff for the owner and the powerful payoff for the employees comes five years later when the PEG sells the company now valued at $50 million to a strategic industry buyer. This second bite of the apple values the owner's retained 16 ½% stake at $8,250,000. The loyal employees cash out at that same level from an original $500,000 bonus. Now that's a bonus!
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