Exit Planning and Succession IV - The Internal Sale

The most probable opportunity for company owners looking to sell their business is a management buyout—a sale to senior managers or family. An MBO exit has a lot of flexibility and, if properly structured, can have significant tax advantages. In certain situations, the MBO will reap a better bottom line result than an outside sale because of the tax savings. Remember, it is not how much an owner gets, but how much he or she keeps.

An MBO is a win-win for the buyer (management) and the seller (owner/s). Management has the opportunity to build significant personal wealth, and the owner benefits by cashing in on the investment built in the company. Sellers also leave a legacy with trusted stewards who bring a new energy.

Additionally, in an MBO, the company pays. If management can keep the company growing and profitable, the company will buy the stock from the original owner and pass it along to the management buyers.

However, MBOs come with inherent risks. The largest obstacle in executing an MBO is that managers often do not have the financial ability to pay for the business. This requires that the business owner structures a plan that will allow the business to pay for the transition. Therefore, careful consideration should be given to the many tools available to help achieve the best tax yield for the sale while minimizing the financial risk of getting paid for the business.

Another major obstacle for the seller of an MBO is the financial risk—the risk that the owner will not be paid. The buying senior management team performance is tied to the cash flow that will pay the owner.

In order for an MBO to be successful, and for the owner to get paid, all parties must work to manage a number of risks. This risk management involves considerations of the business, the financial partners and the people involved. This article outlines these key considerations for an MBO.

Buy-sell agreement: The shareholder agreement must address the “four D’s”—death, disability, divorce and departure—and how each triggers the buy-sell. The agreement should leave little ambiguity for the reader. Remember, in most cases, the document will be referred to by the existing owners, the deceased shareholder’s spouse, and legal counsel. The agreement should consider valuation formulas, funding and transfer of ownership.

Payment management: In an MBO, the company is the goose that lays the golden egg. The company must remain fiscally healthy during the buyout and endure the economic cycles. I recommend that payments be kept flexible, to ensure that the needs of the company come first.

Financing: The sale is many times funded by company profits or seller financing—the redemption of the owner’s share over time. However, it can also be funded by outside financing via a leveraged buyout, but this is a more expensive option.

Financial partners: The owner and management should be transparent with key financial partners, including the bank and bonding company. These financial partners should be kept in the loop with the transition plan. The company still needs to keep healthy financial ratios and the necessary working capital, but it will look different as money is transferred to the owner in the buyout. Financial partners will understand and benefit from a well thought-out transition plan.

Personal guarantees: Get the new management and especially the comptroller engaged with your financial partners. Banks and bonding companies depend on the owner’s personal guarantees, which will have to be transferred to the new owners near the end of the buyout.

Succession: With an MBO there is a risk of the owner/s not being paid by the managers. That is why it is critical to find the right person/s who have demonstrated the broad capability to run the company and show the leadership ability to take the company to the next level.

First the managers need to get to the next stage by growing and performing as champions. During this time, they must begin to think like owners and always put the company first. They then will move into leadership, deal with their blind spots, and put their associates and teammates first.

Succession takes time. It is a continuous process, not a single event. The process is about the development of talent and not the typical replacement of talent. The best players are developed in a company’s internal culture, and owners must provide the curriculum, training and leadership development.