Management Buy-Out (MBO)

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An MBO is the process of an existing management team[1] within a business (the Management) acquires that business (the Target) from the current owners.  The Target maybe a subsidiary or it may simply be a division in the company which the management team thinks it can optimize.  This is often done with external equity finance from private equity providers and debt finance either from debt providing institutions.

To execute a MBO a new company NewCo is almost always formed[2].  Typically, the directors of NewCo. will be the current management tea of the Target.

Initial Considerations:

• Business Plan

Management must prepare such a plan to explain the Target’s background, its financial record and the projected performance of the business following the MBO. This business plan is a critical element in approaching potential funders.

• Equity Finance

In most buyouts, finance from external sources will be required as usually the Management will not have sufficient funds themselves to buy the Target.

If a private equity provider is interested, heads of terms would usually be signed up. These increasingly require that the Management will deal exclusively with the nominated private equity provider.

This stage is critical for the success of the business; choosing the right investor with the matching investment horizon is often the key to success or failure.  The Management team will have to give up equity in NewCo and the form of the agreements as well as the amount sold are critical matters.

Remember the equity is always more expensive than debt since the equity investor requires a much higher rate of return.

We can help you find the right type of equity investor for your business.

• Debt Finance

Leverage / Debt finance will usually form a large if not the largest part of the required funding in a buyout. Banks will want to ensure that profits and cash are protected and that should Newco run into difficulties the bank’s position will be protected and that they will be able to “control” any restructuring.

The principal component of this debt will tend to be a secured term loan to finance the acquisition.

Incorporation of Newco

It is important at an early stage for the acquisition vehicle to be formed. Consideration will need to be given to the following:

• What is to be the name of Newco?
• Who are to be the directors and secretary of the company on incorporation?
• What is the authorised share capital?
• Who is to be the shareholder on incorporation of Newco?
• Who is going to be responsible for incorporating Newco?

Equity term sheet/ offer letter

Once the private equity provider has decided, in principle, to proceed, the next step is to draw up a term sheet.  This will often take the form of an offer letter entered into between the seller and Newco (as buyer).

The offer letter or term sheet will often include an exclusivity provision which grants the private equity provider an exclusivity period during which the seller or Management agree not to negotiate with anybody else in relation to the transaction.

Due diligence

It is important to settle from the outset who will carry out due diligence. There should be adequate communication between the due diligence team and those conducting negotiations with the seller.

The due diligence exercise helps to highlight areas of risk for a private equity provider so that it can more accurately assess the attractiveness of the opportunity.

Negotiations

When the due diligence exercise has been completed the parties will negotiate the key legal documents. This will involve the seller, the Management, the private equity provider and their respective advisors.

The Principal Element of the Transaction

A buyout involves, in effect, three transactions:

Equity. This is the deal between the private equity provider and the Management relating to their subscription for shares in, and the managements’ employment by, Newco. The key agreement:

Investment agreement

The investment agreement governs the relationship between the Management and the private equity provider. The following are some of the key provisions to negotiate:

• What provisions are to be made for restrictions on what management can and cannot do with Target without the consent of the private equity provider?
• What provision is to be made for the private equity provider to appoint directors to the boards of Newco and its subsidiaries?
• Is any provision to be made to enable the private equity investor to assume control of Newco to procure a sale or otherwise act to protect its investment? Management should resist the extension of these rights beyond certain critical events such as insolvency or another major breach of the investment agreement by management.
• What restriction is to be made on the ability of shareholders to transfer their shares freely to third parties?
• Is there to be an obligation on all parties to abide by the provisions of the articles of association of Newco?
• What warranties are to be given by Management to the private equity provider? On a buyout, the Management usually warrant the reasonableness of their business plan and confirm certain factual information contained in due diligence reports.

Acquisition. This is the deal between Newco and the seller for the acquisition of Target.  Prior to the acquisition NewCo will have to be created and the articles of association will set out the rights attaching to its shares, including dividend entitlements, rights of shareholders on a return of capital, and restrictions on the ability of shareholders to transfer shares.

The acquisition of Target by Newco is typically a share or business purchase, the principal documents of which include (where relevant) the following:

• a share purchase or asset purchase agreement
• a tax deed (also known as a tax indemnity or a tax covenant)
• trade mark or trade name licences
• pension documents dealing with any transfer of employees’ pension funds
• property documents dealing with transfer of any leasehold or freehold property
• documents dealing with any transitional arrangements relating to the handover of services performed by the seller’s head office (for example, monthly accounting, pension administration and insurance services)

• a disclosure letter
• novations or assignments of contracts
• service contracts – Management will be employees of Newco and will have service contracts to reflect this. The key terms are likely to relate to remuneration and other benefits, duties, notice periods, other termination provisions and restrictive covenants.

Further, Newco is likely to want warranties in the sale and purchase agreement on the state of the business that it is buying. The seller is likely to want Management to share the burden as they will in many cases be closer to the operation of the business than the seller itself.

Finance/Debt. These are the arrangements between Newco and the providers of finance for the acquisition of Target.

Bank facility agreement

This agreement specifies the amount of money being advanced, the purposes for which it can be used, the circumstances in which it must be repaid immediately, the circumstances in which it can be repaid early (if any) and the various tests which Newco must satisfy at all times to indicate to the bank that it is financially healthy.

Bank security documents

This is the package of documents which grants the bank security over the assets of Target. If the bank requires security over the assets of Target the usual security is for Newco to give a debenture in favour of the bank to secure its borrowings.

Inter-creditor agreement

This is the agreement between Newco, the bank(s) and the holders of any loan notes in Newco by which they agree the order of priority for the payment of money by Newco and the control of any insolvency process to recover money from Newco. The agreement is entered into because the bank will want to make sure that it has priority over, for example, mezzanine finance and the loan note holders in the Newco group and it will want to ensure that it can control any insolvency process of Newco.

Other Critical Considerations:

Tax:

It is important that Management are fully advised on the tax aspects of the transaction at an early stage. We will issue a further briefing on the related tax issues shortly.

Exchange of contracts

The culmination of the preliminary stages of the buyout process is the exchange of contracts in respect of all three elements of the deal (the provision of equity, the provision of debt and the acquisition itself).

Between exchange and completion

A split exchange and completion may be necessary for various reasons, which include:

• approval of the sale by the seller’s shareholders
• obtaining landlord’s consent to the assignment of key leasehold properties
• consultation with employees under relevant employment law if confidentiality concerns do not permit this prior to exchange of contracts
• obtaining consents to the assignment of key contracts where, because of the commercial sensitivity of the transaction, this has not been possible beforehand.

It is important to consider whether any of the above are relevant to the particular transaction.

Completion

At completion, the private equity provider and management will make their equity subscriptions in Newco, the bank will provide their finance, and the acquisition of Target will be complete.

Post- Completion

Matters which will need to be dealt with include the following:

Ensuring that the necessary statutory filings are made at Companies House.

Notifying the relevant registry of any changes in title to assets such as real and intellectual property.

[1] Note that a Management Buy-In is where an external management team buys into the business, that are also MBO/MBI hybrids

[2] An MBO can sometimes be structured as a spin-out depending on the initial structure

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