A management buy-out is the transfer of a company to its (managing) employees or management. It is therefore an interesting instrument for both the current owner and the successor when it comes to small and medium-sized enterprises.
In particular in family-owned companies, where there is the lack of an heir or personal interest in continuing the “family business”, the sale to the existing management offers an excellent possibility to safeguard the achievement of a lifetime or even several generations and ensure continuity in its management. The particular appeal of this type of transfer of business lies in the fact that the company’s management is already familiar with the company’s organization and structure. Moreover, sales negotiations are often facilitated by the ties between the acting individuals and the company. This being said, the management’s dual function is not unproblematic. On the one hand, in their function as corporate bodies, managers are obliged to represent the company’s interests within the scope of sales negotiations. On the other hand, the management regularly endeavours to conclude negotiations with the aim of maximizing personal advantage for itself as a future shareholder. In addition to this conflict of interest, the success of a management buy-out depends to a large extent on its financial viability. As the management often does not have sufficient equity capital, external financing regularly funds the purchase price for the greater part. The company therefore not only becomes a source of security, but also a source of income for a potential company succession. However, an adequate financial endowment for the company itself and its stable development is the basic prerequisite for financing the purchase price and therefore ensuring a successful management buy-out.
At first glance, the possibility of closing the management’s financing gap may seem obvious, but it requires a loan from the previous owners, which will be (proportionately) deducted from the company’s income on an agreed annual pro rata basis. This approach involves two risks: On the one hand, a high degree of risk tolerance on the part of the existing shareholders is a prerequisite for such an approach, since a considerable part of the financial burden lies with them. On the other hand, there is a dependency of the new owners on the existing owners and possibly a conflict of loyalty among the company’s staff. In order to safeguard their commitment and exposure, the existing shareholders can be granted extensive co-determination rights even after the transfer of the company. However, since the interests of the old and new employers are not necessarily the same, this may lead to conflicts of loyalty among the staff when conflicts arise between previous and new owners regarding the future strategic direction of the company and the associated investments.
An alternative and often less problematic approach is when the previous owners partially finance the management buy-out via a loan and the remaining financing requirements are assumed by a bank and/or financial investors such as private equity companies or family offices (asset management). As a rule, subordination for the loan is agreed upon, whereby the repayment claim of the bank takes priority. The previous owner’s loan only becomes due when it has been repaid. The appealing aspect of this funding approach is that the previous owner basically defers the repayment of the purchase price to the management against the payment of interest.
As a further option, full funding by financial investors is also conceivable. The downside of this alternative is, however, the influence of the private equity provider on the company management. In contrast to banks, it is not only in the aim of the private equity provider to obtain interest on the invested capital, but also to terminate the investment after a certain period of time with the best possible lucrative exit, for instance. As a result, financial investors regularly tie their investments to significant participation rights in the day-to-day company management. These participation rights may lead to conflicts concerning the company’s orientation. The challenge of (partial) funding through private equity lies in the fact that the management has to accept that the financial investor will, for the duration of the loan, be continuously involved in the company’s development.
One of the determining elements for the choice of the type of financing is the structure of the articles of association. In the course of a management buy-out, the financial investor usually does not acquire a direct participation in the company. Regularly, he acquires an indirect participation in the company via a so-called NewCo. In order to avoid a tax relevant commercial co-entrepreneurship, the NewCo is usually structured as a corporation and the management’s participation does not exceed 15 percent of the NewCo shares. The participation of the NewCo in the existing company is either executed by a direct acquisition of existing shares or as part of a share capital increase.
When it comes to the legal relationships within NewCo as Acquisition Company, the financial investor and management usually conclude an agreement that amongst other aspects regulates, in particular, the joint investment, the objective of the investment and the exit of the investors. As the shareholders naturally want to participate jointly in the company’s increase in value, the agreement contains provisions on the sale of shares outside an IPO to third parties. In certain cases, drag-along rights or tag-along rights can be established for the managers. In addition, anti-dilution provisions (subscription rights, retention of the capital structure, etc.) can be agreed upon for corporate actions of the shareholders. The distribution of the exit revenue is generally based on the equity shares within the NewCo, whereby deviating revenue distribution agreements in the transferred company are possible.
In the event of the termination of an employment contract or the appointment of a manager to the company’s board of directors, the manager in question may be required to sell and transfer his or her shareholding (so-called call option). This may also apply in other cases expressly regulated by contract. In certain situations, however, the manager is entitled to exercise a put option. In practice, the buyback price is in this case based on the reason for the withdrawal. The distinction is usually made between the so-called good-leaver and bad-leaver. The good-leaver leaves due to death, disability or dismissal, reasons for which he or she is not responsible; whereas the bad-leaver has been dismissed for important reasons for which he or she is responsible (e.g. a breach of duty) or voluntarily leaves the company within a certain time period after the commencement of work. In good-leaver cases, the market value of the shares is paid, whereas in bad-leaver cases, often only the difference between the acquisition cost and the market value is paid. The time of payment can be determined with an exit clause or with the occurrence of an option case, which is usually determined by the option counterparty’s liquidity.
Where the management buy-out is an option, this constitutes a most attractive alternative to the entrepreneur’s “standard” option of a testamentary regulation of his or her inheritance for his or her succession in the company. A management buy-out is in fact also an interim solution for the entrepreneur. With such a transitional arrangement, the company management can continue to manage the business on an interim basis until the actual successor is ready to take over. In this respect, it is important to consider at an early stage who will be considered as successor, how long such a transitional solution should prevail, and whether the external manager should be integrated into the company as an employee or whether he or she should receive a participation in the company.
As a permanent successor solution, selling to one’s own management is an interesting alternative. For both management buy-out options, the same applies with regard to strategic alignment and positioning the company in due time. This requires the timely development of a management that ensures continuity under a new leadership or a new owner, as well as the early identification of market, product and profit priorities. In this way, companies can, even in succession situations, achieve a higher cash flow and thus a higher enterprise value. Finally, the definition of the investor’s rights in the contract should also be clear and practical.