A legal guide to management buy-ins and buy-outs

A management buy-out (“MBO”) involves a business’s existing management team purchasing the business or a stake in it. Management buy-ins (“MBIs”) are similar to MBOs, but the purchaser comes from outside the company. MBIs are often used where there is not an existing strong internal management team and often, an MBI results in the new management replacing the business’s existing management structure with their own. Both ventures enable an exiting owner to leave their business in capable hands and senior managers to transition from managing a business to having complete control and ownership.

MBOs and MBIs are complex procedures that require significant preparation. Here, our corporate law team explains what you must consider before embarking on the processes, the steps involved, and the advantages and disadvantages of MBOs and MBIs.

What is an MBO?

An MBO is where a company’s existing management team acquires all, or a controlling stake, in the business they currently manage. Following the MBO, the management team has complete control of the company and can use their expertise  to enable it to develop and grow.

MBOs are utilised for a variety of reasons, including the following:

• the owner wishes to sell the company and sees an MBO as an attractive succession plan;
• the individuals who take over already know the business and have proven themselves;
• there are limited external purchasers wishing to acquire the company;
• the owner wants to utilise a process which is usually quicker and more straightforward than when selling to an external third party; and
• from the purchaser’s perspective, an MBO is a relatively safe transition from employee to owner. The purchaser  already knows the ins and outs of the company they are acquiring and often has a clear vision of how they wish to grow the business and enhance its performance.

MBOs often involve businesses with proven profitability and good prospects, whose management teams are fully invested in their future and ongoing success.

What is an MBI?

An MBI is when an external management team purchases a company and takes over its management. The purchaser may acquire the entire company or take a controlling stake in it. Following the MBI, the new management team often replaces the company’s management, including the board of directors, with their own.

MBIs are utilised for a variety of reasons, including the following:

• the company is underperforming, and external managers possess the sector knowhow to drive the company forward and maximise shareholders’ returns;
• the new management team have better knowledge and greater experience than the current team;
• the new management will bring new contacts and opportunities to the business; and
• the company’s owners wish to sell the business and believe that the new management’s expertise will stimulate growth.

MBIs often involve a poorly performing company that is struggling in one or more areas. Recognising the business’s potential, several buyers may compete to purchase the company.

Initial considerations

Successful MBOs and MBIs requires significant planning and preparation. Before embarking on the process, the parties must consider a variety of complex factors, including the factors set out below.

Suitability

A key consideration for both seller and purchaser when considering an MBO is the suitability of the circumstances and proposition.

It may take the management team longer to raise the funds required to purchase the company, so the seller may need to be flexible about how the consideration is paid. In the case of MBOs, since the business is not being sold on the open market, sellers are often concerned that the price and terms agreed do not reflect the best deal. Therefore, their desire for continuity and a safe pair of hands to take over must outweigh their desire to achieve the highest possible return on their investment, although the issue can be alleviated by obtaining external business valuations.

The management team must be satisfied that the business represents a good investment and that their combined skill set is up to the job. The transition from employee to owner can be highly challenging for those who are unprepared, so they must be comfortable in their ability to ensure the company’s ongoing success in their new role.

Funding 

Purchasing a business is expensive, so the management team must consider how they will fund the acquisition.

MBOs and MBIs typically involve payment of the consideration through a combination of cash, debt, and private equity. Sometimes, the seller may be willing to facilitate the buy-out or buy-in by agreeing to defer payment of part of the consideration or granting a seller deferred loan.

Before investing in an MBO or MBI, investors may wish to carry out extensive due diligence on the company and the management team’s capabilities. Furthermore, private equity firms may insist on taking a share of the company in return for the loan.

Structure

MBOs and MBIs can be carried out through either a share sale or an asset sale. As the name suggests, in a share sale, the management team acquires the company’s shares. In an asset sale, the management team can select the assets it wishes to purchase. Often, a new company is set up to purchase the target company’s shares or assets. The shares in that new company are held by the management team and, sometimes, their investors.

Each method has advantages and disadvantages and different tax implications. The appropriate route in any case will depend on the circumstances specific to each transaction. 

Process

Once funding has been secured and the structure of the deal decided, the buy-out or buy-in process can begin. Since a share acquisition is the most common structure used when purchasing companies, our articles focusses on this scenario.

Generally , the share sale process involves the following key steps:

Due diligence

Due diligence enables the purchaser and their funders to deep dive into the target company’s affairs and ensure there is nothing that contradicts the seller’s representations as to the current state of the business.

There are several key types of due diligence, including commercial, financial, and legal. Commercial due diligence is often undertaken by the purchaser and their lenders themselves and involves looking into the company’s goods and services, its customers, and the marketplace. Financial due diligence investigates the company’s financial health. It aims to validate the seller’s claims and purchaser’s assumptions as to the company’s financial position. Legal due diligence is concerned with matters such as whether there is any existing or threatened litigation against the company, whether all contracts are in order, and whether all assets, such as intellectual property, are properly registered and protected. 

The extent of due diligence necessary from the purchaser’s point of view is more considerable in an MBI than in an MBO. This is because the existing management team should already have an in-depth understanding of the company’s affairs, whereas for an external management team, the company is an unknown entity.

Warranties 

Warranties are contractual promises from the seller to the buyer regarding the state of the company. Warranties protect the purchaser against future liability for issues that existed before they purchased the business and are vital in the context of both MBIs and MBOs. Whilst existing management teams will have a detailed understanding of the company, they may have had limited involvement in areas such as tax, insurance, and pensions, so they must seek full warranty protection in connection with these matters.

For issues considered particularly high risk, the purchaser may seek an indemnity from the seller with respect to specific warranties. If the seller breaches a warranty given on an indemnity basis (i.e., a promise to compensate the purchaser fully for a specific loss), they are responsible for reimbursing the buyer for their loss on a pound for pound basis (i.e., if a breach occurs then the seller must repay the purchaser exactly what the purchaser has lost as a result of that breach even if there is no loss in value of the shares).

Restrictive Covenants

Restrictive covenants are commonly included in the purchase agreement to protect the value and goodwill of the business following completion. They are particularly important where the seller has been heavily involved in the company’s operations and has built strong relationships with customers, suppliers, and employees.

Typically, restrictive covenants prevent the seller from competing with the business for a specified period within a defined geographical area. They may also prohibit the seller from soliciting or dealing with the company’s customers, poaching key employees, or interfering with supplier relationships. These restrictions are designed to ensure that the purchaser receives the full benefit of the business they have acquired and that its goodwill is not undermined immediately after the sale.

In the context of an MBO, restrictive covenants apply to the exiting parties who will no longer be involved in the company. In an MBI, they are frequently more extensive, particularly where the outgoing owners or management team possess valuable industry connections or confidential information.

To be enforceable, restrictive covenants must go no further than is reasonably necessary to protect legitimate business interests. The duration, geographical scope, and extent of the restrictions must therefore be carefully considered and appropriately tailored to the circumstances of the transaction.

Handover Period

A smooth transition of ownership and control is vital to the continued success of the business. For this reason, the parties will often agree a handover period during which the outgoing owner or management team remains involved in the company for a defined time following completion.

The purpose of the handover period is to facilitate the orderly transfer of knowledge, relationships, and operational responsibility. This may include introducing the new management to key customers and suppliers, explaining internal systems and processes, and supporting ongoing projects.

In some transactions, the seller may remain in the business as a consultant or employee for a fixed term. The terms of this arrangement, including duration, remuneration, and scope of responsibilities are usually documented separately, often in a consultancy or service agreement.

The length and intensity of the handover period will depend on the complexity of the business and the familiarity of the incoming management team with its operations. In an MBO, the transition may be relatively seamless given the existing team’s knowledge of the company. In an MBI, a longer and more structured handover period is often advisable to ensure continuity and minimise disruption to the business.

Legal documentation

The types of legal documentation required in an MBO and MBI depend on the circumstances of the deal. Examples of the documentation commonly involved include Heads of Terms, Confidentiality Agreements, and Disclosure Letters. However, the key document in both MBOs and MBIs is a share purchase agreement (“SPA”). This is the document that transfers ownership of the company from the existing owners to the new management team.

The SPA details the terms negotiated by the parties and the basis on which the deal will proceed.  Examples of terms usually included in SPAs include the following:

• parties;
• price;
• warranties and indemnities;
• restrictive covenants;
• handover period;
• sale conditions; and
• completion timetable

Exchange and completion

When all parties are happy with the form of the SPA, the deal can proceed to completion. At completion, the SPA and any other relevant documentation are signed, and the acquisition is completed.

Successful completions require careful planning and orchestration to ensure everything runs smoothly and the transfer is effective.

Post completion matters

There will invariably be several matters that must be attended to post completion. For example, all necessary Companies House filings must be made and company registers will need to be updated. The appropriate stamp duty must also be paid. 

Advantages of MBOs and MBIs

Both MBIs and MBOs offer a convenient exit strategy for retiring business owners and empower a new generation of leaders to take the helm and move the business forward. However, each route offers its own specific advantages and disadvantages, which are broadly outlined below.

Advantages of MBOs

• the seller will not incur the time and cost of marketing the business and sourcing a suitable purchaser;
• the certainty of the deal completing is enhanced when the purchasers are already involved with the business. They will already have intimate knowledge of the company’s affairs, so the chances of them uncovering something that derails the deal during due diligence is reduced;
• MBOs facilitate continuity of operations since the existing management remain in position;
• the existing management team are a proven entity, and are already familiar with the company’s suppliers, customers, employees and culture; and
• in an MBO, the seller does not have to disclose trade secrets and other sensitive information to third parties.

Disadvantages of MBOs

• management teams rarely have the means required to fund the acquisition themselves. They will usually need to source external funding, thereby increasing the company’s debt and squeezing its margins;
• MBOs often involve an element of deferred consideration, so the seller may not receive payment immediately;
• the purchase price may be lower than that paid by a strategic external buyer; and
• while the management team will have proven their abilities in terms of running the business, they may struggle with the switch from employer to business owner.

Advantages of MBIs

• MBIs often attract multiple potential buyers, so the seller may attract a higher price for their business than through an MBO;
• on the other hand, companies undergoing an MBI are often in difficulty and may, therefore, be undervalued. An obvious advantage for a purchaser is the potential to turn the company around and enjoy a favourable return on their investment;
• a new management team can inject some much-needed life blood into a company, reverse its fortunes, and enhance shareholders’ profits; and
• new management often bring with them new contacts, fresh strategies, and different ways of working. As well as enhancing profitability, these changes can incentivise employees to work harder towards the company’s continued success.

Disadvantages of MBIs

• MBIs do not facilitate the continuity that MBOs offer. Customers, suppliers, and employees may be unhappy with the change in management, which can negatively impact the company’s success;
• the new management company may fail to achieve the financial growth promised and needed;
• external purchasers are likely to conduct far more extensive due diligence than an existing management team, and the seller will have to reveal details of trade secrets and other confidential information;
• the new management team may demand more far-reaching warranties and indemnities than the existing management would in an MBO; and
• management teams often lack the financial capabilities to purchase a business outright, so the seller may need to be flexible about how and when they receive the consideration. Further, any additional funding required introduces an increased level of debt to the company and may affect shareholders’ profits.

Key takeaways

MBOs and MBIs offer attractive succession plans in many scenarios for owners wishing to exit their business and leave it in the hands of a carefully selected, capable, and driven management team. For management, making the leap from manager to owner can be both personally satisfying and financially lucrative. However, successful MBOs and MBIs require careful preparation, planning, and execution. Choosing the correct structure for the deal, sourcing appropriate funding, balancing the needs of purchaser and seller, and preparing effective, watertight documentation are complex but essential tasks. 

How we can help

Advising on MBOs and MBIs require a careful balance of technical expertise and practical judgement. We work closely with purchasers/sellers and their advisers to ensure processes and expectations are clear and appropriate protections are put in place.

If you are considering a MBO or MBI (either as a seller or purchaser), we would be pleased to discuss how we can assist. We usually offer a no-cost, no-obligation 20-minute introductory call as a starting point or, in some cases, if you would just like some initial advice and guidance, we will instead offer a one-hour fixed fee appointment (charged from £250 plus VAT depending on the complexity of the issues and seniority of the fee earner).

Please email wewillhelp@jonathanlea.net or call us on 01444 708640 as a first step. Following an initial discussion, we can provide a clear scope of work, a fee estimate (or fixed fee where appropriate), and confirm any information or documentation we would need to review.

We usually offer a no-cost, no-obligation 20-minute introductory call as a starting point or, in some cases, if you would just like some initial advice and guidance, we will instead offer a one-hour fixed fee appointment (charged from £250 plus VAT depending on the complexity of the issues and seniority of the fee earner).

 

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This article is intended for general information only, applies to the law at the time of publication, is not specific to the facts of your case and is not intended to be a replacement for legal advice. It is recommended that specific professional advice is sought before relying on any of the information given. © Jonathan Lea Limited. 

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