Ritson Smith hot topic: Owner-managed businesses and MBO’s - the succession solution

 
The following article has been prepared by Graham Alexander, corporate finance partner with Aberdeen-based accountancy practice Ritson Smith.

The characteristics of owner-managed businesses (OMBs) often differentiate them from their larger, and sometimes listed, rivals.  However, in Scotland this type of business represents by far the majority of all business activity, and within most of these businesses there comes a time when it is inevitable that the entrepreneurs who founded and grew the business will consider their options for stepping down and looking to the future.

It may be that there is no natural line of succession within the business and, where there are sons or daughters, it may be that they have chosen to pursue alternative careers.  In these circumstances many owners consider that the only option open to them is a trade sale. 

However, management buy-outs (MBOs) are widely recognised as an alternative to a third-party sale, and present an opportunity for second-tier management to own and run their own business which they may not otherwise get.  Many retiring or departing owners may prefer to sell to second-tier management teams as it will retain the independence of the company and maintain the company’s name and profile as a testament to achievements of the original owner and his entrepreneurial spirit.  It may also allow owners to feel as though they are rewarding managers for their hard work and loyalty through the years as the business has grown and developed.

Trade sales may offer vendors the potential of realising a larger amount of money but may involve giving a significantly larger level of warranties to the purchaser than in the case of an MBO.  Owner-managers can also be concerned about the dismantling of what they have built up over the years and the significant effect this may have on the work force.

Using corporate finance advisers

In terms of funding, MBO’s second-tier management teams have a variety of sources to go to and circumstances will dictate which is the most appropriate for the transaction involved.  This is where the management team’s corporate finance advisers can assist in developing the funding package most appropriate for the deal.

The traditional route is to source institutional or venture capital funding with these equity providers taking a stake in the business and in the process diluting management’s shareholding. In recent years, however, many venture capitalists have refocused on doing larger and fewer transactions leaving management teams looking to other sources for the required funding. 

An alternative where equity is concerned can be where private individuals wish to invest either individually or through recognised business angel networks such as the locally-based Aurora Private Equity.  These business angel networks are becoming increasingly popular given the perceived equity gap in many transactions.  Other networks in Scotland such as Braveheart and Archangel have also achieved some success in recent years.

Alternatives to venture capital and other forms of external equity can also prove attractive - particularly where it means that management retains more control of the company - in some circumstances 100%.  These alternatives, which involve utilising the company’s assets such as its property, plant and equipment and, increasingly, its trade debtors, are becoming popular ways of raising the necessary capital.  Through factoring and invoice discounting, companies can borrow up to 70-80% of their trade debtors in order to raise capital to fund the deal and this is in addition to funding raised against property and other fixed assets.

The “earn-out arrangement”

A further option to be considered by all parties, particularly where MBOs are being used as the solution to succession issues, is where the existing owners may be prepared to leave money in the business by way of a loan or deferred consideration. 

In these circumstances, the existing owners are essentially backing the second-tier management to continue to run the business successfully and generate sufficient cash to pay off these loans.  The loans can earn interest and can also be structured in such a way that if the business achieves certain targets, an enhanced price is paid out.  This can be described as an “earn-out arrangement” and can be used to bridge a gap between what existing owners feel a business may be worth and what a purchaser is prepared to pay.

The role of corporate finance advisers in the fund-raising process is important, as much for their knowledge of particular sectors and the issues associated with family businesses as for their experience in raising finance from venture capitalists and debt providers.   Advisers should be aware of the various funding structures and opportunities that exist if they are to really help vendors and purchasers (second-tier management teams) reach a situation where both are satisfied with the deal that is agreed and that it meets their requirements in terms of value and funding.

For many businesses, an MBO can meet the requirements of both the vendor who is looking to exit and the non-shareholder management who are looking to take a stake in the future of the business.  To support such buy-outs, a variety of sources of finance exist and, by engaging an experienced corporate finance adviser, the right funding package can be structured to achieve the desired outcome for all parties.

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