What Is a Management Buyout?

A management buyout is when managers of a business buy enough stock to own the company. It is a type of corporate acquisition. Instead of another company or an outside group taking over the business, managers, who are employees, take ownership of their own company.

Management Buyout: What Is It?

Often called an MBO, a management buyout means that a company's managers purchase the business's assets and operations. This turns managers into owners. As owners, managers get paid bigger returns the better the company performs. These returns motivate managers to work harder to grow the business.

An MBO can happen at any time, but it is common when a business owner wants to retire. It is a smart choice for a company that wants to sell a division of its business.

Why Are Management Buyouts Important?

One thing an MBO does is take a public company private. This means the new company pays lower registration and listing costs and shareholder servicing fees. It may also be subject to fewer regulations and disclosures.

An MBO forces the new manager-owners to put more stock in the company. This motivates managers to work smarter and make better decisions for the future of the company.

Reasons to Consider Pursuing a Management Buyout

  • It allows for a smooth transition.

Managers already understand how the company works. They don't have to learn as much new information as an outside owner would.

  • It can inspire trust.

Since clients already know the management team, they are more likely to trust the restructured company. Employees who know and like the management team may feel less nervous about the change.

These firms see MBOs as low-risk, especially if they know the managers. They may fund the MBO if an owner retires or if a large business sells off a division or asset. In this case, an MBO saves both the buyer and seller time and money.

Reasons to Consider Not Pursuing a Management Buyout

  • It can mean a conflict of interest.

A company's executives almost always have more information than outside investors do. If managers opt to buy a company when it is undervalued, this can point to a conflict of interest and cause distrust in the company. However, if the board declines the MBO, the management not like the outcome and underperform.

  • Several buyers are competing to own the company.

An MBO can be a smart choice if it is the only option available. If several buyers are bidding for the company, management may deny other offers or bid lower than the company is worth.

  • It could change the direction of the company.

Too much private equity can force management to change its course dramatically. Some private equity firms require certain terms so they can benefit quickly. Venture capitalists want to see an annual rate of return around 30 percent. This may require management to change the way they plan to run the company. In some cases, joining private equity firms also enables managers to cash out stock while receiving more during the buyout. A 2013 study shows that, on average, management receives over $50 million in stock sales and can replenish their stock in the private company, with an average ownership percentage of 21.9.

Examples of What Can Happen During a Management Buyout

In 2007, Kinder Morgan and HCA underwent MBOs. For HCA, it was the second time. Both involved private equity firms and received vocal criticism about the relatively low purchase price. Both companies went public again in 2011, resulting in significant financial gain for the management team.

An attempted tech MBO went much more poorly in 2007. When Darwin Deason and Cerberus Capital Management attempted to buy out Affiliated Computer Services, the management team received ample criticism from the board. After the management team was accused of manipulation and five directors resigned in protest, Xerox purchased the company for $6.4 billion. The management team received a substantial sum, and shareholders pursued litigation.

Also in 2007, Robert F.X. Sillerman, chief and major stockholder of CKX, owner of "American Idol," made his first attempt at an MBO. Four years later, he arranged funding and purchased the company with Apollo at a much lower value per share.

The same year, Institutional Shareholders Services responded proactively to often unfavorable views of MBOs. The company outlined the risks and rewards before requesting that its clients vote for the MBO of OSI Restaurant Partners, the owner of Outback Steakhouse.

In 2008, CEO Tilman J. Fertitta attempted to buy the company he managed, Landrys. He offered several subsequently lower rates over the course of two years as his funding options disappeared. After hedge fund Pershing Square Capital Management purchased a large stake in Landrys, however, Fertitta bid a sum more generous than his first offer.

In 2011, Piccadilly Hotels, the parent company of Menzies Hotel, went into administration. The management team purchased the hotel and restructured the company in accordance with its lender, Lloyds Banking Group. The team owns a majority in Cordial Hotels, the restructured company.

In 2013, Michael S. Dell, founder of the Dell computers, worked with Microsoft and private equity firm Silver Lake to repurchase the business. Like many management buyouts, this caused concern about a potential for a conflict of interest. However, Dell was required to file paperwork describing the sale with the Securities and Exchange Commission, which alleviated some shareholder concerns.

Along the same lines, Kenneth Cole purchased his own fashion company during a lucky dip in the stock market. He offered just 25 cents per share over the initial offer to successfully complete a $280 million buyout, raising the question of whether he paid a fair price.

Millard Drexler, chief executive of J. Crew, completed a similar MBO under unusual circumstances. He lowered his bid by $2 per share right before completing the sale. Despite the lower bid and the fact that Drexler arranged the deal without informing the board, the deal was approved. This is just one case of management taking advantage of its position to get the sale price it wants.

F. Ross Johnson, chief executive of RJR Nabisco, also attempted to negotiate an MBO without informing the company's board of directors. Suspecting manipulation, however, the board rejected his offer.

Many companies form special committees when deflecting a conflict of interest, but Bankrate opted not to when its management team and two directors started an MBO. After the company contacted just one other possible buyer, the directors and management team negotiated the deal together. Though the management team offered a lower price at the last moment and Institutional Shareholder Services criticized the sale, it still succeeded since the management team owned over a quarter of the shares. Bankrate went public two years after the MBO.

Common Mistakes

  • Not doing a complete financial analysis. Most MBOs need a lot of funds. Buyers should know if the risk is worth it. They should be able to repay their debts without hurting the business. A complete financial analysis shows:
    • Growth potential
    • Cash flow
    • Sales numbers
    • Debt capacity
    • Fair market value
  • Over-leveraging the company. Over-leveraging is taking on too much debt. If a company has a lot of interest to pay and sales are down, it could go bankrupt.
  • Not growing the business quickly. Right after an MBO is the best time to invest in new products, tools, and staff. If the management team doesn't work to grow the business, it could suffer.
  • Not planning for dealbreakers. Not everyone will be excited for the MBO. Managers should plan for contract negotiations, changes in financing terms, and disagreements between managers.
  • Not hiring an attorney or an adviser. Experienced attorneys make MBOs easier. Management teams benefit from an adviser during negotiations and throughout the transition. Attorneys help shape realistic goals and transition managers to owners.
  • Not forming a special committee of independent directors. When a potential conflict of interest arises, many companies opt to form a special committee of independent directors. In some cases, they can run with the shareholders' best interests in mind, but in other cases, they fail to stand up to the management team.
  • Not shopping for the right type of financing. Buyers often need several kinds of financing for an MBO. Options depend on the company's size and success. Look for  financing with the best terms that allows for the most growth:
    • Personal Funds: Many buyers use their own money to share the risk and show their commitment to the business. Many refinance assets to get the money they need.
    • Bank Loans: Buyers can use assets as collateral for low-interest loans to buy stock.
    • Seller Financing: The original owner can fund part of the sale with personalized repayment terms. This may include loans, preferred shares, or credit notes.
    • Stock Installments: Buying stock in installments lets managers take on debt a little at a time.
    • Stock Sales: Selling stock to employees raises money to help gain control. It also incentivizes employees.
    • Debt Assumption: Some buyers assume business liabilities.
    • Private Equity: Private firms and venture capitalists may provide equity, buy shares, or provide loans.
    • Mezzanine Financing: This option combines equity financing with debt financing. Lenders take on greater risk by linking repayment to the health of the business. In return, they may get some ownership or equity. Borrowers choose this option for reasonable interest rates and flexible repayment options.
  • Not finding funds for business operations. After the acquisition, many owners need money to run the company. They can use:
    • Lines of Credit: Credit is a flexible, affordable source of funds.  However, credit may not be available for businesses that have already used assets as collateral.
    • Accounts Receivable Financing: For companies that struggle to collect from clients or debtors, this type of financing offers a boost. Payments the business expects to receive are used as collateral.
    • Inventory Financing: Inventory is used as collateral for a line of credit.
    • Vendor Financing: In some cases, a company's vendors may provide funding. If the company expects to grow a lot, vendors may offer better terms to the business. This frees up cash.
    • Purchase Order Financing: This method can help companies get cash to fill orders. Purchase order financing usually requires a gross profit margin of 20 percent.
    • Asset-Based Loans: These combine accounts receivable financing with inventory financing and equipment financing. They have fewer terms than a line of credit.

Frequently Asked Questions

  • What is a leveraged management buyout (LMBO)?

Some MBOs are technically LMBOs. In these cases, inside executives buy the company by using business assets as collateral. An additional group of investors who finance the LMBO may hold equity. LMBOs can make a company less flexible and increase its overall debt.

​Instead of an internal management team taking over the company, an MBI is when an outside management team buy the company and replaces the existing managers. Many private equity funds prefer MBIs if they know the new managers.

  • How much personal capital do managers typically invest?

Buyers should plan to invest a year's salary in an MBO.

  • How long does an MBO take?

It usually takes about six months. This includes a due diligence period, negotiations, and signing contractual agreements.

  • Are MBOs profitable?

Buyers who grow the business, repay debt quickly, and sell the business can get a high rate of return from an MBO.

Steps to Complete a Management Buyout

  1. Agree on a sale price.
  2. Complete a valuation. An external valuation of the business confirms the sale price. Valuations consider the company's size, sector, growth prospects, and investment requirements.
  3. Draft an agreement. The buyers should determine how many shares they want to purchase and write a shareholder agreement. This should specify what happens to the business if a shareholder exits for any reason.
  4. Get funding. Buyers should get funding from investors or financial institutions. They will need a strong business plan with realistic goals. For a large MBO, management may need funding from several sources.
  5. Make a transition plan. Buyers and sellers should make a transition plan that includes succession and taxation.
  6. Transfer ownership. After signing an MBO agreement, the new owners begin to operate the company. They can make changes to the management team and other parts of the business that help meet their new goals.
  7. Pay debts. Managers must repay debts in a timely manner.

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