Management buyouts: Rewarding, but not for the fainthearted.

As an increasing number of companies reposition themselves to become more competitive in the global marketplace, opportunities abound for management to take control of part or all of their business operations. Here's a primer on initiating a management buyout.

In the film "Dead Poets' Society," Robin Williams plays a gifted teacher in a school with a long and distinguished tradition. In one scene, he takes his class to the school entrance hail, which is decorated with photographs of all the students who have passed through the school over the years. Williams stands his class in front of a photo of a year group and asks them to imagine what words of wisdom these accomplished professionals -- all now long since dead -- might pass on to them from across the years. As the class leans forward to try to imagine what their predecessors might say, Williams whispers the words: "carpe diem"- seize the day. That phrase captures a major theme of the film: take advantage of life's opportunities and realize your full potential.

This is also true for all those ambitious managers in organizations who initiate a buyout of a company or division. They are taking control of their lives and their destinies. With most companies now needing to get their houses in order, opportunities are arising for managers across Canada and in almost every major industry. The transition of moving from corporate management to an entrepreneurial lifestyle is rewarding, but not for the faint of heart. To succeed, you must seize the day.

It's important to know if you're a real entrepreneur, or simply a dreamer. Statistics tell us that only one out of 10 managers has what it takes to be an entrepreneur. What separates the entrepreneurs from the dreamers is the willingness to risk money -- lots of money -- and likely your job to acquire a business. That means having the ability to "invest" or "pledge" somewhere in the vicinity of $250,000. This figure can go as high $1 million in larger deals. Investors need to know you are committed.

Working partnerships of more than four are generally suspect. Private investors who will personally support the management team or make a company investment are greatly encouraged and almost always required. Institutional investors request that private investors have some management background or special knowledge to co-invest with them. Institutions refer to these investors as the "smart money." If something goes wrong or an important decision needs to be considered, the institutional investor wants to have other intelligent investors as part of the deal, beyond the management team, to help them work issues out.

Since most management buyouts are leveraged acquisitions, it's essential to know some fundamentals. The prudent use of leverage can create exceptional returns to equity investors by satisfying the purchase price with borrowed funds in addition to their own equity. Typically, funds borrowed have a much lower cost than equity does, and additionally, the interest components of the cost of debt are tax deductible, thereby further lowering the cost of funds. The net effect is that the value of the equity grows inversely to the reduction in debt, thereby significandy increasing the return on the initial equity investment.

To ensure the success of a leveraged acquisition, it's extremely important to establish an appropriate capital structure. Having a professional assist in the process is strongly encouraged by all sides. Your advisor will need to understand and present your written business plan detailing seasonality, cash flow cycles, capital expenditure requirements and other such factors. And regardless of such factors, only certain types of business are good candidates for a leveraged buyout. Following is a list of preferences presented by lenders when financing a leveraged buyout:

1) Most industries, except for high-tech and those with rapid product obsolescence.

2) Companies which are not highly cyclical and have steady, predictable cash flows.

3) Low capital expenditure requirements resulting in high free cash flow.

4) Growth businesses, especially high value-added manufacturing, or those with proprietary or sophisticated engineered systems or processes.

5) Companies with strong committed management teams and well communicated, compelling business plans.

Management buyout opportunities present themselves often and for a number of different reasons. The first and most common reason is that a company or division no longer fits within the strategic aims of the parent group or owner. Another reason may be that the parent group or owner simply requires liquidity or cash. Or, profit levels may not be considered acceptable, or the company is showing a loss. Other reasons are that a private owner wants to sell his or her business and not bother with the complicated process of selling to an outside buyer. Usually this seller has a very good relationship with the management team, and has confidence in their ability to manage the business beyond. This type of owner usually retains some equity ownership, or assists in financing the business with vendor take-back notes. Today we are seeing opportunities in the government sphere, where a business or functional unit will find itself in the process of privatization.

It is encouraging to know that from the corporate perspective, management-led buyouts are generally regarded with great favour. They provide corporations with a convenient alternative to the acquisition of their company by an outside suitor, while at the same time allowing them to avoid the conflicts that often arise between management and outside buyers. A management buyout can be also be conducted more quietly and efficiently than a sale to an outside buyer or investor group. And, of course, the prospective managers do not need the same warranties or detailed due diligence investigations than an outsider would.

If the proposal and approach are serious and the management group has consulted with the appropriate professionals, the potential for closing a deal become excellent. Investors also depend on the fact that the vendor will assist in the financing of the transaction. Vendor take-back notes are very common in any and all management-led buyouts.

Unfortunately, there are significantly more buyers than sellers at the moment, because of the number of corporate buyers, financial institutions, merchant bankers and high net-worth investors on the hunt for good potential company acquisitions. Most of these groups are usually seeking management partners. Structuring a deal can be tricky. Not every deal is going to be accepted by the owners. Some deals cannot be financed by management-led buyers.

So why are there not more management-led buyouts taking place? Are Canadians averse to risk? Not really. The entrepreneurial spirit is alive and thriving in Canada. Unfortunately, many people want to do it, but can't. Most people do not realize that a contingency fund has to be established by the management-led group to cover legal, accounting and other advisory fees before a deal can be completed.

Sometimes careers can be sacrificed when an inexperienced team decides to approach their parent companies themselves. This approach can be disastrous. Sensing a mutiny in the making, some large corporations have dismissed top-level managers without even listening to their proposals. And even when they do, many deals are lost because of highly charged emotions that turn negotiations into a protracted and often traumatic process. For this reason, it is important that management agree on an arrangement amongst themselves (infighting is another reason deals fall apart), and that they enlist a professional and experienced intermediary. This professional will help package the opportunity, set up the process, structure the buyout deal, and negotiate with financiers and ultimately the owners. And do not forget the legal, accounting, tax and other levels of expertise that need to be integrated into the deal.

Maybe it's a fluke in the business cycle, but never in history has there been more diverse, abundant and inexpensive investment capital available chasing so few deals. This is an optimum time for talented management teams to take charge of their future and attempt to do a management buyout. Seize the day...

Mark Borkawski is president of Toronto-based Mercantile Mergers & Acquisitions Corporation, a mid-market mergers & acquisitions brokerage firm. He can be contacted at [phone], ext. 232 or at [e-mail]