Management buyouts: a framework for value realization; All parties involved in a management buyout should see a good return on their investment. With the right structure, and the support of a facilitator, this goal is easier to realize.

Management buyouts (MBOs) have become increasingly popular in recent years due in large part to the abundance of available capital in the North American marketplace. They can be particularly attractive as an exit strategy for business owners planning for retirement and for corporations seeking to divest a non-core business segment.

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In addition to the many Canadian-based financial investors searching for good MBO candidates, a growing number of players from the U.S. and other parts of the world are looking to Canada for buyout opportunities. This is due to the scarcity of good prospects and the country's quality companies and management teams. Financial investors will compete among themselves for the chance to secure an opportunity that meets their investment criteria.

Financial investors may take a minority equity interest or a majority stake in an investee company, and some financial investors specialize in certain industry sectors. Most financial investors publicize their areas of interest and general investment criteria on their Web sites.

There are three main parties involved in an MBO: the owner of the company who is seeking to divest, the management team looking to acquire an equity interest, and the financial investor seeking a return on invested capital. To be successful over the long term, an MBO must be structured to satisfy the collective, yet sometimes conflicted, interests of these parties. A facilitator can play a critical role in bringing them together.

The financials

The financial details of what an MBO commonly sets out to achieve is best illustrated through a simplified example. Consider Company A, which generates $5 million in annual earnings before interest, taxes, depreciation and amortization (EBITDA) and has no debt. The owner of Company A wants to divest and the management team would like to buy an equity interest in the company. Following comprehensive analysis, the parties agree that a price of $25 million for the shares of Company A would be fair, which effectively equates to a multiple of five times EBITDA. However, the management team collectively can only raise $1 million. Therefore, it seeks one or more financial investors for the remaining $24 million.

Assume that a financial investor is found and that investor assists in raising $10 million of senior and subordinated debt from third party lenders to finance a portion of the transaction, at a blended average interest rate of 10%. The balance of the funds ($14 million) is financed through equity. Therefore, at the outset of the transaction the management team owns 6.7% of Company A (calculated as $1 million invested by the management team divided by $15 million of total equity in the deal), while the financial investor holds the balance. In addition, the management team is granted options that will give them the opportunity to earn up to a further 10% of the equity in Company A if certain performance targets are met.

The management team and the financial investor believe that they can grow Company A's EBITDA by 10% per year in each of the next three years. To do so, Company A would have to invest $1 million per year to support incremental working capital and $1.5 million per year for new capital spending, which approximates annual depreciation expense. Company A pays income tax at a rate of 35%. The management team and the financial investor believe that once growth is achieved, Company A will be an attractive acquisition target for a strategic buyer who likely will pay a price that effectively equates to six times EBITDA at the end of the third year. Exhibit 1 illustrates the net cash flow that Company A is expected to generate over the next three years.

The cash flows accruing to the equity holders and the rates of return that they expect to achieve are illustrated in Exhibit 2.

As illustrated in Exhibit 2, the equity holders (the management team and financial investor) initially put up $15 million of equity and financed the balance of the purchase price with debt. The net cash flow generated by Company A each year will be used to make principal repayments on the outstanding debt. Consequently, the amount of debt outstanding at the end of the third year will decline to $5.829 million. During that time, Company A's EBITDA is expected to grow to $6.655 million, and the effective multiple that will be paid for Company A is expected to increase to six times EBITDA due to the company's larger size and more established market presence. Therefore, the transaction value at the end of the third year is estimated at $39.93 million. With only $5.829 million of debt to repay, this leaves $34.1 million for the equity holders, providing them with a blended return on equity of 31%.

Note that the management team is expected to enjoy a considerably better return on equity than the financial investor because of the options that allow the management team's proportionate interest in Company A to increase to 16.7%. Financial investors purposefully design this type of payoff structure to give management the incentive to perform well, while still allowing the financial investor to realize its threshold rate of return. While threshold rates of return sought by financial investors vary depending on the nature of the investment, a range of 25% to 30% is not uncommon today for established businesses with a defendable market position. Higher rates of return generally are sought for riskier ventures.

Essential MBO components

As illustrated by the previous example, financial investors generally seek companies that offer three opportunities:

1. Organic growth potential. Financial investors are generally more interested in companies with a sustainable differential advantage in the marketplace. They want companies that operate in a growing industry, rather than 'me too' types of businesses, or businesses in declining industries.

2. Leveragability. By using debt to finance a portion of the purchase price, the return on equity is higher (as is the risk). The debt capacity of a company is a function of the nature and quantum of its underlying tangible assets and its ability to generate cash flows to service debt.

3. Exit strategy options. Financial investors generally have a three to seven year time horizon. They seek companies that can either be sold to a strategic buyer or are believed to be good candidates for an initial public offering. These avenues offer 'exit multiple expansion,' which means that the effective price multiple paid on exit is expected to be richer than that paid on acquisition.

MBOs are simpler when the owner has realistic expectations of the price that will be paid for their company. This is not to suggest that financial buyers will not pay a fair price, but they are less likely to pay a significant premium (compared to what might be paid by a strategic buyer). The advantage of dealing with a financial buyer is that they will usually offer a cash deal; a strategic buyer may offer less attractive forms of consideration.

It also is helpful when the owner is prepared to accept a deal structure that offers a compromise position. For example, when the owner agrees to retain a partial equity interest in their company, the financing requirements are reduced and financial buyers are generally encouraged by the owner's belief in the exit strategy prospects.

Finally, the owner should expect to offer transitional assistance to the financial investor and management team, where required. For example, an owner who was active in the business should expect to remain active for a period of time following the transaction to ensure a smooth transition with employees, customers and suppliers.

Financial investors will thoroughly scrutinize the management team. The assessment of the management team principally revolves around their:

* abilities -- experience, knowledge, and so on;

* depth -- the company has a team of competent managers in all key areas of the business (e.g. sales, operations, finance) and successors can be identified in the event that these individuals leave or must be replaced; and

* commitment -- financial investors will want to ensure that each key member of the management team makes a financial investment in the business, in an amount that is meaningful to them (based on their personal net worth) so that they are deeply committed to making the venture a success.

An MBO is not a one-way street. The management team (and the owner who retains a residual interest in the company) should expect to receive more from the financial investor than just a lump sum of cash on closing. Other important considerations include:

* the ability of the financial investor to accommodate follow-on financing that may be needed to support growth or an unexpected shortfall in cash flow;

* alignment of interests with management in terms of growth strategies, participation in upside potential and their level of patience or tolerance for shortfalls from the plan; and

* value-added service offerings. Financial investors should be expected to provide things such as sound business advice, business contacts, and other services that help the business to grow and prosper.

The MBO Value Matrix

The interests of the various parties involved in an MBO are naturally conflicting to some degree. The owner wants the highest price for their company, management wants the ability to earn a large equity stake and the financial investors are seeking to maximize their own return on invested capital. For an MBO to be successful, all parties must make compromises and structure a deal that creates a three-way win-win-win.

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To do so, it is useful to engage a facilitator who can help bring the parties together. The facilitator is normally a financial adviser (supported by other consultants, such as legal and tax advisers) who not only understands the workings of an MBO, but who can also offer the parties objective advice on the pros and cons of various alternatives.

The principal role of the facilitator is to help both the owner and the management team identify and attract the right financial investment partner, and help develop the terms of a deal that satisfies the collective interests of all parties. In doing so, the facilitator helps the various parties identify ways in which they can reconcile their differences and preserve a sense of 'value fairness' to each. The role of the facilitator within the MBO process is captured in the MBO Value Matrix[TM], illustrated in Exhibit 3.

MBOs can provide a viable exit strategy alternative for owners of established companies, particularly those that offer organic growth potential, the ability to use financial leverage and an attractive exit strategy. The financial payoffs in an MBO can be substantial when forecasted operating results and exit strategy expectations are realized.

MBO transactions are more likely to occur when the owner has realistic expectations of the value of their company, and is prepared to work with the management team and the financial investors in establishing the deal's structure and transitional assistance. Key to the MBO is the financial investor's perception of the management team's abilities, depth and commitment. The owner and the management team should seek the right financial investment partner--in terms of their financial resources, alignment of interests and the value-added services they offer. The MBO Value Matrix is a framework that illustrates how the facilitator can play a pivotal role in bringing the various parties together, helping to develop a deal structure that allows all participants the opportunity to gain value from the association. By carefully applying the steps above to an MBO plan, all parties can reap rewards.

Howard E. Johnson, CMA, FCMA, is president of Veracap Corporate Finance (www.veracap.com), which specializes in shareholder value enhancement.

Exhibit 1 Cash flow projections for Company A ($000)

                              Current      Year 1     Year 2     Year 3

EBITDA                        5,000         5,500      6,050      6,655
Depreciation                               (1,500)    (1,500)    (1,500)
EBIT                                        4,000      4,550      5,155
Interest expense                           (1,000)      (905)      (768)
Pre-tax income                              3,000      3,645      4,387
Income taxes at 35%                        (1,050)    (1,276)    (1,535)
After-tax income                            1,950      2,369      2,852
Add back: depreciation                      1,500      1,500      1,500
Deduct: capital expenditures               (1,500)    (1,500)    (1,500)
Deduct: working capital                    (1,000)    (1,000)    (1,000)
Net cash flow                                 950      1,369      1,852

Exhibit 2 Cash flow and rates of return to the equity holders ($000)

                       Current    Year 1   Year 2   Year 3   Exit

EBITDA                  5,000                                 6,655
Cash flow (Exhibit 1)               950     1,369    1,852
Debt repayment                     (950)   (1,369)  (1,852)
Residual                              0         0        0
Effective transaction       5X                                    6X
  multiple
Transaction value      25,000                                39,930

Financed by:
Debt                   10,000     9,050     7,681    5,829    5,829
Equity                 15,000                                34,101
Total                  25,000                                39,930

Ownership
Management team             6.7%                                 16.7%
Financial investor         93.3%                                 83.3%
Total                     100%                                  100%

Equity investment
Management team         1,000                                 5,684
Financial investor     14,000                                28,418
Total                  15,000                                34,101

Return on equity
Management team                                                  78%
Financial investor                                               27%
Blended                                                          31%