PROCEDURAL GUIDANCE TO INVESTORS DURING MANAGEMENT BUYOUTS

• Concept of a management buyout
• Rationale of management buyout
• Process of executing a management buyout and due diligence processes encompassed
• Advantages and disadvantages of a management buyout

1.0 Introduction

A management buyout (MBO) is a transaction where a company’s management team purchases the assets and operations of the business they manage. It is a type of acquisition where a group led by people in the current management of a company buys out majority of the shares from existing shareholders and take control of the company.

The financing required for an MBO is often quite substantial and is usually a combination of debt and equity that is derived from the buyers (the managers and executives purchasing the business), financiers (banks or other financial institutions) and sometimes the seller (the shareholder selling the business). The management team pools resources to acquire all or part of a business they manage. Funding usually comes from a mix of personal resources, private equity financiers, and seller-financing.

It should be noted that though there are no specific laws governing management buyouts as a field of law in Tanzania, the transaction tends to require compliance to different laws such as competition law, labour laws, tax laws and the Companies Act.  The key difference between an MBO and other types of acquisition is the expertise and domain knowledge of buyers. Here, the buyers have more knowledge about the company and its true potential compared to the sellers who may not be involved in the day-to-day business of the company. The Corporate and Commercial Department at Breakthrough Attorneys has prepared this article to guide investors on the processes that entail an MBO and important considerations to take note of during an MBO.

2.0 Process of an MBO

The documents which are normally involved during the process of an MBO include;

1. Head of Terms (HOTs) also known as Letter of Intent, or Management buyout Offer Letter to be prepared by the buyer.
2. An information memorandum prepared by the seller to give an overview of the company business to the buyer.
3. Requests for financing prepared by the buyer to secure funding from potential financiers.
4. A due diligence checklist to be made by the buyer to manage liabilities and risks.
5. An MBO Agreement to finalize and execute the buy-out transaction.

The following steps are the most essential steps throughout the MBO process:The following steps are the most essential steps throughout the MBO process:

2.1 Appointment of a Lead Advisor
A corporate finance advisor is very essential in order to assist the management throughout the deal. The advisor needs to have credentials and great experience in MBOs to be able to properly assist the management in the process. In practice professions that are likely to be lead advisors include lawyers, accountants and financial analysts/auditors.

It is the advisor’s job to constantly check if the management’s plan is still viable throughout different stages of the MBO deal. An advisor can and probably should represent the management when dealing with the company whether on a legal level or not. Some of the key services that an experienced advisor can provide are:

2.1.1 Objective evaluation of the deal
2.1.2 Handling negotiations with the company
2.1.3 Assist with funding options
2.1.4 Project management of the entire process

2.2 Approaching the seller
This is also a key step through which an advisor can help greatly by giving tips and advantage points in negotiations. An advisor can help by simulating possible talking points that the management (who is not necessarily familiar with negotiations on such a huge level) might not have in mind.

Having the advisor lead the negotiations is a very valid option. He may approach the seller to ensure that a mutually beneficial deal is agreed upon by the parties.

2.3 Agreement with seller
This is when negotiations actually take place and agreements on payments and strategies are laid out. It’s important for an investor to remain composed and professional throughout the course of negotiations.

It is important to remember that if the negotiations do not go as planned, the manager might return to his position as an employee in the company and thus conflicts of any kind ought to be avoided.

2.4 Preparation of Information Memorandum by the Seller’s Lead Advisor
An information memorandum (IM) is a document presented by the company to potential investors to give an overview of the company. It is more of a marketing tool than a legal document. As an investor, you should expect the company to present an IM when you show interest in buying out the company. This helps you understand the potential risks and rewards.

It is still important to be careful, as such a document is essentially a marketing tool where companies tend to highlight, and maybe even overestimate the value of their assets.

2.5 Discussions with potential financiers
Once an agreement between management and the company is reached, it is important for the buyer to reach out to potential financiers that will be responsible for providing the necessary funds for a successful buy-out. Perhaps the simplest approach is to reach out to the current bankers or financiers that the investor might have had long relationships with and have built a sound reputation over the years.

However, it still important to consult your advisor for other potential funders who might be interested in the business your target company is in. It’s important to remember that banks are typically reluctant to give out loans for MBOs since the amount of money and risk involved is huge. This is why there should be identified multiple funders for MBOs.

2.6 Commencement of due diligence
This is your chance as an investor to check that everything is in order and in good working condition. An investor’s position in the company prior to the MBO doesn’t necessarily allow him to be fully aware of the working conditions of everything in the company. This is why a due diligence is important to assess whether an investor is getting exactly what he is paying for. It is important to leave no questions unanswered to avoid any hassle in later stages.

Well prepared businesses are optimally positioned to respond to the many challenges that will come through the due diligence process led by not only financial lenders but also the private equity sponsors. For a company that is not prepared this can be a daunting process. Once the structure of the deal is determined, the institutional investors and lenders will wish to commence their due diligence enquiries.

The object of this exercise is to ensure that there is nothing which contradicts the financiers’ understanding of the current state and potential of the business. Key due diligence elements include:

2.6.1 Commercial due diligence
This entails research of the products, and customers of the business and the markets in which it operates, often carried out by the investing institution itself.  The company can be ready for commercial due diligence by preparing a well thought out (vetted) strategic plan with which the vendor and management are fully aligned.

2.6.2 Market report
The commercial due diligence may be reinforced and amplified by a marketing study carried out by consultants. Management should understand their product markets thoroughly and be prepared to answer questions about market positioning, share and growth opportunities. If management believes there are new markets that can be penetrated, they need to demonstrate a thorough understanding of the market and a potential execution strategy. These claims need to be supported by quantitative data.

2.6.3 Legal due diligence
This will tend to focus on the implications of litigation, shareholding and equity status, title to assets (especially property) and intellectual property issues, among others. Working with the company’s legal advisor to ensure records are in order is vital during the buy-out process.

2.7 Execution of MBO
After agreement, all parties involved in the transaction shall sign the necessary documents with the help of their advisors. It is important for the management team to stay in touch with the advisor until all parties are satisfied, and have access to the funds.

2.8 Transition
The new management finally takes over and starts running the business. It still remains important to take care of logistical issues quickly and smoothly so that the workflow of the company is not disrupted.

3.0 Considerations to be made during an MBO

Common considerations that ought to be made by the management include;

3.1 The management must consider all possible options before pursuing a buy-out in order to avoid premature decisions that may lead to a re-trading process (practice of a buyer renegotiating the purchase price of a company after the initial price and terms have been agreed to).

3.2 Avoidance of initiating the deal without considering both parties’ perspectives and not ensuring the alignment of all stakeholders’ key objectives. This is one of the most common pitfalls as it creates an environment of re-trading.

3.3 The impending possibility of a buy-out may lead to principal-agent problems (where either the seller or buyer appoints an agent to act on their behalf in executing the buy-out), moral hazards, and perhaps even the subtle downward manipulation of earnings so that management can get the best deal possible.

3.4 Management must avoid approaching the owner with a buy-out or walk scenario in a manner which may make the owner feel handcuffed into doing the deal thus creating significant animosity between the parties and hamper the buy-out process. There must be a mutual alignment between the owner and management.

3.5 Does the management team have the appetite to do what is required to make the buy-out work, and are they ready to be owners? Is there a clear leader who can take control of the process and speak for management or is it a diluted structure?

3.6 Has the vendor and management communicated effectively with staff about the potential transition or have they let rumors abound unmitigated.

3.7 Asymmetric information possessed by management may offer an unfair advantage relative to current owners and must be considered in the purchase agreement through representations and warranties.

3.8 Determining if the business is ready to go through a sale process. Underestimating time/effort required to complete a successful buy‑out is more common than not in transactions.

3.9 Typically management underestimates the personal commitments and securities that the lender will require to fund the buy-out. Management should discuss the requirements early on so that they understand the responsibilities attached with the transaction.

4.0 Why MBO is advisable and what are the associated pitfalls.

4.1 Pros

4.1.1 Familiarity As mentioned before, the MBO team is already familiar and involved in the business and is most likely to perform better than an external team. Starting a business from scratch is harder, riskier and time consuming. It is also a great opportunity to gather a team of professionals who are interested in the business they run. The history they have working together and dealing with the same issues provides them with a similar solid background of the challenges of their market.

4.1.2 Financial RewardsMaking the transition from an employee to a manager will have a huge impact on the compensation of the management team members, if the MBO is successful.

4.1.3 Job Security An MBO team eliminates the uncertainty of the job market by simply appointing themselves managers of the company.

4.1.4 Taking Business Private In many cases, an MBO team will privatize the target company. This saves the business a lot of paper work, legislation, and unnecessary procedures that ought to be invested elsewhere.

4.2 Cons

4.2.1 Limitations on size
While MBOs are a popular and perhaps the most feasible way to having your own business, they are still limited by the kind of company you’re working for. MBOs are most suitable for rather smaller companies. The chances for finding funders to assist in buying a huge corporation are very slim if not zero. This is why MBOs are more suitable for divisions of corporations that fall out their business scope. Having a solid history of cash flows and promising potential for success is necessary to be able to convince funders of actually taking the risk.

4.2.2 Difficulty in raising Capital
It’s unlikely to find a group of investors that have enough money to buyout a business. Consequently, loans will constitute a huge pressure on business. Unless the new management has new plans to increase revenues, funders won’t be eager to invest in the company.

4.2.3 Transition hurdles
The transition from an employee to a manager won’t be necessarily a successful one. This may lead to further complications and may cost the business a lot of money. While the new management team could have had a history of managing the division or the company, it still not necessarily true in all cases. It is also important to note that the management team could’ve have been responsible for local management and not necessarily involved in the vision or the overall policy of the company.

4.2.4 Disagreement on strategies and policies
An MBO team might find it hard to agree on who ought to fill certain positions. This might cause unwanted tension and affect operations. The MBO team might agree to take over the business but that doesn’t necessarily mean that they’ll agree on policy on the long run. This might cause challenges to the business. Although this is applicable in any given partnership, it is more likely to happen with an MBO team.

5.0 Conclusion

For an MBO to succeed, all parties’ objectives and perspectives have to be considered and aligned at the earliest possible stage of the buy‑out process to ensure a smooth transition. Management and the vendor should ask the hard questions early on and not enter into the buyout process blind. By avoiding common pitfalls, all parties will be in a better position to achieve their transaction goals.

Important Notice:
This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, Breakthrough Attorneys, its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.