Ian Richardson elaborates on the background of
management buy-outs, including the sources, structure, advantages,
documentation, warranties and interests and objectives of parties involved in
such a process.
What is a Buy-Out
Essentially, a buy-out is the purchase of a business by its existing management ('MBO'), or a new management ('MBI'), usually in co-operation with outside financiers. Buy-outs vary in size, scope and complexity, but the key feature of each is that the managers acquire an equity interest in their business, often a controlling stake, for a relatively modest personal investment. The existing owners normally sell most, or usually all, of their investment to the managers and their co-investors.
At this stage, it is worth noting that all parties enter into the buy-out process because they expect to gain something from it. The management team ordinarily stands to gain independence and autonomy, a chance to influence the future direction of their business and to enjoy the prospect of a substantial capital gain. The financiers (venture capitalists) will also expect to participate in this success. As a reward for sharing in the risk of ownership of an unquoted business, the venture capitalists will expect a return on their investment unparalleled in comparison with other investments. The venture capitalists' return will ordinarily take the form of an annual income stream (dividends) together with a capital gain on the sale of their equity holding (most commonly by trade sale or flotation, but increasingly often by way of a second generation MBO or MBI, known as the 'exit'). Venture capital is not a cheap source of funds.
Sources of Buy-Outs
Some of the more common sources of buy-outs are as follows.
Sale by parent of division or subsidiary
Ordinarily, this will involve the sale of a business which is, or will become, a 'non-core' activity. In these circumstances, the management can become isolated from the parent company's overall strategy and, in consequence, may not receive the full support of the parent organisation.
Distress sales
Highly-geared groups may be required to raise funds at short notice. They are often compelled to accept a forced sale of the business to raise those funds. Management may be the only potential purchaser able to meet the short timescales required.
Succession issues
In many established family companies, there is often no obvious successor to the owner/managers planning to retire. In such circumstances, the incumbent managers may be able to purchase the company from the retiring family members or, frequently, a suitable solution is an MBI, which will see the current management being strengthened with external managers from outside.
Divergent shareholder aspirations
In many privately owned companies with diverse shareholder groups, it is possible for the aspirations of different shareholder groups to diverge over time. This may require a reorganisation of the shareholders with one group acquiring the shares of the other. Such a reorganisation can often include a buy-out orchestrated by some of the shareholders.
Secondary buy-outs
This is an increasingly common subset of buy-outs arising from divergent shareholder aspirations. Institutional investors and, in some instances, members of a previous MBO team, may be seeking an exit from their investment. In such circumstances, a reorganisation of shareholdings is possible in which non-equity holding managers become shareholders and existing equity investments held by managers can be sold, in whole or in part, or can be restructured to allow some of their 'locked in' gain to be realised.
Criteria for a Successful Buy-Out
Four principal conditions have to be met for a buy-out to be feasible:
Structure of a Buy-Out
A buy-out will usually involve the establishment of a new company, referred to here as the buy-out vehicle, which will be funded by both debt and equity and which will apply the funds at its disposal in the acquisition of a target company or business.
Financing a buy-out usually includes:
Debt
So far as the debt element is concerned, this will be provided pursuant to a term loan agreement or facility between the bank and the buy-out vehicle containing the usual terms including, in particular, positive covenants (matters which the company must do unless the bank consents), negative pledges (matters which the company may not do except with the consent of the bank) and events of default (which can trigger immediate repayment of the debt). The term loan agreement will also contain detailed financial covenants that must be adhered to.
There is also often an inter-creditor deed setting out the priorities of payment of any debt as between the banks, the venture capitalists, the seller and any other lender to the buy-out vehicle.
Equity
On the equity side, a typical share structure might consist of ordinary shares, preferred ordinary shares and preference shares or loan notes. The ordinary shares will be held by the management and possibly also by the venture capitalist, the preferred ordinary shares and the preference shares or loan notes will be held by the venture capitalist. The rights of these different classes will vary according to the financial requirements of the venture capitalist. This will be the case particularly if there is to be an equity ratchet. An equity ratchet arrangement is designed to result in the percentage of the buy-out vehicle's equity represented by the management's shares varying according to the performance of the buy-out vehicle after the investment is made, rising if the company performs well and (sometimes) falling if it is not successful. This is often introduced into pricing negotiations between the management and venture capitalists to bridge the gap between the management's optimistic performance forecasts and venture capitalists' more conservative projections. Whilst common in the buoyant 1980's, ratchets are less common in today's market place with many institutions arguing strongly that negotiations at the outset should conclude the level of the management's shareholding.
Advantages of a Buy-Out
Often, the success of a buy-out can be attributed to two principal factors, namely the availability of finance and the speed and nature of the negotiations made possible by the management's knowledge of the company.
Another advantage an incumbent management team has over other interested parties is that they have a thorough knowledge of the business and do not need to carry out a 'due diligence' exercise to the same degree as third party purchasers or a venture capitalist pursing an IBO. Having said that, often a venture capitalist will still require a substantial due diligence exercise to be completed although this is more often aimed at verifying the management's business plan and forecasts.
The venture capitalist will want further assurance from the management that they know all there is to know about the business and that the information being provided to them is accurate, by requiring the management to give warranties in favour of the venture capitalist in the subscription and shareholders' agreement, and to invest cash in the buy-out vehicle company alongside the venture capitalist's funds.
Main Documents
The term loan agreement or facility letter and the accompanying security documentation set out the involvement of the financing bank. This article does not deal any further with the banking documentation.
The rights between the venture capitalists, the management team and the buy-out vehicle and the terms of the acquisition of the target company by the buy-out vehicle are set out in three other central documents:
Each of these documents, together with various principal matters dealt with in them, are considered in more detail below.
Subscription and Shareholders' Agreement/Investment Agreement
The purpose of the subscription and shareholders' agreement is to regulate the arrangements between the management, the venture capitalist, the buy-out vehicle and the target company following the completion of the acquisition. It is likely to detail the principal commercial terms between the parties and to record how the target company should conduct its business affairs in the future.
Venture capitalist's requirements
The venture capitalist will require the investment agreement to contain certain terms, including representation on the buy-out vehicle's (and usually also the target company's) board, regular up-to-date financial and other information and consent for certain specific strategic decisions of the buy-out vehicle and the target company.
It is important that the restrictions imposed by the venture capitalist should not be so tight as to fetter the effective day to day running of the business by the management. A balance needs to be achieved between keeping the venture capitalist informed as to matters which he considers important and the ability of the management to run the business effectively. The venture capitalist will usually set time limits for the receipt of the financial information which it is seeking. Clearly, the objective of the various rights and controls is to allow the venture capitalist both to bring to bear its experience and to identify and contain a financial problem arising within the buy-out vehicle/target company before it is too late.
Warranties
In addition to other types of protection contained in the subscription and shareholders' agreement, the agreement will contain a number of warranties given by the management to the venture capitalist. Although the venture capitalist will have gone through a 'due diligence' process to evaluate the management and the target company, it will also require warranties from the management because it will subscribe for shares in the buy-out vehicle on the basis of information from the management team about both the buy-out vehicle and the target company. Warranties required from the management team will comprise 'fill in' warranties concerning the target which, due to the knowledge of the management, have not been given by the seller and also give comfort on the management team's business plan and forecasts and the reasonableness of the same.
Restrictive covenants
The venture capitalist may also require the management of the target company to enter into restrictive covenants designed to protect the goodwill of the target company should the management subsequently leave and to ensure that if any of the management should leave, they cannot set up in competition with the target company or solicit employees, customers or suppliers. Restrictive covenants would be given by the management team both in favour of the venture capitalist under the terms of the subscription and shareholders' agreement and in favour of the target company or the buy-out vehicle through their respective new service agreements (which will be entered into at the time of the buy-out).
Buy-Out Vehicles' Articles of Association
The articles of association of the buy-out vehicle typically include provision for several different types of shares, including ordinary shares, preferred ordinary shares and preference shares and also loan notes. The inclusion of several different classes of shares provides a means by which the venture capitalist can attempt to structure its return and ensure that it, together with the management, have the appropriate percentages of the equity of the buy-out vehicle and so have appropriate percentage interests in the performance of its underlying asset, the target business. The articles will reflect the rights of the various classes of shares.
The venture capitalist will require the management to make a financial commitment to the target company (through investing in shares in the buy-out vehicle) in the expectation that the management will be motivated to realise a substantial gain for both themselves and the venture capitalist. To maintain this, the venture capitalist may seek to prohibit the management from transferring some or all of their shares in the buy-out vehicle without its consent. Various share transfer provisions are commonly included, such as the following.
Pre-emption rights
A typical buy-out vehicle's articles of association will include pre-emption rights upon transfer. These usually operate so that, save in certain specific instances, any management shares which are to be offered for sale must first be offered to the other shareholders of the same class of shares; secondly, to the other shareholders of the other classes of shares; and finally, to a third party. It is not uncommon for the venture capitalist to require that its consent be given to any transfer to a third party, and that any such third party be required to enter into a deed of adherence.
It is common to have specified exemptions to the pre-emption provisions that all shares should be offered to the other shareholders, such as transfers to family members or trusts.
Mandatory transfer notice
The buy-out vehicle's articles of association also usually provide that an employee shareholder who ceases employment with the buy-out vehicle or a subsidiary must, if requested to do so by the board of directors of the buy-out vehicle or the venture capitalist, serve a transfer notice in respect of all or any of his shares held in the buy-out vehicle. The price obtained by a leaver in such circumstances often varies, depending on whether the employee is a 'good' or 'bad' leaver.
Drag along provisions
A provision is sometimes included to the effect that, if a certain percentage of the equity shareholders accepts an offer for the buy-out vehicle, then any dissenting shareholders must either purchase the accepting shareholders' shares on the same terms as the offer or be obliged to sell their own shares for the same price per share. The use of such a 'drag along' provision ensures that a dissenting shareholder can be required to sell without the need to proceed with the compulsory acquisition procedure set out in section 428 of the Companies Act 1985, et al.
Tag along provisions
The articles of association are also likely to provide that if a third party acquires a controlling interest in the buy-out vehicle (more than 50% of the company), then transfer(s) to such third party cannot be registered unless the third party offers to purchase all the other shareholders' shares on the same or similar terms as those in its acquisition of its majority stake. In comparison to drag along rights, the operation of 'tag along' rights do not require the beneficiary of the rights to accept the offer made, but facilitate an exit for a minority shareholder, if required.
Allocation of sale proceeds
A sale may not always provide the venture capitalist with the appropriate internal rate of return or the recovery in full of its investment, through the buy-out vehicle, in the target business. Some venture capitalists therefore require that, if the normal operation of the sale provisions in the articles of association would provide the venture capitalist with a return of less than its original investment, then the proceeds of sale should be reallocated between the shareholders so that the venture capitalist receives its original investment (plus possibly an internal rate of return if the sale is at the instigation of management) and, thereafter, the balance is divided between the shareholders in proportion to their equity shareholdings.
Duplication between the Subscription and Shareholders' Agreement and the Articles Of Association
When preparing the documentation, it is important to consider whether particular provisions should appear in the subscription and shareholders' agreement or the articles of association or both.
Whether there is any duplication of the restrictions contained in the subscription and shareholders' agreement in the articles is, to some extent, a matter of preference and personal style. However, an important distinction between the subscription and shareholders' agreement and the articles of association is that the articles must be filed with the Registrar of Companies at Companies House [the UK equivalent of Singapore's Registrar of Companies & Businesses] and are, therefore, available for public inspection. This has the advantage that third parties may have actual notice of matters contained in the articles, which they will not have in relation to matters dealt with in the subscription agreement, a private document as between the buy-out vehicle, the management team and the venture capitalist.
Another difference between the Articles of Association and the subscription and shareholder's agreement is that the provisions of the articles are automatically binding on all of the shareholders in the buy-out vehicle, whereas the provisions of the subscription and shareholders' agreement are only binding on the actual parties to that agreement.
Warranties
In an MBO, the seller often suggests that it need give very limited or no warranties. The seller often resists giving warranties where, for example, there is a sale of a subsidiary or part of a business of a large group and the seller claims the management team are well placed to know as much, if not more, about the affairs of the target company as the seller.
However, the venture capitalist providing the finance will take a different view, as may a bank providing senior debt. Although the venture capitalist will have obtained warranties from the management team in the subscription and shareholders' agreement, it will also want warranties from the seller. It is often the case that the management has less knowledge about the business than it realises, as a number of the significant management tasks may have been undertaken centrally at the head office, such as the preparation of accounts, taxation and statutory matters.
The question of seller warranties is more relevant in the case of an IBO. In any event, warranties serve two functions: the provision of information through the disclosure letter regarding matters which are known by the giver of the warranties and the apportionment of risk regarding matters which are not known. With regard to the latter, the sellers will be receiving the consideration and the person receiving the consideration for the sale should give the warranties. Certainly, any other third party purchaser of the business would require warranties and it is hard to see why a purchaser in which the management has an interest, should be worse off unless this is reflected in the price.
The involvement of a venture capitalist is most helpful in relation to the negotiation of the warranties. In an IBO situation, the venture capitalist and its legal advisers will negotiate the purchase on behalf of the buy-out vehicle and will be negotiating from a position of strength, whereas the management would always be subject to the argument that they knew more about the company being sold than the seller. Ultimately, whether the seller will give warranties and indemnities depends on its willingness to sell, whether there are any other interested parties and other commercial factors affecting relative negotiating strength. In the absence of a third party, the seller, if he wishes to sell, may have no real choice other than to give some warranty cover.
In order to compensate for the lack of warranties from a seller, both the venture capitalist and the bank providing the senior debt will take comfort from a variety of matters, such as the appointment of a firm of investigating accountants, obtaining warranties from the management team and the fact of the financial commitment of the management to the venture.
Interests and Objectives of the Different Parties
Emotions may run high and a trusting and healthy working relationship between the management and the venture capitalist is essential for both the success of the acquisition and the future prospects of the business, particularly as the venture capitalist may have relied predominantly on information supplied by the management when making its decision to back the venture.
Part of the problem in effecting a successful buy-out may centre around the
problem that there are not just two parties involved, but three, or possibly
four (with the bank) parties.
Whereas in relation to negotiations with the seller, the management and the venture capitalist are on the same side, there are other issues where the management and the venture capitalist may find that their respective positions may be in conflict. It is likely that the management and the venture capitalist will have similar viewpoints in relation to the requirements of the bank providing the senior debt, such as the amount of cash required for working capital and the financial covenants to be imposed, though the venture capitalist will wish to ensure that the company is adequately financed and have to consider its existing relationship with the particular bank.
The management will also need to maintain an element of realism as to the future prospects of the target company. The early months following the completion of the buy-out are the most precarious, as what may have been a loss making business will possibly have incurred further debt in order to finance its acquisition. In addition, business performance invariably deteriorates during the buy-out process as strategic decisions are postponed and the management's attention is diverted from the day to day operation of the business. This again should be kept under close review.
The divergence of the aims of the parties can be a source of conflict between the management, the bank and the venture capitalist. The venture capitalist will want to obtain a return on its investment, possibly by way of the receipt of dividends on the shares held by it in the target company, and in due course make an exit. The bank will be anxious to ensure that the funds provided by it have adequate security and that repayment of interest and capital proceed according to schedule. In addition to taking charges over assets to protect its loan, the bank may also restrict the activities of the company until the loans are reduced to a certain specified level or may have a veto on the payment of dividends or the redemption of shares. It is, therefore, necessary to cater for the different requirements of both the venture capitalist and the bank. Again, the parties will need to take great care in reviewing the cash position of the company.
It is also important that there is agreement about how the venture capitalist should be able to make an exit following the buy-out. It may be the aim of the venture capitalist to expand the business, possibly requiring more capital in the expectation that once it achieves a certain profitability the business will either be sold to a trade buyer or obtain a listing or quotation. The management, on the other hand, may wish to carry on the business indefinitely with a view to purchasing the venture capitalist's stake in the company. These differences in perspective will need to be addressed from the outset if a positive working relationship is to be maintained.
Ian Richardson
Eversheds
© Eversheds