MBOs: Structuring the consideration
7th September 2017 by David Scrivener
In previous blogs published by the Ensors Corporate Finance team, we had discussed the basics of management buyouts (MBOs), preparatory stages of an MBO and the price of an MBO. In this blog, I will be discussing the next step in an MBO process – structuring the price consideration.
Those who have been through our blog on MBO price would probably know that getting an agreement on price between the Sellers and the MBO Team is no mean feat. But if you thought that agreeing on the price meant that most of the deal negotiations are over, you would most likely be wrong. An important part of the overall price is the structure of the consideration – because of this; the highest overall price offer may not always be the best option for the Sellers.
To understand why this could be the case, let’s first explore the different elements that make up the price consideration:
This is the amount that the Sellers will receive on the day of completion of the MBO. Most solicitors and corporate finance advisors would agree that this is the guaranteed amount that the Sellers will receive for selling their shares in the business. The upfront cash consideration also includes the excess or surplus cash in the business (i.e. the cash not required for working capital purposes).
Most deals will have an element of deferred consideration. This is the amount that is not paid upfront to the Sellers, but after a certain period following completion of the MBO. The deferred consideration can be structured such that a fixed amount is payable over a number of years (usually between 2 to 5 years), or it could be structured such that the amount payable to the Sellers is dependant on the future performance of the business. The latter is normally termed as an ‘earn-out’.
Sometimes, the MBO Team and/ or the Sellers may agree that the Sellers will retain a minority shareholding in the business following completion of the MBO. There might be various reasons for the Sellers wanting to retain shares in the business, such as providing business continuity, maintaining supplier/ customer relationships and reaping the rewards if the business grows successfully. However, it is important to note that there are risks associated with retaining shares in the business, which are briefly discussed later.
Let’s consider a hypothetical example to illustrate the different consideration elements in more detail. Assume that the MBO Team of a hypothetical company has made an offer to acquire the Sellers’ shares. They have presented the Sellers with two options:
- Option 1 – An overall price of £10m for 100% of the Sellers’ shares in the business. Of this £4m would be paid as upfront consideration and the remaining £6m will be payable over a period of 3 years at a fixed amount of £2m each year; or
- Option 2 – An overall price of £7m for 70% of the Sellers’ shares in the business. Of this £2.5m would be paid as upfront consideration and the remaining £4.5m as deferred consideration over 3 years such that a fixed amount of £1.5m is payable each year to the Sellers. The Sellers will also retain a 30% shareholding in the business post MBO completion.
Which of these two deals would you recommend to the Sellers if you were advising them?
As is the case with most real life MBO questions, this one is also not straightforward to answer. The overall price for both deals is £10m i.e. £10m for 100% shareholding in Option 1 and £7m for 70% shareholding in Option 2 (£7m / 70% = £10m). However, the main point to bear in mind when comparing the two offers is the degree of risk that the Sellers are prepared to take.
If the Sellers are risk averse, then Option 1 might be more suitable as there is a greater proportion of the consideration payable upfront in comparison to Option 2. It is also worth noting that the deferred consideration can be viewed as debt owed by the business to the Sellers. Debt repayments always have preference over equity repayments. Hence, there is also considerably lesser risk of repayment with the deferred consideration in Option 1 as compared to retained equity in Option 2.
However, if the Sellers are risk neutral and they expect the company to grow, then Option 2 might be a more suitable option. The upfront consideration and deferred consideration are both lower than that in Option 1, however, the Sellers still retain 30% equity in the business. If the business fails, the Sellers’ equity would not be worth very much, however, if the business succeeds and grows, the Sellers’ 30% shareholding might be worth a lot more than what it originally would have been at the time of MBO completion. Therefore, there is greater risk but greater reward in Option 2.
The above two options can be complicated further if there are performance conditions attached to the repayment of the deferred consideration. For example, if the MBO Team stipulates that the deferred consideration would be payable each year only if a certain sales or profit level is achieved by the business. These earn-out considerations can potentially get very complex depending on the performance conditions attached to them. Hence, it is important that the earn-out is structured in a thoughtful manner.
We have discussed the deal from the Sellers’ perspective so far, but the other equally important question is – which of the two options would be preferable to the MBO Team?
Again, as you might have suspected already, there is no straightforward answer to this question!
In the case of Option 1, the higher upfront and deferred consideration may be less preferable to the MBO Team. Remember that the MBO Team are Buyers and therefore, they would look to retain as much cash in the business as possible for future growth. From this perspective, Option 1 seems expensive for the MBO Team. However, on the other hand, the MBO Team become 100% owners of the business. This means that they have complete control over the destiny of the business and ultimately on their own destiny!
On the other hand, Option 2 is cheaper on the upfront and deferred consideration, however, the MBO Team would need to forego 30% of the equity in the business. Option 2 will dilute the MBO Team’s equity post MBO completion in comparison to Option 1. Further, the Sellers would become ‘influential’ minority shareholders in the business. Therefore, the MBO Team will not have complete control over the decision making process in the business.
Choosing the right option for the MBO Team depends on the level of control they are willing to cede to the Sellers in exchange for a lower upfront/ deferred consideration. In some cases, the MBO Team might view retained equity positively as this would ensure active participation from the Sellers in managing the business – this can greatly assist with maintaining business continuity, customer relationships etc. post MBO completion. In other cases, the MBO Team might be looking for a ‘clean break’ i.e. they might want the Sellers to exit the business completely so that the MBO Team have full control over the management of the business. Hence, as you can see, there is no ‘one size fits all’ solution for the MBO Team.
Getting the consideration structure right is an important balancing act by taking account of the aspirations of the MBO Team on one hand and considering the expectations of the Sellers on the other. As with most MBOs, a healthy working relationship between the Sellers and the MBO Team can greatly ease the process!
Please contact me today for more information about price structuring considerations.
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