Management Buyouts: Getting the price right
9th May 2017 by Parik Bhandiwad
Management Buyouts (or MBOs) can deliver a speedy exit mechanism for the owners of private companies by handing over the reins of day to day operations and ownership to senior management. Once the groundwork for the MBO has been laid out and the senior management team leading the company post-MBO has been identified, its time to discuss the most important component of the MBO: valuation.
In simple terms, valuation reflects the price that a seller (owners) will be prepared to accept to sell his/ her shareholding and the price that a buyer (senior management team) will be prepared to pay for the acquisition of those shares. Whilst the definition may sound beguilingly simple, valuation can often be the most time consuming and contentious topic in the context of any transaction. Many times transactions fall apart because the buyer and sellers cannot agree on the value of the company. Whilst the pricing discussions in an MBO are much more friendly and constructive (since the buyer and the sellers have worked with each other previously), it is still crucial to get the price right. Remember, that an MBO could very well be a once in a lifetime opportunity for both the buyer and the sellers to fulfil their aspirations; hence each party will want to get the most out of it.
The main question is – why is a valuation contentious? The answer lies in the so called ‘expectation gap’ between the buyer and the sellers. Clearly, the sellers would want the highest price for their shareholding … after all in owner managed businesses; the sellers have worked extremely hard their entire lives to build a thriving business, so it is only right that they should want the highest price for the fruits of their labour. On the other hand, the buyer would want to restrict the price being paid to the sellers … remember that the buyer is the senior management team, who have been pivotal for the growth of the business. It is therefore also right on the buyer’s part to restrict the price paid to the sellers, as the senior management team has been responsible for creating a fair portion of the ‘value’ in the business. Hence, it is justifiable that the buyer would want this value to be retained in the business rather than paid out to the sellers.
To complicate matters further, the sellers and the buyer may also have differing views on what is achievable in the future. If the sellers were to stay on in the business, there would be continuity in terms of leadership, supplier and customer relationships etc. Therefore, in a growing business, the sellers are often very optimistic about the future prospects of the business and therefore expect a higher value for their shares. However, the buyer on the other hand, would be stepping into the owners’ shoes for perhaps the first time in their lives. The senior management team face an uphill challenge as there would be steep learning costs of becoming the new owners. At the same time, they would be expected to ‘hit the ground running’ to keep the transitioning to a new ownership as smooth as possible for the suppliers, customers and the employees. These ‘costs of new ownership’ are likely to affect performance in the near short term and hence, the buyer probably has a less optimistic view of the near future prospects of the business and therefore a lower valuation expectation for the company.
So, is there a solution to the valuation conundrum? The answer is yes! The buyer needs to see things from the sellers’ viewpoint and the sellers would need to see things from the buyers’ viewpoint to arrive at the ‘right price’. The beauty of an MBO is that since the buyer and the sellers usually already have a good working relationship, it is much easier for each party to see things from the others’ viewpoint. This encourages the buyer and the sellers to seek a ‘common ground’ and cross the expectation bridge together. Once this common ground is reached, the headline price is agreed upon.
Now that the headline price has been agreed upon, can the buyer and sellers rest in peace? Not quite yet. The price agreed between the buyer and the sellers will most likely be what is termed as the ‘enterprise value’ of the company. This is the value of the business on a ‘cash free debt free basis’ i.e. it excludes any debt/ financing in the business and its cash reserves. So, in effect, this is not the final price that is payable to the sellers. The enterprise value of the company is subject to ‘debt’ and ‘cash’ adjustments. Again, the definitions of debt and cash may seem straightforward, but in real life, these can be quite contentious too. The cash adjustment usually refers to any cash in the business that is not part of the working capital cycle of the company. Both these adjustments are particularly relevant to companies that have high levels of debt or cash on their balance sheet. In our professional lives, we have seen transactions where the cash adjustment was more than the enterprise value of the company and the debt adjustment accounted for over 80% of the deal value!
These adjustments are also agreed upon through negotiations between the buyer and the sellers. In rare cases, transactions can fall apart due to disagreement between the buyer and sellers over the debt and cash adjustments. However, this is far less likely to happen in an MBO, where the buyer and sellers will already have a good idea of what the debt and cash position is in the company as they have both been involved in the operations of the business.
The final price after adjustments for cash and debt is termed the ‘equity value’ of the company. This is the value that will be realised by the sellers in respect of their shareholding in the business. The agreement over the equity value marks a big step towards the completion of the MBO, and in most cases, one of the principal ‘pressure points’ of the deal.
As can be seen, getting the price right is no mean feat … it requires patience and empathy from both the buyer and the sellers. It is highly advisable to consult an experienced advisor to assist with the valuation process (and beyond) of the MBO as this can greatly help narrow the expectation gap between the buyer and the sellers.
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