Management Buyout
Nicola Gelormino
Are you considering selling your business now or in the future? We will be discussing one of the most effective exit strategies in business, the management buyout, on this edition of the Inside BS Show. Hey now, I'm Nicki G.
This is the Inside BS Show. I'm here this morning with Dave Lorenzo, the godfather of growth. Dave, how are you?
Dave Lorenzo
Hey now, Nicki G. I'm doing great. We're talking about management buyouts.
That's right, management buyouts. You need to listen to this show if you're thinking of selling your business because this is probably one of the best options for you. And if you're not a business owner, if you happen to be an advisor to business owners, you can't afford to miss this show.
We're going to give you the inside scoop on management buyouts. I'm so glad you're with us today. Let's jump right into it.
Nicola Gelormino
All right. Let me tee this topic up for you, Dave. Let's start with what's a management buyout.
Dave Lorenzo
Sure. A management buyout, as the name suggests, is when a group of people who are the leaders of the business decide to pool their funds and pay the owner to go away. Essentially, you're buying the owner or owners out of their shares of the company.
So if the three top managers in the organization have the money and they have it saved up, they go to the business owner and they say, Mr. Business Owner, we think the company is worth $10. We've put our money together. We have $10.
I put in four. The other two people put in $3 each. I'm going to be the new CEO.
Here's your $10. Let's create a transition plan. That's a management buyout in its simplest form.
Now, when we talk about this as it relates to a going concern, when we talk about this as it relates to either a main street business or a bigger business, a mid-market business, the management team is probably bigger than three people, or it could be as small as three people, but it's probably bigger than three people, and they probably need to find some outside money to help them buy the business. But in its simplest form, the easiest way to describe it is it's a group of people who are leading the business, who have decided to take the owner up on an offer to buy the business from him or her.
The reason that we love this as a strategy is because you as a business owner can put this in place right now. You can focus your hiring of your management team with the intent, whether it's five years, 10 years, 15 years down the road, of selling your business to that group of people, and you can create an opportunity for them, and that opportunity can be ready and available to you as the business owner whenever you need it. So if you suddenly decide you don't want to be in the business anymore, and your management team can run the business on their own, you should have the management buyout option ready to go, and we'll teach you how to do that today.
If you don't have this in place, and you want to put it in place, we're going to share with you the steps you need to take to make this happen right now. Just because your business is ready for a management buyout doesn't mean that the management buyout is the only option you'll have, but that word option is critical. If you have a management buyout that's always ready to go, you always have an option for an exit.
If somebody comes along and says they want to buy your business from you, you can weigh whether you sell to that third party, or you sell to your managers, and if you think selling to the third party is a better option, then you go ahead and do that, but having the management buyout in place is a fantastic strategy because it's a contingency plan for you, and it has multiple uses beyond selling the business.
It creates a management team that is ready, willing, and able to run the business at any time. That's one of the main reasons why we really love it. So let's talk about how a business owner determines if a management buyout is right for them.
So let's say you're within three years of selling your business, and you sit down with us, and you have a good management team in place. How do we determine whether a management buyout is the right option for you? Well, there's a handful of steps that we go through, and to kick those off, I'm going to ask Nikki G to pop back in and talk about how we determine if a management buyout is a good strategy or the right strategy for any specific business.
Nicola, why don't you take us through the first few steps?
Nicola Gelormino
Sure. So as the name suggests, the management buyout really depends upon that core management team of your business. So step one for us is taking a look at that management team, assessing both their capabilities, their interests, and their skill sets.
Now, are they interested in taking over ownership of the business? That's a critical question before even going down this path. Do they want to do that?
The next we really want to look at, you know, what are their capabilities to take over? Your management team has operational excellence. That's why you are here considering this option.
They've led the company's operations, allowed the company to be strong and stable, and now the question is not, can they continue that forward? They're going to be in a completely different role. They'll be moving from an operations role to leadership.
So do they have the ability to lead the company to where you want it to go? Do they have that strategic vision and leadership skill set that's going to be required to do that? So those are some of the things we're looking at first when we're assessing just, does the core management team have the ability to do this?
And should we continue to explore this further? Now, assuming that they do, we want to really drill down on the second point, which is the financial health of the business. So you're going to hear financing throughout our discussion this morning, because what really matters here is a critical part of a management buyout is going to be financing that buyout.
So we want to look at the financial health of the company for a number of reasons. We want to make sure it's the right timing for the company. So what does the company's cash flows look like?
What does its profitability look like? We want to assess that to make sure the company is in a good position to be considering this option at this point in time. And then we're going to dig in a little bit more of the actual financing, because that's going to impact the company just as much as going to impact the management as we go down that path.
You want to also be looking at the company's financial statements. That's going to be critical. So I mentioned cash flows, but also all the statements, looking at the overall health of the company, looking at things like what is the debt load it already has in the event we're going to be considering some type of debt financing that would impact the company.
So overall financial health of that business is going to be a critical component of our consideration here to determine if the management buyout is right for a particular business. The third point that we look at is understanding what's going to be the impact on your operations and your culture of the business in the event we go forward with a management buyout. So here's where there is a key benefit of the management buyout option as an exit strategy, because you have those operations that are going to be nice and strong.
So you're going to have that group of managers who have led the company to where it is. And that's a huge advantage in making sure you have that continuity when you're transitioning the business to new ownership. Now, oftentimes, when you're looking at having third parties buy that business or completely new ownership come in that's unfamiliar to the company, there is going to be a high risk of disrupting the operations while that's going forward.
So having that same team in place provides you significant advantages that you want to look at and see how can we leverage that. We already have this significant advantage, and we want to incorporate that as the company moves forward. So it helps us with the operational piece and helps us with the culture piece.
So we already have familiarity with the management roles of this company and who those people are. So that gives your employees a little bit more confidence in what's going to happen with respect to the transition. So certainly there are risks there, but that gives us advantages that we want to look at and leverage in that process as we move forward.
So let me at this point turn it over to you, Dave, to go through the other two items that we look at in determining whether this is the right fit for an exit strategy for a particular business.
Dave Lorenzo
Sure. Number four is the financing options. So if you're considering a management buyout, you want to take a look at whether the timing is right to finance a management buyout now.
And we'll get into this in a little bit more detail when we talk about the ways to pay for the management buyout. But let's say that your business is doing really, really well. The best time to sell the business is when the business is doing well, whether it's a strategic sale or a management buyout.
If your business is doing well and the owner is willing to carry back a note and finance the buyout him or herself, then that's a great time to approach your leadership team about a management buyout. And you can say, hey, listen, I will take back 50 percent of the purchase price and you can pay me through your distributions instead of taking distributions because the business is doing so well. You can pay me your portion of the distributions and I will use that for two years, three years, five years to finance the rest of the purchase price.
So looking at financing options from a health of the business standpoint, as well as the availability of money. So while we're recording this now, we are at an inflection point in interest rates where they've come down from their peak slightly. So your ability to borrow from a bank is a little bit better today than it was, say, two quarters ago.
But the availability of money in the finance markets is one of the elements you want to consider and the price of that money is the other element you want to consider when you're thinking about the financing options for a management buyout. You don't want to end up having the management team that's buying you out have such a significant amount of debt service that they're beholden to that debt service every month to the point where they're not going to be able to make the same kind of money they were making when they were just employees. The worst possible scenario is now they're owners and they're making less money than they were making when they were just management team members.
So looking at those financing options, both internal financing options and external financing options and weighing those factors is critical when considering a management buyout. It's a big misconception out there that, hey, you know, I don't have to worry about my financing options because my management team is going to buy me out. It's not the case.
You need to pay as careful consideration to how the sale is being financed with a management buyout as you do if a third party is buying your business. The fifth and final element that we want to take a look at when we're considering the suitability for this strategy, the management buyout strategy, is the long-term outlook for the business and the strategy that this management team has for the business in the future. And you as the selling party, you as the business owner, or you as the advisor to the business owner, really need to pay careful attention to this because most of the time you're going to take back some form of financing or you're going to have some vested interest in the success of the business moving forward.
There's one person that Nicola and I work with whose name is still on the business, although he's largely out of the business now. He sold his business to his partners, so that was a management buyout because those partners were not equity partners in the firm when he sold it to them. They became owners and his ownership interest wanes over a five-year period.
He's being bought out over a five-year period, but his name is going to remain on that business because his name has high brand recognition in the industry. If your name will remain on your business beyond your involvement, you want to make sure that you're in agreement with the new management team's strategy for how to move that business forward. Because once those documents are signed and once you've signed over the business to those people, you no longer will be able to control the destiny, control the fate of the business.
So if the management team has a completely divergent strategy from the strategy that you've been pursuing all of these years, you have to be okay with that. If you're not, don't do the sale. So examining the long-term business strategy and having a gut feeling for yourself if you are concerned about the legacy of that business, having a gut feeling that that strategy will be successful is a factor you have to consider in doing a management buyout.
Now for those of you who are participating in this program, who are members of the exit success lab community, you will find in our learning management system a management buyout checklist. I also will refer to this as the management buyout suitability checklist. And these are the items that we've just described with three elements to each item that we think through when we're advising a business owner to consider a management buyout.
I want you to review that management suitability checklist if you're a member of the exit success lab community, because it's very helpful in assessing a business and determining if a management buyout will make sense for a business that you own or for a business that you're advising. All right, Nicole, let's take a turn now and talk about structuring the management buyout. How do we structure a management buyout and what are some of the steps involved in creating that management buyout structure for the business owner?
Nicola Gelormino
So the first thing we're going to do is take a preliminary assessment of the business, and this incorporates some of the principles we've already been mentioning. We're looking at, you know, what is this right for the business and is this the right timing for the business? So we're looking at management again, you know, are they ready?
Do they have the skills? Do they have what's necessary to take us into that leadership role and into the future? And are they ready at this point in time?
So we've really got to drill down on where they are. Are they in the right position for us to take this on at this point in the business's life? We also want to be looking at the company's financial status.
You know, we both touched on this. We want to make sure that financially this is a good time for the business. What does the business look like on its books and what does this look like in the overall market?
So if we're talking about considering different financing options, we want to know what the landscape looks like for doing this now or doing this in a matter of months, wherever we're looking at for our timing horizon to make sure that's going to make the most sense for the company. So we can obviously leverage the opportunities that are there and we can minimize any sort of disruptions that will exist. And then finally, we want to look at what are the operational impacts going to be to our business.
So what is going on in the operational landscape of the business currently as we look at this? Do we anticipate any potential risks or struggles based upon what we see on the time horizon associated with going forward with this? We want to make sure that if we do see things, we're minimizing that disruption to the extent possible because the buyout itself is going to create a little bit of disruption and we don't want to create that balance where it goes too far to one side versus the other.
Minimize that operational disruption as we're going through this. So that's part of your overall assessment that you're going to look at as a starting point for how we're going to structure this. The second step that we like to look at when we're determining what's the right structure is the valuation of the business.
You should have a valuation done and there's a lot of reasons for this. So up until now, if you're considering this management buyout, leadership and management has been aligned. They've been aligned with what the value of the company is.
They've been aligned with what they think it might be worth. But now consider this, you're putting them on two opposite sides of the negotiating table. So having a valuation done by an expert is going to give you a starting point to have those negotiations and to make them a little bit more smooth.
So we have an objective opinion as to what that company is worth to be able to work off of that as they negotiate what's going to make sense for everyone involved in that transaction. So there's going to be some push and pull there and this is going to be a critical factor in helping those negotiations go smoothly and help them reach hopefully what's going to be, you know, a successful result that allows the company to proceed with this particular option. And then we're going to look at the financing of the buyout.
So and Dave previewed some of this already, but there's so many ways to structure the financing which we'll dig into in a little bit more detail. But generally speaking, what we see is a combination of options out there. So that could be debt financing, equity financing, it could also be seller financing.
We want to survey that landscape of all the financing options out there so that we can leverage the best possible one. What makes sense for this company, this management, we're going to have to look at both sides of that. Does management, for example, have the financial wherewithal to come forward with significant financing?
Are they going to do it themselves? Maybe they have personal financing they can add from an equity standpoint, you know, or they might be considering they might need some investors to help them. Well, that's going to be on the debt side, the seller side.
So it's looking at all of those options because looking at all of them allows us to make the right decision having considered them. So what makes the most sense and viewing all those financing options to make that determination. So those are the first three steps we look at.
And Dave, I'll let you walk through the remaining four that we look at.
Dave Lorenzo
All right. So the next is the negotiating and the agreement. And there's price and then there's term, right?
So those are the two elements of negotiating your exit when it comes to any type of exit strategy. But a management buyout, really the negotiation stems from you going to the management team and saying, here's the valuation I got. How are you going to pay me?
Come back when you're ready. That's typically the way the negotiation works in a management buyout because there's no real pressure on you as the business owner to sell. In fact, one of the things that we've talked about, we talked about it in the last episode of the show.
We talked about it in the last lesson that we covered here at Exit Success Lab. You want to have multiple contingencies available for your exit in case you're forced due to illness or circumstances to sell your business. This is just one of them.
So when it comes to negotiation, the management buyout is typically a friendlier negotiation than a negotiation in a strategic sale or a negotiation with a private equity fund because you can go to the management team and you can say, here's what I want for the business. See if you can come up with the money. If you need help coming up with the money, I'll try and figure out a way to help you.
That's your negotiation for price. And helping them find the funding is your negotiation for term. So negotiation and agreement is all about how they're going to pay for it and if they're going to be able to pay the price that you want.
The second element that I'm going to cover today, the fifth element overall in structuring a management buyout is the legal and due diligence process. Again, because these people are inside of your organization, because they're a part of your company already, they pretty much know where the bodies are buried. So if there are any legal issues that are ongoing, everybody knows it because they already work in your business.
If there are pending legal issues or there's legal exposure, they probably know about that too. If they don't, before you sign the contract, you have a duty to disclose what those legal issues are. Again, you're probably going to have some interest in this business at least for the next couple of years moving forward.
So it makes sense for you to disclose whatever the legal issues are. They will also have some due diligence process that they want to complete. For example, if you're including your chief operating officer, your chief legal officer, and your chief technology officer, and your head of sales in the team that's going to buy the business from you, the head of sales may not have gone in depth and reviewed all of the financial statements.
So they may want to take a couple of weeks and familiarize themselves with the financial statements. Your chief legal officer may not know how the widgets are manufactured, so the chief legal officer may want to spend a couple of weeks on the manufacturing floor, making sure they're comfortable with the manufacturing process. Again, in this scenario, these people are already familiar with your business, which is a huge advantage, so there should be a truncated due diligence process.
You're talking about weeks, not months. You're talking about people being able to go wherever they want to go because they're already part of the business. In fact, the only thing that may be the least bit sensitive is perhaps some financing that you put in place as the owner.
You're going to have to share that in case they weren't aware of that, and you may need to expose your customers to people who normally wouldn't have contact with them. So for example, if I were buying a business and I were part of the management team, I would want to talk to the customers if I were not in a customer-facing role, at least the top two or three customers. So as the CEO, you're going to say, hey listen, I want you to talk to our chief legal officer.
I'm considering getting her more involved in the day-to-day operations of the business. Please take a few minutes and spend some time on Zoom with her, or she's going to arrange a trip to your city. Please go to lunch with her so that she can get to know you because as she becomes more integral to the day-to-day functioning of our business, I want you to know her and her to know you.
So the due diligence process is easily managed without revealing the confidential nature of a potential buyout or a potential sale. The next element, which is number six in the steps to structuring the management buyout, is essentially finalizing the transaction. And what this means is putting some steps in place that clearly delineate what will happen from the point where you come to an agreement on the fee and the terms of the sale.
Here's what the next steps look like. So imagine that you're creating a checklist for the process of the transition. That's what you should be thinking about at this point in time.
What are the steps necessary for the transaction? So we've agreed on price. We've agreed on term.
Now step number three is to find the financing. And I've agreed that I'm going to take back a note for this amount. You need to go out and find some financing.
You're going to take two weeks to do that. I may make a few introductions if I'm the business owner to the management team. That's when the financing will be put in place.
After the financing is put in place, we each get separate lawyers outside of the company to make sure that the documents that are being drafted are fine. We put a timetable on that. Once those documents are drafted, we put a transition plan in place.
Then when we sign the documents, we execute the transition plan. That's step number six. And then step number seven is essentially executing our transition plan.
What does that look like? Well, there's an internal aspect to the transition plan and there's an external aspect to the transition plan. The external aspect is talking to your customers and then going out to the public.
Any industry trade associations, any press releases, any public relations stuff you want to do. The first thing you have to handle though is the internal transition. So once the deal is signed and the financing is in place, you gather the employees together.
You talk about the transition with the employees. You talk about the transition with your suppliers. Your suppliers are going to want to know what's going on.
You may have landlords or people who are lease holders to your properties. You want to talk to them and share with them what's happening and what's going on. So that transition plan should be spelled out step by step in a checklist type guide.
My preference in doing this is that the current owner who will become the previous owner and the new ownership group sit down and the current owner says, okay, new ownership group. If there's two people, one person is in charge of handling the financing and the second person is in charge of planning the transition stuff. You as the outgoing owner deal with both of those people separately.
If there's three people, it's even easier. If there's three people, one person handles the financing, usually that's the CFO. The other person handles the external transition.
Usually that's the chief customer officer or the VP of sales or the person who's the head of marketing. And then the third person handles the internal transition. Usually that's the chief operating officer.
So my preference is that we delegate those responsibilities. We create detailed checklists and step-by-step guides so no stone is left unturned. Nothing is missed and the financing and the transition planning are happening at the exact same time.
So as soon as that financing comes through, you can execute the transition plan and you're ready to go from top to bottom. So those are the seven steps in structuring a management buyout. Now let's talk about the different ways to make this happen.
And this is specific to how do you pay for this? Where does the money come from? So I'm going to turn it over to you, Nicola.
Turn it over to you to share some of these with folks. At the end of the day, they probably all get wrapped up together and every one of these management buyouts is a combination of them. But let's lay them all out individually and then at the end, we'll talk about how they all come together in a hybrid model.
Nicola Gelormino
Sure. So as I mentioned earlier, this is going to be a critical component of the management buyout. How are we going to pay for this?
So as you mentioned, Dave, too, this is likely going to be a combination, what you end up with for the financing. But let's run through each of these options individually. So the first one is a leveraged buyout.
Now I know that term can sometimes be used to refer to outside parties buying the company. But here again, just to remind you, we're talking about internal. So the management of the company now buying the ownership of the company.
So when we're talking about leveraged buyout, what we are really talking about is financing the purchase with debt. So the purchase of the business will be a substantial portion of it rather will be financed by debt. So that's using bank loans, issuing bonds, that sort of thing.
So it's going to put debt on the company to be able to use this option. So it will require less upfront from the management team. But again, that's going to increase the debt load of the company.
So we want to be mindful of that and what the existing debt load is with this particular option. Next option is seller financing. So that's looking at the company as the financer for the purchase by the management.
So that's going to look at extending loans to the management as the buyer. So again, that's going to impact the company's financials. So something we want to look at is where does the company stand financially now?
And what position is it in to be able to extend that seller financing? It has benefits in the sense that there's already a level of trust with management. Sometimes seller financing, as we know, can be risky in different scenarios because you tend to be extending seller financing to an unknown party.
But here we have that additional layer of trust because the financing is being extended to the management who likely has been with the company a long time. So they have that familiarity and trust with the leadership. So it's using that financing from the company side to be able to allow the management to go ahead and purchase the ownership of the company.
Although that may, one other factor there is that it may end up lowering the sale price when you use seller financing. So something to think about as well. The third option we look at is going to be an earn out agreement.
So that's where you pay a portion of the buyout price over time. And that's going to be tied to future performance of the company. So that will align both parties' interests and reduces your initial financial burden, but again, tied to performance of the company.
So the payments will be spread out, which helps in that regard, but tied to performance. So we want to be careful about what does the future performance look like? So that goes back to the kind of the assessment and looking at what do we project that we can do with the management buyout long term?
So strategic thinking, because this particular option, you really want to be thoughtful about what do we think the financial performance of this company can be if we take that management and we put them at the ownership level. So because we're really focused here on what's going to be the company's success and those payments are going to be tied to that success, we want to be thinking long term of this option and really drilling down there. So Dave, let me turn it over to you for the last two options that we look at for financing.
Dave Lorenzo
Sure. So the last two are equity funding. So you bring in an outside party, they get an ownership interest in the business and you continue to manage the business as a management team.
So this is often called a silent partner and they're an external investor. They're buying your business as an investment. They get an equity investment.
If the business is sold, then they get whatever portion of the business they own. They get that portion of the proceeds. If the business is sold down the road afterwards, this avoids additional debt.
You don't have to go to a bank, but you're giving up an ownership portion of the company to a third party to an outside person. And then the final option is the hybrid model, which includes debt and equity or it includes taking back a note like seller financing. It includes leveraged buyout.
When you're considering each of these, you need to choose the structure that makes the most sense for the management team that's coming in. That's the thing that really needs to be considered. And you, if you're the seller as the business owner, you want to be mindful of not loading up this business with so much debt that it's going to fail because you're probably going to end up taking back a note or you're probably going to end up being involved in some way.
The last thing you want is to be out of the business for three or four years and then have to come back in and save it because there's so much debt that the company couldn't afford to operate any longer. So the hybrid model is going to include all of these or some of these or a combination of these. And it is most common that there's a hybrid structure, at least seller financing and some sort of leverage involved in the transaction.
I prepared a quick chart and I'll walk you through this really quick. You see in the left hand column is the structure type of the buyout and then next to that is the description and then we have some pros and cons. So the leverage buyout is essentially a buyout through debt such as bank loans or bonds in a bigger company.
The pros of this is that it minimizes the initial capital required and it can accelerate your return on investment if you're the purchaser of the business. The cons are that there's increased risk because you're putting debt onto the company. So if you're part of the management team, your distributions may be reduced because your debt service is going to be higher.
If you put too much debt, the business has the burden of carrying that debt. If cash flow is less than it is at the time of the sale, your debt service is a bigger percentage of your cash flow. It could be a problem for the business moving forward.
The second element that's here on the table is seller financing. That means basically the seller provides a loan to the management team. It's an easy financing process.
It's just a promissory note that the seller takes in exchange for the sale of the business. There's a lot of trust there. It makes sense.
There's a potentially lower sales price for the owner. There is also the opportunity for the owner to have to come back into the business if the business doesn't go as planned. The third element you see there is the earn out and that means that over time the people who are the new owners are essentially paying the former owner based on the performance of the business.
So if the business is doing a million dollars in sales and we agree the purchase price is one x and you're going to get an additional x on the business. So you're going to get an additional multiple on the business if the sales are increased and then sales increase to two million dollars in the second year and you have a five-year earn out. Then the value of the business is increased also by that million bucks.
So the sale price goes up. The earn out is contingent on the performance of the business. You as the business owner don't get a certain fixed fee for your business.
You're betting on the future success based on the management team. You as the management team don't get to take that additional cash flow, the additional proceeds of the business as distributions. You have to pay the owner as if he or she is still in the business.
That's what an earn out is all about. So there's pluses and minuses there. You can see them on the chart.
Equity financing is having a third party come in and have ownership in the business. You don't incur debt. That's the positive.
The negative is you dilute the ownership of the business which is problematic if that person decides they want to become an activist. They want to have a say. There could be that investor interference.
I don't know that you want that. If you're okay with that potential then equity financing may be the way to go. And then finally the hybrid which combines all of these.
You got to just keep it straight. I mean let's just be honest. There's a lot of positives to a hybrid model.
You can go borrow some money from the bank. You can get your uncle Phil to be a silent partner and provide some equity. You're just going to have to keep it straight and manage all of it.
If you're the buyer of the business you got to keep all of it straight. If you're selling the business the hybrid model makes sense for you. But if there's a combination of an earn out as well as some seller financing you got to keep straight what's what.
So if you're doing the hybrid as most people do just make sure everything is spelled out in the agreement and how you're going to manage this process of earn out versus seller financing is critical. So just make sure that your paper is good on this. You have everything spelled out in great detail in the agreement.
That's the structure grid. We put it up there for you. We also have a copy if you're a member of the ESL community there'll be a copy of this in the learning management system so that you can refer back to it.
And we're happy to have you share this as long as you attribute credit to us. Happy to have you share this with your business owner clients as they're thinking about management buyout. You can have them take a look at this grid just attribute it to us when they do.
All right let's talk about the advantages of a management buyout as an exit strategy now. There are 10 specific advantages to a management buyout. We're going to go through these quickly for you.
They need to be considered carefully. We're just going to touch on the tops of them here and we will discuss these in detail with you as you introduce these to business owners or if you're a business owner yourself we'll look at all of these in great detail as we continue to weigh this as an option for a potential exit strategy for you. So Nicola start with the first couple.
Why don't you introduce the first couple of advantages of a management buyout to the folks who are with us today.
Nicola Gelormino
Sure so advantage number one is definitely that continuity. So your management team has been leading the day-to-day operations of the business. That gives them intimate familiarity with the operations.
They already know how the business is doing. They know how it is moving forward. So that the biggest advantage is leveraging that so that you minimize that disruption.
You know again this is going to cause disruptions in operations any type of transition in leadership but here you really have a significant advantage to minimize that disruption because of the management team that has already been in place. So not only do you minimize that for internally the employees for the management team itself but also your customers. This allows it smoother transition during that period of time where you're going through that ownership transition.
So excellent excellent advantage there is that continuity. Another one for us is going to be preserving the company culture which we touched on a little bit. Because your employees and customers are already familiar with who has been leading the company from the operational perspective that gives you an advantage of maintaining that same level of culture.
Most often they're going to keep kind of the same ethos the same culture at the company when they've already been there for so many years and they've been embedded in it. It would be unlikely for them to completely change the culture given that familiarity with the company. So you can expect that would be a little bit smoother of a transition in terms of the culture.
We've seen so many times with companies that come in to purchase you know from an outsider comes in to purchase a company that they could completely change the culture. That's certainly a risk that you know we discuss with business owners that you have to be prepared for that and there are ways you can try to do that but here you have that advantage that it's most likely going to stay the same. So that provides that level of credibility and comfort for your employees as well as your customers that that's going to maintain the same.
Let me go through one more and I'll turn it over to you Dave. So we have incentivization and motivation of your management. So let's think about this your management team is transitioning from the operational level to the leadership level of the company.
They're going to be motivated if they want to do this interested in it they have the capabilities to take on the leadership. This will really motivate them to make a significant impact long term for the organization. So there's that natural incentivization for them to succeed in that new role given that they're going to already have that core knowledge of the company's operations.
They've been there a long time and they're able to leverage that moving forward. So that's really something that's going to help the company increase the ability to succeed whenever they have that change of leadership.
Dave Lorenzo
The fourth element here the fourth positive is the smooth transition. It's super easy. These people are already involved in the business.
They don't have to be introduced to the team. They don't have to be indoctrinated in the culture. There's very little hit in employee morale.
It's really easy to do a management buyout from the perspective of the people who work in the business. The suppliers are already familiar with the people who are part of the leadership team. The customers are already familiar with the people who are part of the leadership team.
It's smooth. Number five is speed and confidentiality. You can get this deal done quickly.
These folks are already there. The biggest thing is securing the financing and negotiating the terms. It is super quick to get a management buyout done.
The financing is the only hurdle that you have to overcome and you can keep it confidential. You can literally do this within the confines of your boardroom and your negotiation sessions look like your management team meetings every week. It doesn't have to be difficult.
The speed and confidentiality are a huge plus in this. And then number six is the alignment of the business goals. You already have goals with your management team.
Their goals are probably going to be similar if not identical. So everybody's pulling to get the same stuff accomplished before, during, and after the sale. So the alignment of business goals makes it really easy to get this done.
These three elements, the smooth transition, the speed and confidentiality, and the alignment of business goals really make a management buyout attractive. Nicola, give us number seven, eight, and nine, please.
Nicola Gelormino
So number seven is going to be reduced due diligence time and cost. So once again, because management is already familiar with the company, this should achieve efficiency in that due diligence process. So you don't have an outside party coming in saying, I now need to look at everything and look at it for the first time.
Here, management is already familiar with what's been going on because they've been a part of that process. They know where to look for information. They know what the risks and concerns are with that business because they've been living in it.
So we have the efficiencies there that we can achieve associated with due diligence and certainly that cost perspective. When we're going through a due diligence process with an external buyer, that's going to be an expensive, time-consuming process because again, they're looking at it for the first time. They really want to dig into all the areas of the business to make sure it makes sense for them, understand those risks, but here we have great efficiencies with that.
So the next benefit is going to be that there's a potential for employees to benefit from this as well. Management buyouts sometimes can create opportunities for employees to take on a participation in the profit sharing or have maybe some ownership share even. So having that opportunity for employees is also going to enhance their engagement and their loyalty.
And being able to be more involved with your employees is always going to help you when it comes to their engagement and staying long-term with the company. So there's a possibility here with this particular exit strategy option that you will have that participation by some of your employees.
Dave Lorenzo
I want to add one thing to that potential employee benefits too, Nicola. The thing to add to that is as these managers ascend to the ownership role, they are going to have succession in their roles as well. So a rising tide lifts all boats.
There will be employees who are promoted from within to fill some of the roles that they were handling when you as the business owner were in the ownership role. So for example, the person who's the chief operating officer may become the CEO and that person's number two when you were the owner may be now the chief operating officer. And the chief financial officer may take on some of the aspects of the CEO's role.
So he may have to elevate the number two in his area to become the chief financial officer as well. So those are some of the ways that employees can benefit in addition to potential profit sharing and that sort of thing.
Nicola Gelormino
Yeah. Great point, Dave. You have the opportunity there to elevate some of your existing employees to different positions in the company with management taking on that new role and transitioning out of their current roles inside the company.
So the next benefit is going to be flexible deal structuring. We mentioned some of those financing options such as the earnouts, the seller financing. We don't see those where it's an outside purchaser.
Those are very unlikely that you will be seeing that type of financing. So here that can be an advantage. It can be an advantage in the sense that it gives you flexibility in your deal structuring.
We've been saying that oftentimes where we end up is a hybrid when it comes to financing the management buyout. And because of those options, flexibility can be very, very good for this business in terms of putting that financing in place because you have a lot of options to work with to be able to identify the one that makes the most sense for the company.
Dave Lorenzo
Okay, so let's cover the last element here and that's the avoidance of external risk. By choosing a management buyout instead of any other exit strategy, you can avoid the risk of having to shop your business around and deal with an auction scenario. You don't have to expose what's going on to your competitors or to the public.
If you're a private person by nature, this is a great, great benefit for you. Your entire transaction can be done, papered, consummated, handled completely from start to finish before anyone in the public ever hears a word about it. And that avoidance of external risk is incredibly valuable to people who are in highly competitive industries or to people who just don't want nosy parkers out in the public to know what's going on.
All right, as we bring this episode home, as we bring this learning session home, let's cover the challenges associated with a management buyout. I'll cover the first few here. And again, we're just going to touch on the tops of these.
If you're a business owner and we're sitting down speaking to you about this, we will go through these in great detail so that you can make a good decision. The first challenge in handling a management buyout is securing financing. Listen, your management team is probably going to have to go outside to secure some financing, whether they take out a loan or find an equity investor.
They're also going to potentially mortgage their homes or go into their savings to make the investment in this business. Those are decisions that are not made lightly. So securing financing is the first challenge, the first hurdle you have to overcome.
The second challenge is valuations. I know that everyone trusts the accountants when they do these valuations, but the management team may believe the business is worth one thing and the owner may believe the business is worth something else. To be candid, you have valuation discrepancies in every form of Business X's strategy.
This is no different. So just be aware that everyone has to agree who's going to do the valuation and everyone has to agree that that valuation is going to be accepted by all parties. And then you may not like the valuation, but you're going to have to come to some kind of agreement on it.
The third element, the third challenge is the debt burden. So if this is leveraged, if there's a loan taken out, again, putting a lot of debt on the business could hamper the operating capabilities of the business. This is true if there's a private equity buyout or if there's a management buyout.
But you need to be particularly careful if the business cannot support the debt service, the business is going to fail and nobody benefits from that. That's going to be bad for everybody. So you want to keep an eye on the debt burden.
You want to manage the debt burden associated with the management buyout. Nicola, why don't you go ahead and take the next three?
Nicola Gelormino
Sure. The next one, number four, is going to be your managerial challenge post-buyout. So obviously we have experienced managers, right?
Again, they're running the operations of the company. So they've been sitting in operational roles. And as I mentioned earlier, they're transitioning largely into completely different roles of leadership and strategic thinking.
That can lead to some challenges. You may have managers who have not had experience at a leadership level in an organization. So that can be a little bit bumpy.
So we just want to look out for that challenge, for that transitional period to get them into that leadership role so that they're now thriving in it. We will certainly minimize that because they have that familiarity with the company, but could face some challenges along the way. The next one, potential conflicts of interest.
I will try to keep this short because there's so much I can explore here from a legal perspective. And this is not to dissuade you, but so that you're aware that you can have the potential for conflicts of interest in this space. So managers consist oftentimes of officers and directors.
And officers and directors of corporations owe fiduciary duties to the organization and its shareholders. So they have to be careful when they enter into a management buyout because now they're wearing two hats. They're sitting in the role of a buyer and they're still sitting in the role of the manager of the company, owing those fiduciary duties.
So they want to, as a buyer, obviously get a price that would be advantageous for them. But they have to be careful because in their role as an officer and director of the company, they have to put the company's interests first in what they are doing, the decisions that they are still making in running the day-to-day operations of the company. So we want to look out for that potential conflict of interest.
And sometimes it can get so high that we need to take steps to reduce it. So by being aware of it, it gives us the insight to be able to look at some of that. So the primary responsibility needs to remain running the operations of the company.
And things you can do, just so I've at least mentioned a few, if you need to take a look at how you can minimize that conflict of interest, you might have to look at, depending upon the size of the organization, the level of the conflict, you might have to look at putting an independent committee in place of directors at the company while you go through that process. Something else you can look at is possibly having those managers step down as they go through the process. Now these may seem like extreme options, but again, there are things to think about.
Your legal counsel can help you there. But I do want you to be thinking about the possibility for the conflict of interest because we've got to make sure that those managers stay in the same role of making decisions in the best interests of the company. So we are not harming the company while we are going through this process.
And then I'll mention one more point and go back to you, Dave. So we have operational disruptions is going to be a challenge too. Here again, we've minimized those because this option offers such an advantage there of having the managers who have already have a familiarity with running the company.
You're going to minimize the disruptions, but that does not mean that you will not have disruptions, right? We anticipate some as there always is with the transition of ownership of the company. We can't eliminate that completely, but we have those advantages of those who've already been in those roles.
So we'll try to leverage that to the extent possible so that we do minimize what those disruptions may be.
Dave Lorenzo
All right. Number seven is employee morale and retention. So my feeling on this is, yeah, you do have some exposure to employee morale issues.
They're far greater if you sell the company to someone from the outside than if you sell to the internal management. Candidly, if you have employee morale and retention issues with your current management, maybe you shouldn't be selling the company to that current management. But there might be some employees who may be on the fringe of being key employees who were left out of the management buyout process who might have wanted to participate in it.
Those are the areas of biggest exposure. And where I see this happening most often, and it does happen, is when the key operating managers are included in a management buyout, but the people who generate the revenue are not. So you leave out the heads of sales and marketing.
You don't even offer them the opportunity to participate in the buyout. Here's what happens. You have the operators who are part of the buyout, but the people who are generating all the business are not included.
Those people then are left hanging, and they end up going out on their own, oftentimes competing with the company. And that's where your employee morale and your retention issues really come into play. So if you're considering a management buyout, if you're a business owner and you're considering a management buyout, don't forget to include your key people from the revenue generation side.
If you're someone who is selling a business, you should insist that the revenue generation folks be offered the opportunity to participate. Because if you don't, that's where your morale and your retention issues could really become a problem. Number eight is the pressure to perform.
And this is hard to explain to the people in a management buyout if they haven't been the CEO and they haven't experienced the role of an owner or the role of ownership. So, you know, I would tell you that you have to just sit down and have a candid conversation with the folks who are buying the business, with the internal folks who are part of the management buyout structure, and you have to say to them, here's the thing, once we sign this deal, it's all on you. The sleepless nights are now yours.
The debt service is now yours. The burden to continue to grow and perform, that's all on you. As much as you felt like you were invested in the business when you were a key manager or a key employee, you're now literally invested in the business.
So I want you to think about that very carefully and I want you to understand what you're getting yourself into. So that pressure to perform is great. Number nine is integration challenges.
Again, we mentioned this before, but somebody's got to become CEO. So if there's a management group that's buying the business, that group has to have their own dynamic in place where they decide who's going to be in charge, they decide how the responsibilities are going to be divided, they decide who's going to be the customer or investor facing part of the ownership team. All of that is included in the integration challenges.
And as these people ascend to the new roles, backfilling their existing roles can create some headaches and those have to be thought through as well. Number 10, I'm going to turn it back over to Nicola because legal and regulatory hurdles, these are things that in businesses that require licensure are particularly important. So Nicola, why don't you just very quickly touch on legal and regulatory hurdles and how they can come into play and what an owner who's selling and what a management team who's buying should look at from a legal and regulatory perspective.
Nicola Gelormino
Sure. So we want to make sure that we're looking at all of the laws and regulations that are going to apply to your business. And that's where it's really critical to involve.
If it's an in-house legal team, they'll be able to get that process started. Or you've got to look at if you don't have in-house lawyers, you've got to consult with your lawyers. Because depending upon what the company does and the industry that it's in, there may be different considerations and requirements you're going to have to meet in order to allow this process to move forward.
So we don't want to be thinking about that too late in the process. Let's look at that early on, understand what we have to comply with. Certain industries are certainly more heavily regulated than others and you might require specific approval, you know, the state or federal level.
So we want to make sure we understand what those legal requirements are as it applies to our business. This really isn't, you know, one challenge kind of suits all businesses because here it really does depend upon what the business is doing, the industry that it's in, that's going to drive, you know, what requirements apply that we're going to have to fulfill. So understanding that early can certainly be helpful so we can work through all of that so that it doesn't slow down the process as we're going through it, make sure we're in full compliance with what we're doing when it comes to those legal requirements.
Dave Lorenzo
I mean, think about it this way. If you're a law firm, your market right now in most of the states in the United States is only to be able to sell to other lawyers. So you need to be sure if you're doing a management buyout that if you have a chief operating officer in your firm who's not a lawyer, that person is not allowed to financially have some sort of ownership interest in the law firm.
The same thing is true if you're a plumber or an electrician. In most states there has to be a licensed plumber or a licensed electrician who has their name associated with that business in order for that business to operate. So these elements are not to be trifled with.
There's a pretty good chance if you're doing a management buyout you're aware of these things. I will tell you though, I've seen in more than one case where the management team needs money and they go out looking for money and the person who's the investor for regulatory purposes is not legally allowed to invest in that business. There may be guidance that says that convicted felons can't own a business in a certain industry or people who are residents of countries that are on the sanctions list cannot own a business.
So legal and regulatory hurdles are real. They exist. So if you are selling to your management team, I will tell you that you should have done your homework on these people before they ascended up the ranks of the management team.
But if you haven't done your homework, make sure you've done your homework before you try to consummate the sale. Make sure that the licenses and the legal regulatory hurdles are in place among your managers and if the managers are getting money from outside sources, make sure that everyone has done their homework on where the money's coming from. That's a key element here.
All right, we've spent the last hour covering management buyouts. This is a 10 hour or a 20 hour topic. So make sure that you review this over and over again.
If you're part of the ESL community and you're going for your certification, the exam will be directly below the video that's here or associated with the video that's here. So go through those exam questions, watch this video, listen to this episode over and over again to prepare. If you're joining us on the podcast, we thank you for being here.
If this is interesting to you, you should consider joining our community. All you need to do is reach out to me or Nikki G directly. We'll talk to you about how you can join our community and deal with fascinating stuff like this every day.
Until tomorrow or until the next episode of our show, please take care and join us back here again. My name is Dave Lorenzo and she is Nicki G. We'll see you back here again for another edition of The Inside ES Show.