With more and more Baby Boomers seeking to retire, we are witnessing an uptick in business owners looking for an exit strategy. For some, a sale of their business may be a good option. Many small business owners, however, have little prospect of identifying a viable partner to acquire the business, especially in an environment where sellers increasingly outnumber buyers. Ultimately, a founder’s only recourse may be a management buyout by a (hopefully) well-prepared and engaged team of key employees. Unfortunately, often those managers who are the most qualified to take over the business may not have sufficient personal resources, borrowing power, or risk-tolerance to pay the owner what he or she thinks the business is worth.
How can the business owner receive full value for the business, without taking too much personal financial risk? Unfortunately, there is no one-size-fit-all solution. The following are a few common way to approach this issue.
The Seller-Financed Buyout
One strategy is to allow the management team to pay the sale price over time. Perhaps the buyers could make a cash down-payment with personal funds, with the balance being paid in monthly or quarterly installments with interest. The buyers would be personally obligated to pay the sale price, which would be evidenced by signing a promissory note. As additional security for payment of the note, the seller could hold the stock of the company as collateral for the loan (known as a “stock pledge”) so that the seller could “foreclose” on the stock and take the back the company in the event of a default.
The seller may also require personal guarantees of repayment from the buyers’ spouses, or even additional collateral such as a mortgage on real estate. The note could also be guaranteed by the company, with the company’s assets serving as a collateral for the guaranty. If the company has a line of credit or other outstanding bank debt, the corporate guaranty will be subject to bank approval and the bank will likely require that the buyers’ note and any collateral be subordinated to the bank’s loan.
Even with these protections, however, the seller still assumes the risk that the company will fail and the buyers will not have sufficient liquidity to repay the loan. In most cases, buyers expect to pay their notes with salary and distributions they receive from the company. As a result, the seller is ultimately relying heavily, if not completely, on the continued success of the company for payment of the sale price. Although the buyers are obligated to pay the note, if the company ends up failing, the personal fortunes of the management team will likely follow. In that situation, filing a lawsuit against former employees (with whom the seller may have a long-term personal relationship) in order to enforce repayment is usually not a desirable outcome.
Another alternative would be to require the employees to finance the sale with a bank loan. This is obviously the best option for the seller, since the bank and the buyers are assuming all of the financial risk. The management team, however, may not have sufficient credit to finance the entire sale price with bank financing. The end result may be that a portion of the price is financed with a bank loan, with the balance being paid to the seller in installments under a note as discussed above. The bank will almost certainly require that the buyer’s note be subordinated to the bank financing. This increases the risk that the seller’s portion of the financing will not be repaid since if there is a default, the bank will always insist on being paid first.
The seller could consider an incremental approach of allowing employees to purchase only a minority interest in the business initially (e.g., 20, 30, or 40%), with an option to purchase the balance of the stock at some time in the future or upon certain events such as the seller’s death, incapacity or retirement. This allows employees to take the first small step toward full ownership, while being required to assume some personal financial risk (i.e., having skin in the game). Until the entire sale price has been paid for the initial buy-in, the seller will typically retain a controlling interest in the company and the right to repurchase an employee’s shares if he or she leaves the company prior to a full sale of the seller’s interest.
An incremental buy-in can be an effective exit strategy, especially if accompanied by effective management training or mentoring and an expectation that the management team will start to “lean in” and assume greater personal responsibility for the success of the company. Fast forwarding a few years, key employees may be in a better a position to take over the reins of management, while also having the confidence and ability to assume the financial risk of purchasing the remaining shares of the company.
Nothing’s Easy, Right?
A management buyout involves a great deal of risk for both the founder and key employees. Achieving a fair allocation of risk between the parties can be challenging. As with most business transactions, there are usually a number of legal and tax consequences that need to be considered in structuring a management buyout. Plus, there are the personal dynamics between the founder and the management team (and sometimes their family members) which must be taken into consideration. Often the management buyout ends up being more complex and taking more time to complete than an outside acquisition. It is important that the sale be carefully negotiated in close consultation with the company’s legal, accounting, lending, and other business advisors.
For questions about this article, or any other business related matter, please contact an attorney in our Business & Transactional Practice Group.