Business Advisor: January-February 2013

There are pluses and minuses to selling your company to your current management. Here’s how to determine if this is the ideal succession plan for you.

There are pluses and minuses to selling your company to your current management. Here’s how to determine if this is the ideal succession plan for you.

If you are in the position where the transition of your business to family members is not in the cards, you may want to consider selling your business to management.

Advantages of a management buyout
This might be more advantageous than selling to third parties. In establishing the value of a business, it is necessary to consider the risk factors affecting the company’s ability to sustain operations. The business’s existing management know the business and therefore will likely be in a better position to understand/manage the risks of the business than a third party. This could facilitate an easier sale than what might otherwise be the case in a third-party sale.

Another advantage of selling to management is that your existing customers, suppliers, employees and creditors have relationships with management, which could reduce risks and facilitate an easier transition after the sale. If the owner is assisting management with financing the purchase, the owner may be able to realize a higher price than might be obtained from a third-party purchaser.
ensuring trust

Finally, since you are dealing with your existing management team, there should be a certain level of trust that usually doesn’t exist when dealing with third parties. Often, third-party deals can crater at the eleventh hour due to a new demand or disclosure, which creates mistrust between the parties. This is less likely to happen when you are dealing with your senior management team.

Disadvantages of a management buyout
One of the main disadvantages of a management buyout is that management may not have adequate capital to facilitate the buyout. This may conflict with the owner’s desire to “cash out” as soon as possible.

In many instances, management will look to the owner of the business to provide vendor take-back financing. Frequently, management will need a longer time to pay off the owner of the business and may need to use corporate profits to do so. This may result in the owner needing to remain involved in the business for a longer period of time than he/she would have desired.

In some cases, management may wish to use the company’s assets as collateral to secure financing. For example, let’s assume a company has accounts receivable under 90 days of $2 million and no bank debt. Assuming the bank would lend up to 75 per cent of the under 90 days accounts receivable, the owner may allow the purchasers to borrow $1.5 million against the company’s receivables and use these monies to fund the purchase. These arrangements complicate a sale.

Major considerations for the owner

1. Price – A business valuation can be a used as a first step to set a realistic framework for negotiations. However, there are many factors that may cause the “value” of the business to be different from the final “price.” For example, vendor-assisted financing might have the effect of increasing the price.
2. Payment of the purchase price – Management buyouts are usually not cash deals, so the timing of the payments of the purchase price will need to be addressed. It is sound advice for the owner to insist that the purchaser put some “skin in the game” by investing a reasonable amount of his/her own money up front.
3. Security and safeguards for the purchase price owing to the vendor – In the event the vendor is assisting with the financing of management’s purchase, and at the same time giving up control of the business, the vendor will need security for the unpaid part of the purchase price. The security could take the form of a pledge of the purchased shares or corporate assets with appropriate priority ranking.
   Depending on the amount owed by the purchaser to the vendor, safeguards will need to be implemented to ensure the vendor is satisfied that the business is run properly so that the remainder of the purchase price owing is not jeopardized. This may include safeguards such as the following:
   • vendor’s participation as a member of the board
   • vendor’s veto rights on certain types of decisions made by the purchasers (e.g., capital expenditures, expansion of the business, compensation/dividend levels, etc.)
   • reporting of profits to the vendor
   • agreeing on consequences for missed payments and other defaults.
4. Retaining a minority interest in the business – The owner of the business will need to consider if he/she wishes to sell part of the business to management and maintain a minority interest, or if he/she desires to sell 100 per cent of the business immediately. A partial sale may occur, for example, where the purchasers simply cannot afford to acquire the entire business even with vendor-assisted financing, so that the vendor may gradually sell additional shares over time.

Major considerations for management

1. Price – Management often expect a reduction in the selling price to take into account their contributions to the success of the business. Ultimately, while the owner wants to maximize the selling price, it is in the best interests of both the owner and management to strike a fair price.
2. Competencies – Will management be capable of managing the business without the owner’s involvement? Do they have the competencies in all key areas of the business (i.e., sales and marketing, operations, finance and human resources)? If not, will the vendor be needed to assist for a transitional period of time, or will additional management talent need to be hired?
3. Arrangement for the timing of the vendor’s withdrawal – The vendor may wish to remain involved until the remaining portion of the purchase price is repaid. However, if there is disagreement between management’s vision for the business and the vendor’s vision, this may result in conflict between the parties. It is best for the parties to agree in advance of the sale for the timing of the vendor’s withdrawal and reductions in control based on certain milestone repayments.
4. Arrangement for utilization of profits – The vendor of the business will want to be repaid as quickly as possible out of future profits. Management will want to be fairly compensated for their contributions in the future. The parties should agree in advance about the timing of the repayments to the vendor and, at the same time, about providing for fair compensation to management and leaving a reasonable amount of working capital in the business.

Selling to management may be a viable option for succession planning. However, to achieve a successful result, you should seek professional advice to ensure that the process is properly planned and managed. 

Bruce Roher is a partner responsible for succession planning and business valuations at the Toronto office of Fuller Landau LLP, Chartered Accountants. He can be reached at broher@fullerlandau.com or at 416-645-6526.