Corporate Finance

Making the break. A practical guide to MBOs

Audit.Tax.Consulting.Corporate Finance. This guide is designed to help managers who are considering a management buy-out (MBO). It sets out some of the critical decisions which have to be made, addresses some frequently encountered issues, describes the various stages of the acquisition and explains how we can help manage the process.

Contents

1. Introduction 1

2. What is a management buy-out? 3

3. Criteria for a successful buy-out 6

4. An appropriate funding structure 9

5. The buy-out process 14

6. Some common issues 20

7. Realising your success 23

8. How Deloitte’s Corporate Finance team can help 24

9. The jargon – explained 26 Making the break –A practical guide to MBOs 1. Introduction

During 1979, 18 management buy-outs (MBOs) took place in the UK, with a total value of £14m. In 2003 there were over 680 MBO transactions recorded with a market value of £16.1bn.

Buy-outs are no longer a rare occurrence – they are now one of the most popular forms of acquisition in the UK economy. In the current economic climate at the robust end of M&A activity. As such, both the sources of finance available to buy-out teams and the complexity and range of possible financial structures have increased.

An opportunity for an MBO is usually a once in a lifetime situation. Unfortunately, there are still a number of misconceptions that stop many managers even attempting an MBO. These include the following: Buy-outs are no • You have to be a millionaire to buy a business This is not the case. longer a rare

A whole industry of venture capitalists and specialist bank departments exists to help occurrence – they management teams buy their business. The point of teaming up with these financiers is that they will provide the bulk of the funds needed to buy the business. By contrast, are now one of the management usually invest a relatively modest amount for a disproportionately high ownership stake. most popular forms

• Management buy-out teams cannot compete with trade buyers of acquisition in the Experience has shown that this is not true. UK economy. There are a number of reasons why an MBO offer may be more acceptable to the seller than a rival bid from a trade buyer. These can include factors such as management’s understanding of all aspects of the potential of the business (and any problems), their ability to act quickly, and the fact that MBOs are often more acceptable to the workforce. MBO teams can and do outbid trade buyers.

• Financiers will only invest in exceptional managers This is not strictly true.

Investors are generally looking for a balanced team of managers who work well together and cover the key areas of the business. Leadership is important, but a successful buy-out is a joint effort by the right team of managers.

1 Making the break –A practical guide to MBOs

• Only a small number of industrial sectors are likely to be suitable for MBOs Not so.

Every sector of commerce has produced management buy-outs in the past (see Table 1), and will continue to do so.

Table 1 – Industrial Distribution of UK MBOs by value 2003

Food Drink Agriculture 2.8% Health Pharma 2.5% Retail, Wholesale 16.2% Finance 3.5%

Transport, Comms 3% Support Services 11.3% Property, Construction 2.8% Paper, printing & IT, Telecoms 8.1% publishing 5.5% Leadership is Manufacturing, Eng 7.4% important, but a Leisure 36.6% successful buy-out is Source: CMBOR/Deloitte/Barclays a joint effort by the • Management buy-outs are multi-million pound transactions that only involve large companies right team of This is probably the biggest misconception of all. The average deal size is now around £25 million. managers.

The majority of buy-outs are of medium sized companies, divisions and subsidiaries. The very largest buy-outs involving hundreds of millions of pounds are the exception rather than the rule.

• MBOs are risky Not necessarily so.

A well-structured MBO will take account of possible shortfalls in performance and ensure that the business can still meet its debt-servicing obligations. If plans are achieved however, management can make very high returns (far in excess of the returns available to institutional investors).

So, if you want to see whether a management buy-out is a possibility for you, read on.

2 Making the break –A practical guide to MBOs 2. What is a management buy-out?

A definition Essentially, a management buy-out is the purchase of a business by its management, usually in co-operation with outside financiers. Buy-outs vary in size, scope and complexity but the key feature is that the managers acquire an equity interest in their business, sometimes a controlling stake, for a relatively modest personal investment. The existing owners normally sell most or usually all of their investment to the managers and their co-investors. Essentially, a

What do the participants want from a buy-out? management It is worth remembering that all the parties enter into a buy-out because they expect to gain something from the process. buy-out is the Clearly the management team stand to gain independence and autonomy, a chance to purchase of a influence the future direction of the company and the prospect of a capital gain. The financiers too will expect to participate in this success. As a reward for sharing in the risk of business by its ownership of an unquoted business they will expect a return on their investment. This return will probably take the form of an annual income stream, and the capital gain on the value of management, their equity. usually in The annual income stream typically comprises interest or institutional loan stock. The capital return will normally be generated by the sale of the business (perhaps by trade sale, flotation co-operation with or secondary buy-out). This is commonly referred to as the “exit”.

How do buy-outs arise? outside financiers. Management buy-outs first came to prominence in the UK during the late 1970s. In recent years buy-outs have become a common feature in the UK’s corporate market.

3 Making the break –A practical guide to MBOs

The sources of buy-outs are many and varied. The sources in recent years are shown in Table 2. These are discussed in more detail below.

Table 2 – Sources of MBOs 2003: number (%)

Unknown 10.6% Family and private 26% Secondary buy-out 9.1%

Receivership 10.3% Foreign Public to private 5.4% parent 7.7% Public buy-in 0.3% Privatisation 0.3%

Local parent 30.3%

Source: CMBOR/Deloitte/Barclays Private Equity

•A division or subsidiary of a larger group which is, or will become a non-core activity The sources of In these circumstances management can become isolated from the parent company’s overall strategy and in consequence may not be receiving the full support of the buy-outs are many organisation. The parent company may wish to dispose of the subsidiary in order to realise funds to invest in those business areas that are core. and varied.

• Distress sales Highly geared groups may be required to raise funds at short notice. They are often compelled to accept a forced sale of a business to raise those funds. Management may be the only potential purchasers able to meet a short time scale.

• Unwanted acquisitions In many large corporate acquisitions a bundle of businesses are transferred. It is often the case that the purchaser is not really interested in all the businesses in the bundle, but has taken them all for simplicity. The managers in those ‘unwanted’ acquisitions may be well placed to buy their companies, not least because their new parent may have borrowed heavily to fund the larger acquisition and may also face constraints on management resources in attempting to integrate the businesses acquired.

• Succession issues Often, in established family companies no obvious successor exists for the owner/managers planning to retire. In such circumstances the incumbent managers may be able to purchase the company from the retiring family members or, frequently, a suitable solution is a management buy-in, which will see the current management being strengthened with new managers from outside.

4 Making the break –A practical guide to MBOs

• Receiverships In a receivership there is a tendency for managers to attempt a buy-out in order to simply preserve their jobs. This is never a sufficient reason to attempt a buy-out. Where the company or group has failed it must be clearly demonstrated that the underlying cause of failure can be redressed after the buy-out. Where a group of companies has gone into receivership it may well be possible to purchase one or more profitable subsidiaries. • Divergent shareholder aspirations Whatever the reason In privately owned companies with diverse shareholder groups it is possible for the aspirations of different shareholders to diverge over time and this may require a for believing that an reorganisation of the shareholders. Such a reorganisation can often include a buy-out of certain of the shareholders. opportunity exists, • Secondary buy-outs A subset of the buy-outs arising from divergent shareholder aspirations is the increasingly it is important to common secondary buy-out. Institutional investors and, in some instances, members of a previous management buy-out team, may be seeking an exit from their investment. In realise that not every such circumstances a re-organisation of shareholdings is possible in which non-equity holding managers become shareholders and existing equity investments held by managers company can be can be restructured to allow some of their locked-in gain to be realised. bought out by • Public to private transactions In recent years there have been a significant number of public to private transactions. management. These involve the management of a quoted company making an offer for the shares of the company.

Whatever the reason for believing that an opportunity exists, it is important to realise that not every company can be bought out by management. The necessary criteria are listed in the section that follows.

5 Making the break –A practical guide to MBOs 3. Criteria for a successful buy-out

Four principal conditions have to be met for a buy-out to be feasible:

• there must be a sound and well-balanced management team;

• the business must be commercially viable as a stand alone entity;

• there must a willing vendor prepared to deal at a realistic price;

• the buy-out must be capable of supporting an appropriate funding structure.

Each condition is discussed below. The whole of Section 4 is dedicated to a discussion of the funding structure. The quality of A sound and well-balanced management team management is The quality of management is without exception the most important consideration in any management buy-out. Venture capitalists are fond of listing the ‘3 Ms of ’: without exception Management, Management and Management! the most important Investors are generally looking for a balanced team of managers who work well alongside each other and cover the key areas of the business. Leadership is important, but a successful consideration in buy-out is a joint effort by the right mix of managers. As a result you can expect to spend many hours talking to potential investors convincing them that as a team you have the track any management record and the necessary skills to be backable.

Clearly each of the management team will be required to demonstrate different strengths buy-out. and capabilities appropriate to their role in the unit.

In general, a team will include the following:

• Chief executive. A leader who unites the team and has the experience and ambition to drive the business forward.

• Finance director. An accountant who understands the business and is capable of maintaining the rigorous financial controls and reporting regime needed as the MBO goes forward.

• Sales director. An experienced customer-oriented sales-person who understands the marketplace, competitors and products, and knows the importance of profit.

• Operations director. A practical technically-based person who understands the processes, technologies and costs associated with the business.

6 Making the break –A practical guide to MBOs

All key managers, but especially the chief executive and finance director, must expect to spend a lot of time with investors and advisers in the process. At the same time as all this activity is going on, you will of course still be running the company on a day to day basis. Above all else the investors must trust you, and you them, as you may be together for some time if the deal is successful.

A commercially viable business It is of fundamental importance both to the short-term and long-term success of the buy- out that the business is capable of operating independently as a commercially viable entity. There may be costs associated with preparing the business for independence.

Operating successfully as a commercially viable entity will require the business to:

• Generate adequate profit and cash to:

– sustain the business as it develops; All key managers,

–provide an adequate return to shareholders; but especially the

– support the ongoing capital expenditure requirements. chief executive and •Meet its requirements independently, including: finance director, – securing the finance necessary to support the business; must expect to –providing the financial, legal, marketing and support services necessary for the operation of the business; spend a lot of time

– not being overly reliant on inter-company trade with existing group companies or on a with investors and single customer; advisers in the – operating from independent premises; process. – having adequate access to the necessary trademarks and licences.

• Define and implement its own strategy:

– clearly there are both opportunities and threats associated with this freedom.

When the target to be bought out is a stand-alone company or group of companies, the viability of the business will be easier to assess than where the target is a division of a larger group.

7 Making the break –A practical guide to MBOs

A willing vendor It goes without saying that without a vendor who is prepared to sell, there can be no deal.

However, many vendors will not have considered a buy-out by management until it is suggested to them, and it is therefore worthwhile taking time to think through why the management, and not a trade buyer, should own the business in the future. You may be fortunate and not be faced with competition from trade buyers, but it is always dangerous Management’s to assume that the current owners will not commence an auction process in order to get the best price. detailed knowledge Strong reasons to favour a buy-out may include any of the following: of the business • Confidentiality. Where there are issues that are commercially sensitive the parent company may not wish to allow competitors access to the business. means that an MBO

• Speed. Buy-outs can be completed very rapidly if all parties co-operate. This can be the offer will often be decisive factor in situations where a parent company needs to divest in order to raise cash rapidly. seen by a vendor as • Flexibility. Buy-out finance is infinitely flexible. It is often possible for the vendor to more credible than participate in the buy-out and this can be highly attractive. Trade buyers can rarely match this flexibility. other competing • Continuity. Many owner managers feel very strongly about the companies they have built up. They may not want to see their company pass into the hands of competitors in a offers. trade sale. One should never under-estimate the importance of emotional factors in a sale.

• Deliverability. Management’s detailed knowledge of the business means that an MBO offer will often be seen by a vendor as more credible than other competing offers.

8 Making the break –A practical guide to MBOs 4. An appropriate funding structure

The funding requirement The total finance required for a buy-out will be made up of:

•the purchase price;

• transaction costs;

• any funding required for capital expenditure or working capital;

• any bank debt taken over. As an independent entity the buy-out must be capable of supporting this finance from the To overpay for the cash it generates from its operations i.e. it must be able to service the funds raised to effect the buy-out. It follows that there is an upper limit on the price that can or should be paid for business is the the business. It is therefore essential that a sensible valuation for the business is arrived at at an early stage. cardinal sin of Valuation and price To overpay for the business is the cardinal sin of management buy-outs. To do so management dramatically increases the risk in the investment, as it becomes possible for a business to perform reasonably well and yet still fail to achieve a return for the investors (and particularly buy-outs. managers) when they come to sell.

Valuing any company is not an exact science and there will always be an element of judgement in arriving at the bid price. Broadly there are three methods employed:

• earnings based valuations;

• net asset valuations; and

• discounted cash flows.

9 Making the break –A practical guide to MBOs

Earnings based valuations This method can be broken into: i) transaction multiples; and ii) public company comparable multiples.

Earnings based valuations are one of the most commonly used measures of value in financial circles. These valuations express value in terms of a multiple of profits.

Transaction multiples relate to researching transaction in the target sector over several years in order to determine an average multiple. The post tax multiple relates to the PE ratio, although this will be at a discount to public company multiples to reflect non-liquidity status. Public company comparables can be easily calculated and are published daily in the Financial You and your Times. advisers need to Financiers tend to refer to the price for a company in the context of its most recent (sustainable) post tax profits. For example if a company that generated post tax profits of agree the absolute £1m was sold for £9m, this transaction would have been at a PE of 9.

The PEs from both methods are often used as the starting points in the valuation exercise. maximum price you

Net asset valuations are prepared to pay. It can be argued that the value of the company is simply the valuation of the assets less any liabilities that it has in its balance sheet. However, it cannot provide a simple guide to the price that should be paid because:

• the balance sheet is usually months out of date;

• the market value of an asset may be materially different to the value shown in the balance sheet;

• for certain businesses the value of the assets is no guide to the cash generating ability of the business.

Discounted cash flows (DCF) The principle of DCF is that the value of any asset is the present value of the future cash flows it will generate. This method uses the cash flow projections of the business and the cost of capital raised to finance the deal to value the business.

Overall, the right price is essentially a matter of judgement. You and your advisers need to agree the absolute maximum price you are prepared to pay. This ‘walk away price’ should be borne in mind throughout the negotiations. Managers and prospective investors will often have differing views of the value of a business, with investors typically erring on the side of caution.

10 Making the break –A practical guide to MBOs

Types and sources of finance Most buy-outs are financed through a combination of debt and equity; other hybrid sources such as mezzanine and vendor finance may also be used and these are dealt with later.

These sources have fundamentally different characteristics.

Debt Debt may include bank loans, overdrafts, and lease finance and may be long or short term, secured or unsecured. The lender receives interest at an agreed rate, and, in the event that this is not paid may be entitled to take control of and sell certain assets owned by the company. A lender does not, however, generally have a share in the ownership of the business.

Equity Equity is the term used to describe shares in a business conveying ownership of that business. The shareholders may be entitled to dividends. If a business fails, the shareholders will only receive a distribution on winding up after the lenders and creditors have been paid. There are over 100 An equity investment, therefore, has a higher risk attached to it than that facing a bank lender and thus the return that the shareholders demand on their money is typically higher. venture capitalist The most common source of equity finance for buy-outs is the venture capital market. Despite their name, most venture capitalists seek to invest in established, expanding companies, which companies and only a few are interested in speculative or start up investments. fall essentially into There are over 100 venture capitalist companies, which fall essentially into two categories; the captives and the independents. Captives are the in-house venture capital arms of the two categories; the banks and insurance companies. Independents are private management companies who raise funds from a variety of institutional investors such as pension funds. captives and the

Relevant business factors independents. When putting together an appropriate structure it is important to consider the following:

• Cash Flow and gearing. This is the most important factor and it is of crucial importance that the buy-out team has a detailed understanding of projected cash flows. Profit generation is important, but capital expenditure, depreciation, interest and dividends and other factors such as restructuring costs come into the equation, and mean that cash generation is the key driver to appraising the forecasts.

The projected cash flows should be considered in the context of any proposed debt redemption or capital repayment schedule. In the buy-out process cash is invariably more important than profit in the early years.

The key issue to understand is the ‘quality’ of the cashflows, which will include the predictability of future orders, the prospects for the marketplace, the types of customers and so on. The higher the quality of the earnings, the more debt it should be possible to raise.

11 Making the break –A practical guide to MBOs

• Assets available for securing debt. In general, at least some of the bank debt will need to be secured. In addition to the projected cash flows, the banks will also consider the realisable value of the assets they will take security over.

• Seasonality of the business and timing of cash outflows. Depending on the nature of the company’s trade there may be certain periods when expenditure exceeds income. Likewise, the timing of tax payments and repayments (and similar outflows) may dictate that the company will be particularly short of cash in certain periods. When determining an appropriate structure it is important to plan for these fluctuations.

• Tax considerations such as the tax deductibility of interest (but not dividends), and the timing of tax payments. Deal structuring In general the deal The large number of sources of finance, the range of financing alternatives and the number of factors to be taken into account means that securing a buy-out is a matter of integrating structure will be put different layers of funding. This provides a structure which enables the purchase price to be paid yet enables the business to operate with some freedom in the future. together by the In general the deal structure will be put together by the financiers in conjunction with the financiers in buy-out team’s advisers. However, it is important that the team has an understanding of what the financiers are trying to achieve. The main criteria of the various finance providers conjunction with the are as follows:

• Debt Finance buy-out team’s Evaluating the level of debt that the business will support is the first step to coming up with a financing structure. As noted above, this will in general depend upon the cash flow advisers. of the business, the asset cover available, and the interest cover – the bank will have certain guideline ratios in mind for each of these. Most debt will be required to be repaid within a defined period – typically seven years depending on the business.

Among the key features to look for in any debt package will be:

– the interest rate;

– the repayment profile;

–the security required;

– the financial covenants.

12 Making the break –A practical guide to MBOs

• Equity Finance To some extent, the level of equity may be influenced by the amount of debt that the business can support. Often equity will comprise loan stock and sweet equity (“ordinary shares”); the former usually attracts a fixed interest and may well be redeemable within a defined period. The latter are entitled to participate to an unlimited extent in the ownership of the company – and the associated risks and rewards. It is in this class of equity that managers will normally invest.

On sale of the business the loan stock is redeemed repaid and the ordinary shareholders would then split the rest of the sales proceeds between themselves according to their ownership stake. It is at this stage that the investors hope to make most of their return.

The key features to look for in any offer of equity finance will include:

– the deal structure (the relative split of ordinary shares, loan stock and other instruments);

– management’s equity share (and the funding that they are required to provide);

– whether any equity stake is variable upon a particular level of performance being achieved (a ratchet);

– non-financial terms such as any constraints over the operations of the business;

– the dividend and interest structure.

• Mezzanine Finance Mezzanine finance is often used to bridge the gap between the secured debt a business can support, the available equity and the purchase price. Because of this, and because it normally ranks behind senior debt in priority of repayment, unsecured mezzanine debt commands a significantly higher rate of return than senior debt and often carries warrants to subscribe for ordinary shares.

• Vendor Finance Vendor finance can be either in the form of deferred loans from, or shares subscribed by, the vendor. The vendor may well take shares alongside the management in the new entity. This form of finance has been more common in the current economic climate to bridge the price gap between venders and buyers.

13 Making the break –A practical guide to MBOs 5. The buy-out process

The Process There is no such thing as a typical buy-out, but the following stages will be involved in each transaction and some will run concurrently:

Stages Purpose

To address whether the business meets the criteria for a successful buy-out. (Includes preliminary valuation and Feasibility assessment initial financial structuring.)

To attract interest from providers of finance by setting out the strategy of the management team and the details Preparing a Business Plan of the business.

Financial structuring To optimise the structure of the transaction and take maximum advantage of both corporate and personal tax and tax planning planning opportunities.

Capital raising To secure the fund you require and assistance in selecting the appropriate financial institutions for your needs.

Vendor negotiations To optimise purchase terms.

Legal documentation To bind the various parties to the transaction.

Project management To enable the transaction to be concluded with minimum necessary disruption to the day-to-day to completion management of the business.

Helping you achieve the buy-out plan post To ensure the objectives for the business, as set by management, are met. completion

14 Making the break –A practical guide to MBOs

While some of these stages are discrete, in that they must take place before the next stage is possible, others (for example negotiations with the vendor) may take place more or less throughout the process. A typical buy-out timetable is illustrated below.

Table 3 – Outline timetable for an MBO

Action

Identifying the opportunity

Agreeing on a management team

Agreement in principle for a buy-out

Appointing professional advisers

Assessing the business and its future

Preparing a business plan

Raising the finance

Accountants’ investigation

Negotiations with the vendor

Negotiations with the financiers

Agreeing on financial structure

Preparing legal documents

Concluding the buy-out

Managing the business

Month 0 1 2 3 4 5 6

15 Making the break –A practical guide to MBOs

Some of the aspects of this complex process are discussed below.

Feasibility assessment The management team must consider at an early stage whether the business meets the The business plan is criteria for a successful buy-out (described in Section 3). At this stage it helps to have appointed advisers, as they will be able to ask the right questions. Management will also the blueprint to need to consider their own aspirations. After all, most businesses after a buy-out are under greater pressure to perform than previously. They are not places for those lacking raising finance. motivation.

The business plan This document sets out the strategy of the management team, as well as details of the business, and will not only form an important element in the finance raising process, but will also help management focus on their business objectives, how to achieve them and their financial implications. The business plan is managements blueprint to raising finance to fund the deal. It is important that time is spent preparing a business plan that delivers a clear and robust buy-out proposition.

The contents of a business plan are covered in a separate Deloitte publication and not dealt with here. However, it is important to note that the tone of the plan should be upbeat but at the same time realistic. Weaknesses and threats to the business should not be glossed over or excluded. Rather, they should be addressed in a balanced and considered manner. Investors will be interested in how management manage their business’ risks. The management Financial structuring team must consider The financial structure will generally continue to evolve throughout the transaction. However, it is important that at an early stage, management and their advisers arrive at a at an early stage rough outline of the structure that they believe is appropriate as the financial structure often determine the price an investor can afford to pay for the business. whether the A key element in this is the amount invested by the management team. In order to convince financiers that management is indeed committed to the buy-out, you will certainly be business meets the expected to put up some of the money for the deal yourself. The money can come from a variety of sources, for example from increased mortgages on property, personal savings, or criteria for a from borrowing against life assurance policies or pension plans. It is often referred to as “pain money” in order to ensure management are financially committed throughout the life successful buy-out. of the investment.

It is important that tax planning is also considered at an early stage. This will include advice as to the optional ways to structure the acquisition and also personal tax advice to the management team in relation to their proposed investment.

16 Making the break –A practical guide to MBOs

Capital raising This will involve the management team meeting a number of banks and venture capitalists, discussing the business plan with them and talking through the issues facing the business. Those institutions that like the business and are convinced of the management’s case will then provide an indicative offer setting out the terms and conditions under which, subject to due diligence and legal documentation, they are prepared to provide the finance for the proposed transaction.

Early on in the capital raising process, management with the help of their advisers will need to choose a lead equity and debt provider. On smaller transactions one institution may provide the whole of the equity requirement, while on larger transactions, or where second round finance is envisaged, then a group of two or more institutions may jointly underwrite the equity. However, there will still be one investor that takes a lead role and the choice for this role is of enormous importance. The management team will work closely with the lead investor, probably over a number of years, and once appointed the lead investor cannot easily be replaced. The key things to look for are: experience in leading similar transactions; goals in line with those of the management team; and, in many ways most importantly, a good personality fit between the management team and the investing institution. Whenever possible,

Negotiations with the vendor an indication of the Whenever possible, an indication of the likely purchase price for the business should be obtained at an early stage. Depending on the nature of the relationship between the buy- likely purchase price out team and parent company management, it may be appropriate for this discussion to be initiated by someone other than the buy-out team. However, once outline offers of finance for the business have been received, negotiations can commence in earnest. Often they will continue throughout the whole process, but it is important that early on the key issues are resolved. should be obtained When they have been agreed, they are usually enshrined in the Heads of Agreement. Although generally these are not legally binding, they do convey a sincere intention to enter at an early stage. into a legal agreement on those terms and therefore should be considered and negotiated carefully. They also usually grant a ‘lock out’ to the MBO team – a period of exclusivity during which the financing can be completed.

Up to completion Two main processes take place before the transaction completes – due diligence and legal documentation – both of which are in themselves complex.

Due diligence Once Heads of Agreement have been signed the institutional investors and lenders will wish to commence their due diligence enquiries. The object of this exercise is to ensure that there is nothing which contradicts the financiers’ understanding of the current state and potential of the business.

17 Making the break –A practical guide to MBOs

The individual elements of due diligence may include:

• commercial due diligence: research into the products, markets and customers of the business and the markets in which it operates, often carried out by the investing institution itself

• market report: the commercial due diligence may be reinforced and amplified by a marketing study carried out by consultants

• accountants’ report: the contents will vary, but will generally include a review of the historic trading record, the net asset and taxation position and the assumptions underlying management projections

• legal due diligence: this will tend to focus on the implications of litigation, title to assets (especially property) and intellectual property issues.

Legal documentation

Table 4 – The Legal Relationships set up in an MBO

MBO team

Subscription Shares Agreement Equity investors Debt Providers

Articles of Service Association Agreements

Loan Shares Newco

Loan Agreement

Purchase Sale and Consideration Purchase Agreement

Cash Movements Vendor Legal Agreements

18 Making the break –A practical guide to MBOs

Once due diligence is underway, lawyers will be instructed to prepare the legal agreements that will govern the relationships between the various parties. As there is usually a degree of Very often, the first interdependence between the various agreements, they are generally signed simultaneously at exchange of contracts. For most buy-outs completion occurs at the same time as priority for any new exchange, but where the transaction requires shareholder approval, where there are delays with property conveyancing or where the consideration is subject to revision according to business is to install audited accounts, completion will be later than exchange. new financial Achieving the plan post completion Establishing the new management structure in the newly independent enterprise can be a management and difficult process, but it must be done swiftly to counteract any effects the buy-out process may have had on the business itself – not least the fact that some managers will have been reporting systems locked in negotiating rooms for the previous few weeks or months. Equally, the implications of the buy-out will need to be swiftly spelled out to employees and reassurance provided needed for its where needed. independent status. Very often, the first priority for any new business is to install new financial management and reporting systems needed for its independent status.

19 Making the break –A practical guide to MBOs 6. Some common issues

Taxation The nature and structure of each buy-out situation will be different, and so too will the tax problems associated with it. However, the transaction will be structured as either :

• the acquisition of the issued share capital of the company;

• the acquisition of the assets of the company or division. Each method gives rise to different areas for consideration which are summarised below. The nature and With a share acquisition, some of the issues are: structure of each • continued availability of tax trading losses, if any, of the company; buy-out situation •effect on group relief of current losses where the company is being bought out of a group; will be different, •effect of anti-avoidance legislation for Capital Gains Tax on companies leaving a group; and so too will the • ensuring that interest payable on acquisition loan finance is fully deductible. tax problems Where an asset acquisition is concerned, the allocation of the purchase consideration will have to be carefully considered in relation to: associated with it.

• the conflict of interest between the two parties as to the allocation of the purchase price. An allocation that will provide the buy-out team with tax allowances in the future may have the reverse effect on the vendor;

• available capital allowances on qualifying assets such as plant and buildings;

• the value at which stock is acquired and the taxation effects on profits resulting from realisation at full value will need to be considered when preparing cash flow forecasts.

In addition the stamp duty and VAT aspects of an MBO will need to be considered carefully to avoid giving rise to potentially material liabilities.

20 Making the break –A practical guide to MBOs

Personal tax for the buy-out team In determining the of their company the individuals should consider:

• the availability of tax relief on interest paid on funds borrowed to provide their share of the finance;

• the availability of tax relief for losses of subscribed capital should the venture fail;

• the availability in the future of appropriate business reliefs for Capital Gains Tax and Inheritance Tax.

Tax advice is not an optional extra, it is a vital ingredient. It is a complex area which will depend on the individual circumstances of each vendor, purchasing company and member of the management team. The consequences of error can be severe.

Customers, suppliers and employees Where possible that The consequence of many buy-outs is that a trade formerly carried out by a subsidiary of a large group will, in the future, be carried out by an independent private company. This may crucial relationships cause concern to customers, suppliers and employees. It is, therefore, very important that, in preparing their future plans, the buy-out team identifies these sensitive areas and ensures with all three where possible that crucial relationships with all three categories are maintained and nurtured to ensure as much continuing confidence and goodwill as possible. categories are

Pensions and other employment considerations maintained and The terms under which it is intended that employment should be offered to employees after the buy-out must be considered carefully. Where a company is being acquired, contracts of nurtured … employment (including pension rights) of the employees will normally continue on a similar basis to those which prevailed before the buy-out. The advice of pensions advisers, and probably of a consulting actuary, is essential in ensuring that pension issues are properly dealt with.

Employee share ownership The extent and form of employee participation in the buy-out should also be considered at an early stage. The practical difficulties of a full employee buy-out are numerous and such a scheme is appropriate only in a limited number of cases. Employees can participate in the future success of their company in a number of ways from productivity bonuses, profit- related pay schemes, share option schemes (whether or not Inland Revenue approved), employee share ownership plans (‘ESOPs’) to direct subscription for shares, possibly shortly after completion of the buy-out.

21 Making the break –A practical guide to MBOs

Under ESOP arrangements, a block of shares can be held for employees generally and can be distributed to them over a period of years. This is often done through an Inland Revenue approved profit sharing scheme so that no tax charge arises. This has a number of advantages, including:

• being publicly acceptable;

• being a source of additional funding for the buy-out;

•providing incentives for the employees who will have a close identification with the company and its performance;

• being tax efficient.

Share structures for the employees are often complex and require specialist advice.

Quoted vendors Where the vendor is quoted on the UK stock market and the buy-out team includes, as it usually does, a director of that company or of a subsidiary, the transaction falls within the scope of certain regulations of The Stock Exchange. It is, therefore, important that the vendor complies with these regulations during the buy-out process.

22 Making the break –A practical guide to MBOs 7. Realising your success

Even though it may seem a long way off, realising the investment that the management team has made, both professionally and financially, can influence the way the buy-out itself is structured.

Financiers will normally be looking to realise their financial stakes, and as a result the shareholders’ agreement drawn up at the time of the buy-out will include provisions relating to future share disposals.

Exits have in recent times been problematic, with trade buyers reluctant to commit capital to acquisitions and stock market volatility making the viability of flotations less convincing. One brighter aspect has been the increased level of activity in the secondary buy-out market.

Each of flotation, trade sale and secondary buy-out are discussed below:

Stock market flotations Flotation on a Stock Market is not suitable for every business, and it does have the disadvantage that management, and perhaps institutions as well, will be unable to sell more Flotation on a Stock than a proportion of their share stake at flotation. Once shares have been successfully floated, further capital can be raised by the issue of shares through the market to fund Market is a common future developments for the business. exit route but is not The chosen Stock Market might be the AIM or the Full List, and a reverse might be the chosen method of obtaining a quotation for the company’s shares. suitable for every Trade sale Another common method of exit is a sale to a trade buyer. This can either allow business … management to withdraw from the business, or it may open up the prospect of working in a larger enterprise.

It generally offers all investors, including management, the opportunity to realise their investment.

Secondary buy-outs An exit method that has emerged recently is the secondary management buy-out, where a new team of younger managers raise fresh institutional funding to acquire the business from the existing team. This mode of exit may be driven by the fact that funds raised by the original equity institutions have a fixed life and must be returned to the fund investors and in recent years the exit options have been limited.

Secondary buy-outs can be attractive to new investors as they can often provide a “bolt-ons” to existing investments.

23 Making the break –A practical guide to MBOs 8. How Deloitte’s Corporate Finance team can help

The management buy-out process is complex and time consuming. From the original idea to the final signature usually takes several months. The process involves not only the buy-out team and the vendor and their financial advisers, but also solicitors, bankers, venture capitalists, accountants and perhaps employees, trade unions, customers and suppliers. As a financial adviser we can guide the buy-out team through each and every stage of the transaction. The process places huge demands on the buy-out team’s time while there is still a business to run. As advisers we can alleviate some of these demands.

We provide independent advice and support to help avoid the many pitfalls and to increase the chances of a successful conclusion to the buy-out. Specifically we offer complete transaction management including:

• valuation of the business;

• feasibility assessment – both of the business and the proposed buy-out;

• financial structuring – to optimise the terms of the transaction;

• tax planning – to advise on corporate and personal tax planning opportunities, share incentive schemes, VAT and stamp duty;

• capital raising – selection of and approach to the best financial institutions for your needs, and help to secure the funds you require;

• negotiation – on your behalf with your financial backers and the vendors of the business;

• pensions – to advise on the pensions implications of the buy-out and negotiate with the vendors’ pensions advisers;

• investigation services – to provide the financial institutions with a complete and independent picture of your business;

• completing the buy-out – as we have been through the buy-out process many times, we are well placed to project manage the transaction to a successful conclusion.

24 Making the break –A practical guide to MBOs

Our work does not have to stop once the buy-out is complete. We can help to develop your business, for example by further acquisitions.

When the time comes for exit, we can advise on the appropriate method – if a flotation, we Our range and depth can act as Sponsor; if a trade sale, we can help identify and negotiate with prospective buyers to achieve the best possible price for the business. of expertise and

Our range and depth of expertise and experience enable us to deliver a seamless service experience enable us tailored to individual needs. With offices based throughout the UK, we are able to provide solutions at the buy-out teams doorstep, and having advised on numerous buy-outs of to deliver a seamless Continental European businesses, our European and worldwide network is well qualified to advise on buy-outs in even the most remote locations. service tailored to individual needs.

25 Making the break –A practical guide to MBOs 9. The jargon – explained

The industry that has developed to support management buy-outs has produced a bewildering range of jargon to describe some of the elements of the buy-out. Here, we have summarised some of the most common terms.

Articles (of Association) The legal constitution of Newco.

BIMBO A combination of management buy-in and buy-out where the team buying the business includes both existing management and new managers.

Bought deal Where an buys the target company as principal, later allowing either the existing management or a new management team to subscribe for equity.

Class transaction An acquisition, disposal or finance raising by a quoted company that meets certain size criteria and is subject to Stock Exchange rules laying down the information given to shareholders. (In certain cases shareholders’ approval may be required.)

Debentures A legal document which formalises the lenders’ charge over the assets of the company.

Deferred consideration An element of the purchase price that is to be paid at some time in the future. Payment may be contingent upon the outcome of defined future events.

Enterprise value The debt-free value of a business equivalent to the business valuation plus the level of debt to be absorbed by the purchaser.

Envy ratio A measure of the valuation implied by the amount invested by management for their equity percentage compared to that of the institutions.

Equity kicker A mechanism whereby holders of debt or mezzanine finance are given the option of subscribing for shares, usually at exit.

Exit The point at which the institutional investors realise their investment. Venture capitalists may, depending on the business and their own situation, look to achieve an exit in anything from a few months to over 10 years.

Fixed or floating charge A legal mechanism whereby security over the assets of the business is granted.

Goodwill The difference between the price which is paid for a business and the fair value of its assets.

IBO An institutional buy-out. This is when the private equity house acquires a business directly from a vendor and incentivises management withequity – some time post completion.

26 Making the break –A practical guide to MBOs

Institutional Strip A proportion of the total finance provided by institutional investors, which may include some or all of ordinary shares, preference shares and loan stock.

IRR Internal rate of return. The average annual compound rate of return received by an investor over the life of their investment. This is a key indicator used by institutions in appraising investments.

Loan stock Subordinated debt which carries fixed interest and is repaid in a defined period, typically on exit.

Newco A new company formed to effect the buy-out by acquiring the operating subsidiaries.

Participating dividend A dividend on ordinary shares which is calculated by reference to the level of profits.

PE ratio Price Earnings ratio. This represents the multiple of profits implicit in a valuation of the business. Thus, if a group making post-tax profit of £2m has a market capitalisation of £24m, it would be trading on a PE of 24/2 = 12.

Pre-tax multiple Similar to a PE ratio, except the ratio is calculated as market capitalisation divided by pre-tax profit, rather than post-tax profits.

Ratchet A mechanism whereby management’s equity stake may be increased (or decreased) on the occurrence of various future events, typically when the institutional investors’ returns exceed a particular target rate.

Senior debt Debt provided by a bank, usually secured and ranking ahead of other loans and borrowings in the event of a winding up.

Sensitivity analysis Illustration of how the financial projections in the business plan change if the key assumptions are altered.

Subordinated loan Loans which rank after other debt. These loans will normally be repayable after other debt has been serviced and are thus more risky from the lender’s point of view.

Subscription or A legal agreement binding the various shareholders of the business. The primary purpose of the agreement investment agreement is to safeguard the rights of the passive shareholders – the institutional investors.

Sweet equity A term used to describe ordinary shares.

Syndicated investment Where an investment is too large, complex, or risky, the lead investor may seek other financiers to share the investment. This process is known as syndication.

Upside A positive outcome over and above the expected result. Managers will typically invest in the sweet equity.

Warranties and indemnities Legal confirmation given by the seller, regarding matters such as tax or contingent liabilities, to assure the buyer that any undisclosed liabilities that subsequently come to light will be settled by the seller.

27 Corporate Finance contacts

To find out more about management buy-outs or for information on other corporate finance services please contact any of the following or e-mail [email protected]

South Bristol Andrew Hillman +44 (0) 117 984 2850 [email protected] Cardiff Colin John +44 (0) 29 2026 4530 [email protected] Crawley Darren Boocock +44 (0) 1293 761 382 [email protected] London Mark Pacitti +44 (0) 20 7303 5871 [email protected] Reading Ian Barton +44 (0) 118 322 2486 [email protected] Southampton Charles Whelan +44 (0) 23 8035 4202 [email protected]

Midlands Birmingham Richard Swann +44 (0) 121 695 5994 [email protected] Cambridge Stephen Fenby +44 (0) 1223 259 476 [email protected] Nottingham David Jones +44 (0) 115 936 3710 [email protected]

North Leeds Stuart Counsell +44 (0) 113 292 1202 [email protected] Manchester Maghsoud Einollahi +44 (0) 161 455 6345 [email protected] Newcastle Paul Kaiser +44 (0) 191 202 5320 [email protected]

Scotland/Northern Ireland Belfast Tom Keenan +44 (0) 28 9053 1147 [email protected] Edinburgh Cahal Dowds +44 (0) 131 535 7343 [email protected] Glasgow Ian Steele +44 (0) 141 314 5830 [email protected]

Audit.Tax.Consulting.Corporate Finance. Americas New York Alan Alpert (Transaction Services) +1 (212) 436 3469 Greg Smith (Advisory Services) +1 (212) 436 4815

Europe London Andrew Curwen (Transaction Services) +44 (0) 20 7007 2941 Chris Ward (Advisory) +44 (0) 20 7303 6472

Asia Pacific Hong Kong Lawrence Chia +852 2852 1094

For further information, visit our website at www.deloitte.co.uk

In this publication references to Deloitte are references to Deloitte & Touche LLP. Deloitte & Touche LLP is a member firm of Deloitte Touche Tohmatsu.

Deloitte Touche Tohmatsu is a Swiss Verein (association), and, as such, neither Deloitte Touche Tohmatsu nor any of its member firms has any liability for each other’s acts or omissions. Each member firm is a separate and independent legal entity operating under the names “Deloitte”, “Deloitte Touche Tohmatsu”, or other, related names. The services described herein are provided by the member firms and not by the Deloitte Touche Tohmatsu Verein.

Deloitte & Touche LLP is authorised and regulated by the Financial Services Authority.

This publication has been written in general terms and therefore cannot be relied on to cover specific situations; application of the principles set out will depend upon the particular circumstances involved and we recommend that you obtain professional advice before acting or refraining from acting on any of the contents of this publication.

Deloitte & Touche LLP would be pleased to advise readers on how to apply the principles set out in this publication to their specific circumstances. Deloitte & Touche LLP accepts no duty of care or liability for any loss occasioned to any person acting or refraining from action as a result of any material in this publication.

© Deloitte & Touche LLP 2004. All rights reserved.

Deloitte & Touche LLP is a limited liability partnership registered in England and Wales with registered number OC303675. A list of members’ names is available for inspection at Stonecutter Court, 1 Stonecutter Street, London EC4A 4TR, United Kingdom, the firm’s principal place of business and registered office. Tel: +44 (0) 20 7936 3000. Fax: +44 (0) 20 7583 1198. Member of Designed and produced by The Creative Studio at Deloitte, London. 9455B Deloitte Touche Tohmatsu