Most literature related to selling a mid-market business is usually focused on issues impacting either the buyer or the seller. But what about the management teams? Their concerns are often secodary, but could have a significant bearing on the outcome of a deal. Here are some issues related to the incumbent management team that need to be considered in any business sale to a private equity group.
In considering the roadmap for a sales process, the time required of management, over and above their day jobs, should not be underestimated. Sales processes are often stressful and exhausting. In the week after closing a transaction, managers often set their email to 'out-of-office’ and lie on a beach somewhere. The distraction to the management team of being drawn into a poorly run process will eventually affect the performance of the underlying business.
A seller should consider:
- concluding any significant business initiatives before commencing the sales process;
- 'seconding’ staff to the sales process to perform administrative tasks, and not leaving these to the CFO;
- setting up the data room properly from the outset, rather than supplementing the data room with documents in response to ad hoc requests during the process; and
- efficiently coordinating the Q&A process.
Management Conflicts of Interest
Dealing with conflicts of interest on the part of management is crucial. On the one hand, management’s attitude to a sale of the business will be influenced by personal factors, such as the identity of the buyer (PE? strategic buyer? competitor?), the buyer’s plans for the business, the employment terms on offer and their day-to-day autonomy after exit. Managers may understandably favor one potential buyer over another, regardless of their offer prices.
In a management buy-out (MBO), there is also the sensitive issue of who is in the management team, and who is not. Further, in any transaction a point is inevitably reached at which management switches allegiance from the seller to the buyer. In a MBO, management is a buyer — albeit indirectly.
On the other hand, managers owe fiduciary and contractual duties to the target company. Managers who are target company directors must act in the interests of the company and its shareholders, and avoid conflicts of interest. In a sales process, this means acting with a view to achieving the best outcome for the selling shareholders. The warranties in the purchase and sale agreement illustrate the conflict. As directors and employees, the managers must assist the seller in preparing disclosures which limit the warranties, while as buyers they may have the benefit of those warranties.
In addition, managers owe the target company employment duties, including:
- devoting their time and attention to running the business, rather than planning to buy the business;
- not disclosing or misusing confidential information, such as using business plans, forecasts or key commercial contracts to formulate a MBO; and
- having loyalty and fidelity — for example, we know of managers who were tempted to produce a different financial model for the seller than the one they produced to support a MBO.
A management-led buy-out is of course possible and in fact it may be desirable.
Management’s knowledge of the business means they have the best sense for its inherent value, and they may be prepared to pay the highest price. The sale process may not call for detailed due diligence, and the seller may avoid giving extensive warranties, with the buyer relying on warranties given by the management team instead. However, a business owner may react with hostility to a poorly presented management-initiated buy-out. Moreover, in a less ideal scenario, improper actions by managers could undermine the sale process, causing the seller undue harm and exposing individual managers to legal claims. Owners and managers should each be aware of their position and duties, and obtain legal advice. Particularly for a management-initiated MBO, the parties are well advised to put in place protocols that address these issues and that facilitate a controlled and fair process.
A feature of private equity investments is the opportunity for management to share in the risk and reward of the business as equity owners. PE firms reserve a significant minority stake in the portfolio company to incentivise management and to align managers’ interests with the PE owner. There is no set formula for the dollar amount that managers are expected to invest, other than it needs to be meaningful in the context of their personal situation, so that the loss of the investment would not be a painless experience.
Equity issued to management is founded upon a desire to reward a successful investment upon exit, while the structure and terms of that equity are driven by tax considerations.
Management equity may be in the form of 'sweat equity’, meaning equity acquired for fair value, and 'sweet equity’, meaning instruments in the form of options, performance rights, rights to be issued further shares or rights which have the effect of converting preference shares held by other investors into a lesser number of ordinary shares, designed in each case to divert more of the total equity proceeds on exit to management. Sweet equity is subject to hurdles before it is 'in the money’, which could be the financial performance of the investee company or, more likely, the internal rate of return (say 30%) of the investment achieved by, and a multiple (say 2.5 times) of the original invested amount returned to the PE fund. Managers should review these arrangements for clarity on how the IRR calculations are affected by refinancings, dividends, further equity issues and value returned to the PE fund through fees and partial sales.
A significant part of the PE fund investment into the target company may be made in the form of unsecured debt instruments such as loan notes. The component that is invested as equity may be preference shares. Management equity will be in the form of ordinary shares, subordinated to the preferred shares, meaning management will be last in line in the event of a winding up of the portfolio company.
Putting aside their complexity, management incentive schemes can be lucrative, but come with the risk of managers losing some or all of their 'sweat equity’. Although the alignment of management with the PE firm through common ownership is real, it will not escape managers that the PE firm’s investments are diversified across all portfolio companies owned by the fund, and probably across more than one fund. By contrast, managers are exposed solely to their own portfolio company, meaning the opportunity to earn significant wealth comes with a concentrated risk of loss.
Stockholders' (Shareholders’) Agreement
The stockholders’ agreement is one of the foundations for a prosperous relationship between new owners. It establishes the legal framework of that relationship — regulating the rights and restrictions of the parties in the way the company is run — significant decisions are made and shares are issued and sold. The shareholders’ agreement can also set down markers about matters such as the business plan and the timeframe to exit.
Like any legal document that supports a good relationship, it will hopefully be put in the bottom drawer. Much of business life involves dealing with the unexpected, though, such as a need for further capital or a CEO resigning, which makes the shareholders’ agreement an important tool to guide the parties to deal with the matter without delay and without deadlock, and move on.