Funding a Management Buyout: Key Options for Sellers and Management Teams

Senior debt and bank lending

Traditional bank lending is one of the most common sources of MBO funding.
Its availability will often depend on the target company’s financial performance, the strength of the management team and the overall transaction structure.

A bank will primarily focus on whether the target business can generate sufficient cash to service the proposed debt. As part of its assessment, the bank will consider, among other things, the target company’s historical financial performance, future forecasts and the strength and experience of the management team that will run the business following completion.

The amount of equity being invested by management and any seller support arrangements, such as deferred consideration or loan notes, will also be relevant.
Senior debt is commonly structured through a term loan facility, providing a lump sum to fund part of the purchase price which is then repaid over an agreed period.

Depending on the requirements of the target business and its asset profile, the term loan facility may be complemented with a working capital and/or invoice discounting facility to enable the business to operate smoothly following completion.

Banking documentation and security

Once a funding structure has been agreed in principle, the bank will begin its formal credit process and issue a facility agreement. This will set out matters including the amount being lent, repayment terms, interest provisions, financial covenants and events of default.

The bank will also issue a list of conditions precedent, or CPs, which must be satisfied before the loan can be drawn down. These commonly include corporate approvals, constitutional documents and financial information.

Lenders will also almost always require a security package. This will typically include security over the target business’s assets by way of a debenture and may include guarantees from the target company or its officers.

In some circumstances, lenders may also require personal guarantees from members of the management team and a charge over their shares in Newco.

Where there are multiple funding providers or different consideration arrangements, intercreditor or subordination agreements may also be required to regulate repayment and enforcement rights and preserve the senior lender’s position.

Deferred consideration

Deferred consideration can significantly reduce the amount of funding required upfront by allowing part of the purchase price to be paid over time which can make an MBO more achievable for management. 

However, the sellers do not receive the full purchase price immediately and must rely on the business performing sufficiently well to fund future payments.

Where deferred consideration is secured, that security will usually be subordinated to the senior lender’s security.

Banking documentation may also restrict, delay or cap deferred payments until senior debt has been reduced to agreed levels.

Deferred consideration can take various forms, including deferred payments, loan notes or earn-outs.

Deferred payments

The most straightforward form is for part of the purchase price to be paid to sellers over an agreed period following completion.

Payments will typically follow an agreed schedule, although the share purchase agreement may include flexibility around payments to allow the business to continue trading effectively and avoid defaults under its banking arrangements.

Loan notes

Loan notes are commonly used where sellers are willing to leave part of the purchase price invested in the business for a period following completion.

They operate as a debt instrument issued by the buyer or target entity and typically specify the outstanding principal, a fixed or floating interest rate and repayment terms.

Repayment may involve a single payment on maturity or staged payments over an agreed period which is normally aligned with the business’s expected cash generation following completion.

Earn-outs

Earn-outs are another form of deferred consideration, particularly where there is uncertainty around future performance or significant differences between the parties’ views on valuation.

Under an earn-out, part of the purchase price only becomes payable if the business meets an agreed financial target or other condition.

Because payment depends on future performance, the share purchase agreement needs clear provisions covering how targets are calculated, the accounting policies to be used, timing and the mechanisms for making payments once the earn-out period ends.

Seller reinvestment

Rather than exiting completely, sellers may choose to retain an interest in the business through partial reinvestment.

Any reinvestment is assessed as part of the overall disposal proceeds for tax purposes and can therefore materially affect a seller’s tax position on completion and accordingly sellers should obtain independent tax advice at an early stage as this will have a crucial impact on the funding structure.

Reinvestment will typically involve the seller retaining a minority interest through ordinary or preference shares.

Ordinary shares

Ordinary shares generally carry voting rights and allow holders to participate in dividends and capital growth in proportion to their shareholding.

Ordinary shares can be attractive where sellers want to participate in future growth following the MBO, particularly as part of a phased exit and where they are comfortable sharing the management team’s risk and return profile.

Preference shares

Preference shares can provide an alternative where sellers want to retain an economic interest but do not necessarily require the same voting rights or level of ongoing involvement as management. 

Their rights can be tailored to the transaction. They are often structured as debt-like instruments with limited or no voting rights, but with different capital rights and a fixed preferential dividend.

Preference shares will also commonly have a fixed redemption price, with the timing and terms of redemption agreed in advance. Redemption may be linked to a future exit, refinancing, long-stop date or achievement of agreed performance milestones.

Compared with ordinary shares, they can provide a more predictable return profile, although sellers may not participate fully in an increase in the value of the business following completion of the MBO.