Vendor Funded Management Buyout: a useful business exit strategy

What is a Vendor Funded Management Buyout?

A vendor funded management buyout is a type of management buyout (MBO) in which the vendor provides financing to facilitate the buyout of the company by its existing management team. Vendor finance is often used where the vendor and management team have difficulty raising some or all of the third party borrowing to fund the purchase price. The transaction allows the vendor to secure an exit and the favourable tax treatment for a share sale while allowing the current management team to take ownership of the business with a large part of the consideration being paid on deferred terms.

How does it work?

Management Team

As part of its succession planning, the vendor needs to approach the existing management team of the company to gauge their appetite for taking on the responsibility and financial risk of becoming business owners. The vendor would normally work with their accountants and/or corporate finance advisers to explore their opportunities for an exit. This will help the vendor to determine what a fair price will be for the business, which is most commonly based on a multiple of profit plus surplus cash.

Financing by the Vendor

The management team would normally set up a new company to purchase the shares in the target. The surplus cash element of the purchase price is loaned by the target company to the purchaser and paid out on completion. The loan from the target to the purchaser is then cancelled by way of dividend from the target to the purchaser after completion.  This enables the vendor to get the surplus cash out as a capital payment which would normally be subject to lower tax than a pre-completion dividend. The purchaser is not disadvantaged by this structure because the post completion intra company dividend is not subject to tax.

The multiple of profit element of the purchase price is usually paid over a period of time after completion. For example, if the purchase price was based on a four times multiple of profits, then it may be paid over five years. This means that the purchase price is effectively funded through the profits of the target.

These deferred payments may be structured as loan notes as part of the tax planning for the vendor. This enables the vendor to roll over their capital gain on the sale of their shares into the loan notes. However, that may not be appropriate if and to the extent the vendor is claiming business asset disposal relief.

Negotiation

As the management team should have a good understanding of the operations of the business and its arrangements with customers and suppliers, you would not normally have the same level of due diligence or disclosure as you would have for a normal trade sale to a third party. Also, the vendor may be reluctant to expose themselves to significant liabilities for claims as they are already taking risk in the provision of finance and the management team may be taking relatively little risk themselves.

The vendor will want to have some security from the purchaser to ensure that it receives the purchase price. This might include personal guarantees from the management team and charges over the assets of the purchaser and target company. The vendor may also want step in rights in the event that the target company is not producing sufficient profits to pay the deferred consideration.

The vendor and management team will need to take independent legal advice on the transaction documentation including the share purchase agreement, security and associated ancillary documents.

Why choose a vendor-funded management buyout?

Benefits for the vendor

1. It allows the vendor to pass the company on to their management team with whom they may have nurtured a strong relationship over the years and can trust with the future of their business.
2. It allows the vendor to sell the business and any surplus cash in the business, which is effectively retained profits from prior years, and be taxed on this as a capital disposal rather than subject to income tax.
3. The vendor may be able to get some security over the assets, step-in rights and/personal guarantees from the management team for protection until it has been paid in full.

Benefits for the management team

1. The management team get the opportunity to become business owners with limited investment on their own part and without having to take out more onerous and expensive borrowing from a third party.
2. Provided the target company continues to make profits as forecast, the management team can fund the purchase price out of the profits going forwards and will become full owners without any related debt in due course and without the risk of starting a new business from scratch.

Risks for the vendor

The payment of the deferred consideration is sometimes subject to the company achieving financial performance targets. If these targets are not achieved, it is usually agreed that payments can be deferred until the financial performance targets are being met again.

Where the company is not performing to the required standard and repayments are not made on consecutive occasions, the vendors can have the right to step in and take control of the board. This will allow the vendors to work with the management team to improve performance and profitability so that the remaining deferred consideration can be paid.

How we can help you

Our team of lawyers can work with your accountants and advise you on how best to structure a vendor-funded management buyout for your company and ensure that appropriate vendor protections are put in place.

Call 01242 574244 or contact us to find out how we can help with the sale of your company.