Handing over the keys so that everybody wins

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This article appeared in the April 2010 issue of CRN magazine.

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Handing over the keys so that everybody wins

You have built a strong reseller business from scratch but now you feel you don't have the same energy anymore. It's time to move on and seek new pastures, perhaps retire. You can do a trade sale and have everyone coming in to kick the tyres. Or you can sell the business to your managers who have been with you for years and who know it inside out.

Alternatively, you are the company's managing director and reckon you have been doing a pretty good job running it for the past few years. But you have a sneaking suspicion you might not figure that highly in the owner's long-term plans and, in any case, you have always wanted to run your own business.

In both cases the best solution might be a management buyout (MBO). Done well, it can produce winners on all sides. For the owner of the business, the MBO can be a good succession planning tool. It's all about handing down ownership of the enterprise to a keen management team that already knows the ropes.

It is also preferable to a trade sale which although it can maximise the sales price can create all sorts of tensions. When your business is on the market, confidential information about strategy, profit and loss projections and cash flow forecasts must be released to interested parties, many of whom could include competitors who may or may not buy.

Furthermore, owners are more likely to discount the price a little rather than selling to a competitor. They might feel that people who have put many years into the business might deserve first bite of the cherry. If they can keep things in-house, and sell the business to people they trust, the price could be lower.

The first and most obvious thing to do is to establish whether there is a willing buyer or seller. This can be a delicate situation and needs to handled with care. There have been occasions where management has said it would like to buy out its division and the owners have said no.

Subsequently, management ended up leaving.

Similarly, there have been occasions where owners approached managers about a sale but the management said they weren't ready. However, the signal had gone out that the business was up for sale and management ended up leaving.

The second step is to establish whether a management buyout is viable. Most MBOs are backed by private equity firms and these are gaining frequency in Australia. Private equity firms however have very strict criteria for the investments they make. They also require a detailed business plan.

Furthermore, successful MBOs require a different mindset to traditional management because the investors and managers become the owners. For the managers, this can be a massive shift, and many might not be up to it. The MBO is the first time they will be flying solo without support of head office.

Second, managers of bought-out businesses have to be aware that private equity is not there forever. They need to ensure they have the business exit-ready within three to four years. What's more, they would need to do that with the pressures flowing from a highly leveraged balance sheet.

Third, they need to understand that cash really is king.

The quality of management however, remains critical because you are asking investors to back you as a team and a private equity firm to buy into the ability of management to add value.

This means all key positions need to be occupied by competent people. And it will be critical to look at the second tier of management so that investors know there is a succession plan.

The MBO will require an enormous amount of debt and the business will need to produce plenty of cash to service that debt.

What backers are looking for in a management team is commitment. As a result, they would expect the management to put up some of their own money and have some "skin in the game".

If the manager is prepared to take out a second mortgage, that might create a strong impression.

But private equity firms would not want the managers to have everything invested in the company as that would put too much pressure on them. What the investors are looking for is experience and expertise rather than cash.

Finally, it is important to remember that MBOs are time consuming. A typical MBO can take anywhere from three to six months to complete. Another problem is that management needs to have systems in place to ensure they don't get distracted in the process.

Most people only go through one MBO in their lifetime. That is why it is a good idea to talk to others who have completed a similar transaction to find out what might be needed. Appointing independent advisers is also important. The advisers will conduct feasibility studies, help prepare the business plans and negotiate the funding.

For all the parties concerned, the MBO is a life changing experience. Handled well, everyone will be a winner.

Next page: Many resellers leave it too late to consider a management buyout

Case study: Many resellers leave it too late to consider a management buyout in their succession plan

The management buyout has been neglected by resellers. That's a pity because the MBO is a critical tool for succession planning. Every succession plan needs to take into account a possible management buyout, even if that is many years down the track. The key is to start doing it early.

Peter Scolari, a director of accounting firm Scolari Comerford, says one of the reasons MBOs and succession planning are not big among resellers is because of the relative newness of the industry.

About 20 years ago, there would have been very few around.

This however, could be changing as more resellers start looking at retirement and as private equity looks around for more deals.

"A lot of the resellers might be starting to look at retirement now," Scolari says. "At the time, it was exciting and everything was happening at once so many of them felt this is not something they need to look at."

Based in Dubbo, Scolari Comerford has set itself up as an accounting firm with a difference.
It offers business consulting services including succession planning and has many IT companies, including resellers, as clients.

Scolari says that not treating the management buyout as a piece of succession planning is a big mistake. That's particularly true these days when there is a skills shortage and talented staff are hard to find and retain.

"A lot of business owners have not considered succession planning early enough for management buyouts. I think a lot of business owners are waiting far too long to consider succession planning as they believe it isn't required and they will deal with it when they either retire or when they would like to leave the business and assume that a trade sale will happen.

"This is a very dangerous strategy as businesses are often not worth as much as they thought, and hence fewer buyers. Or key personnel are leaving because they were unaware the offer would be on the table one day.

"When you have key personnel generally you try to keep them and usually a good way is having discussions as to whether they would like to buy in and have a succession plan, even if it is down the track.

"If you don't do this, not only are you at risk of losing them, they can set themselves up as competition and you are left with a business that you are having trouble selling."

An MBO is also preferable to a trade sale. "You could unnecessarily be putting information out there about your business when you could have kept it in-house with the management who would be looking to buy the business.

"As well as that, you have a greater chance of keeping your key personnel instead of having them go out and work for a competitor or set up on their own."

He says the key is to start planning early.

"If a business is formulating an exit strategy, succession planning will generally identify whether a management buyout is on the cards," Scolari says.

"Even if the buy out is not planned for a few years, by going through the succession planning process, this could alert the business owner to a potential strategy so that discussions are held before key personnel leave as they were unaware that the buyout may be offered.

"Succession planning gives [business owners] more focus to improve the value and the running of the business so that it is worth more at the time of sale."

The management itself needs to be ready to take over too, which means they need to start working early to get themselves up to scratch.

Scolari says: "The purchasers should have their business plan in place, including profit-and-loss and cash-flow projections well-prepared so they can go in with a realistic picture and whether some of the potential pitfalls can be addressed.

"During due diligence prior to the buyout, a business diagnostic or business health check should identify key drivers of the business including debtor days, supplier days, inventory days and whether these terms can be improved so that the business generates more cash flow.

"Of course, margins and overheads and whether the business is growing or in decline will also be reviewed when assessing the value and sustainable profitability moving forward.

"If the business is well set up, is less owner reliant, has systems in place, has less risk in these areas, this will be of less concern for the investors and managers. Again, improvement in these areas will be identified when looking at a succession plan which also includes valuing the business as it stands and how improving these areas before MBO time will make things smoother and less risky for the purchasers."

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