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Executive Summaries Apr 29, 2019

How Will Selling Your Company To Your Managers Influence the Transaction?

Many business owners who, in the short or medium term, intend to sell their company, will consider doing so to the company's management team; one of the reasons being their extensive knowledge of the business. 

The management buy-out, or MBO, is a transaction with its own set of challenges. An MBO differs from a sale to a third party in a number of ways; this may relate to how the transaction will be financed, the dynamics of employer-employee negotiations, the schedule, or the representations and warranties given by the seller. 

Therefore, to maintain an overall view of the sale of their company, a business owner must bear in mind certain elements, including the following:

  • The financial aspects 
  • The employer-employee relationship 
  • The timeline 
  • Risk cut-off

The Financial Aspects

Financing plays a key role in an MBO. Employees who purchase a business often have limited financial capacity and must rely on financing from financial institutions, partners or the selling owner.

An MBO transaction therefore often includes a balance of sale payable to the selling owner over a period of time. The vendor is then essentially paid with the profits generated by the company following the sale: as a result, the balance of the sale price is at risk if the company's profitability decreases. In these circumstances, the selling owner may wish to remain actively involved in the company following the sale, not only to ensure a successful transition for the managers, but also to protect their own financial interests.

As in all cases where there is a balance of sale, the vendor must be provided with a guarantee for the balance of the sale price, namely in the form of a security on the assets or shares. However, due to the financing in place, the vendor must bear in mind that any guarantee on the balance of sale will be subordinated to any guarantees given to financial institutions. This means that the seller will not receive their balance of sale if the company defaults on its obligations to financial institutions, regardless of previous agreements between the buyer and the seller.

The Employer-Employee Relationship

The dynamics of the negotiation are always a determining factor in a successful transaction, but even more so in the context of an MBO. If the buyer wishes to rely on the seller for a smooth post-closing transaction, then maintaining transparent and courteous communications between the seller and the buyer becomes essential. This is especially relevant if, for whatever reason, the transaction were to fail, as the selling owner could be at risk of losing their management team if the parties fail to maintain a good relationship throughout the negotiations. In fact, the more advanced the transition between selling owner and manager, the more important it is to sustain a good relationship, as the blow will be even greater if the manager decides to leave following the failure of the transaction.

Moreover, if the vendor must be involved in the company's business following the transaction, whether to ensure the transition of responsibility or to protect their own financial interests, it is important to properly manage their role and responsibilities to avoid potential misunderstandings and conflicts.

The Timeline

An MBO essentially consists of three transactions in one: the financing, the sale, and the agreement that manages the post-closing partnership, with both the seller and with the other members of the management team. These three transactions must be coordinated to ensure they are carried out simultaneously. In doing so, this can have a significant impact on the timing of the transaction.

Particularly in the context of an MBO, it is in the seller's interest to actively follow-up on the buyer's financing status, as this is often what will cause additional delays in the transaction or prevent the transaction from taking place. Occasionally, it even occurs that the selling owner is more involved in researching and securing financing.

The scope of the due diligence performed by a purchasing manager can have a positive impact on the timeline. If the transition of operations in favour of the buying manager has been initiated before the transaction, this can sometimes mean that the manager has a better knowledge of the company than the selling owner and that their due diligence is therefore very limited. However, if the manager is receiving financial support from an institution or financial partner, they may wish to expand their due diligence, much like a third party would do in the same circumstances. The trust between employer and employee also influences the scope of the due diligence conducted by the manager. For example, if the employee knows that their employer is a shrewd negotiator, their tax and financial audit of the company will undoubtedly be more thorough.

Another important element to consider is the degree of involvement of the vendor when selling their business. This factor is amplified in an MBO transaction, because not only must the vendor be actively involved in the sale process, so must the buying management team, while still ensuring the continuity of the company's daily business.

Risk Cut-Off

Lastly, the impact of the vendor's representations and warranties of the company is pivotal when negotiating an MBO transaction. The representations and warranties are essentially an image of the business and relate to several topics, including the environment, buildings, employees, finance and taxation. If any of the representations and warranties were found to be false or inaccurate, the buyer would have the option of claiming compensation from the seller for damages.[1]

The selling owner may often wish to limit the extent of the representations and warranties they give regarding the business, as the buying manager often knows the business very well (if not better). On the other hand, the buyer will consider that since it was the vendor who benefited from the company's profits during the period prior to the sale, the vendor must therefore bear the risks related to the company's past. This argument is all the more valid if the buying employee pays for the company at its full value: in addition to paying the full price, they will not want to bear the risks relating to past transactions. One possible solution would be to simply stipulate that the seller will bear responsibility for the past, and the buyer for the future.

The financial aspects, the employer-employee relationship, the schedule and risk cut-off are some of the elements that every business owner must keep in mind for a clear overview of their transaction. These considerations will provide guidelines for transferring their business to their managers.

To learn more about the ins and outs of an MBO, contact Nathalie Gagnon and Geneviève Martin

 

[1] Subject to certain restrictions in the sales agreement.

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