Senior executives at many lower middle market companies are sitting on a gold mine, they just don’t realize it. That gold mine is the company they work for. With the aging of the baby boomer generation, we are seeing an unprecedented number of privately held lower middle market companies being sold. These are often strong companies with long histories and solid earnings. The incumbent management teams at these companies should be the obvious buyers when owners get ready for retirement, but they are often left in the dark and aren’t given the opportunity to participate in the acquisition. Companies are more often being sold to strategic and financial buyers instead of management. When I speak with selling owners after a sale has been completed, they often indicate they didn’t sell to the management team because the team didn’t have enough money to make the acquisition. Likewise, when I speak with management teams, I find they never considered pursuing a buyout because they didn’t think they had the money to make the acquisition. I want to tell the owners and management teams they are missing a big opportunity – Waypoint Private Capital can help management teams acquire their companies and create significant wealth. I will show below how management can turn a $250,000 investment into $8.8 million.
As I write this article in February 2019, there is an abundance of capital available to fund good deals. Private equity firms are sitting on billions of dollars of capital they need to deploy, but they can’t find enough good deals in which to invest. Likewise, lenders are flush with cash and are aggressively trying to find solid operating companies that need loans. So, when management teams say they don’t have the money to make an acquisition, I must strongly disagree. Management teams need to look past their own savings and explore the outside capital available to them for a buyout.
The first step in the process is to find an advisor, such as Waypoint Private Capital, who can guide you through the entire process and help your team analyze and value the company, negotiate the offer, and raise the capital necessary to complete the management buyout. Make sure the advisor is an investment banker who is licensed with a broker dealer so they can legally raise the money for the team. They should have experience with management buyouts, M&A transactions, and equity and debt capital sourcing.
Once the advisor is selected, they will work with management to analyze the company, determine an appropriate valuation, and present an offer to the seller. In many cases, the seller is happy to be selling to the management team and the negotiations will be very cordial. Oftentimes, the seller will even pay the fees for the advisor. If the management team can negotiate a fair buyout price and structure, a letter of intent (LOI) to purchase the company should be signed by the management team and seller. It’s worth repeating that the terms of the acquisition must contain a fair buyout price and reasonable structure, because if the negotiated buyout price is too high or the structure is unfavorable, management won’t be able to find the capital necessary to complete the acquisition.
As soon as a fair deal has been negotiated and an LOI has been signed, it is time to arrange the financing. The team and their advisor should start by determining a capital structure that will allow them enough capital to complete the acquisition and fund any anticipated working capital needs. We recommend starting with senior debt and determining how much can be borrowed based on the cash flow and collateral of the company. We often see lenders willing to loan 3 times EBITDA for lower middle market company acquisitions.
Once the debt level is determined, the equity needed to complete the acquisition becomes clear. It is simply the purchase price minus the debt. For example, if the purchase price is 5 times EBITDA, and the appropriate amount of debt is 3 times EBITDA, the equity need will be 2 times EBITDA. To use real numbers, if annual EBITDA for the company is $4.0 million, the purchase price would be $20.0 million, debt financing for the acquisition would be $12.0 million, and the equity needed would be $8.0 million.
With the total equity need determined, management then needs to decide how much they can personally invest and how much they will need to raise from outside investors. Equity investors do not require that the management team invests a significant amount of money into the company being acquired, but they usually want it to be significant to the team. So, using the example above, if the management team could only invest $250,000, which is just over 3% of the equity needed, most private equity firms would find that an acceptable level if it represented a meaningful portion of the wealth of the management team. The investors simply want to know that management has enough skin in the game that it will be painful if they lose it, thereby ensuring they will fight hard to make the company successful.
One might ask how wealth can be created if management can only invest around 3% of the equity for the acquisition. Equity incentives, leverage, growth, and multiple expansion are the four factors leading to wealth creation in a management buyout. The combined effects of those four factors can lead to significant wealth creation for strong management teams.
Equity investors, especially private equity firms, want to give management teams incentives to profitably grow their companies, so they will often grant equity incentives to management teams ranging from 12% to 20% of the equity in the company. To earn that equity, the management teams needs to stay with their companies for the duration of the investment (typically 3 to 5 years) and achieve some predetermined revenue or EBITDA growth goals.
The second factor leading to wealth creation is the use of leverage to finance the acquisition. If management and their investors use debt financing for a portion of the purchase price the required equity investment is reduced. That debt will often be structured with an amortization (payback) period of five years that requires the company to use a portion of its cash flow to repay the debt. After five years, the company will be debt free. Every dollar of debt reduction causes an increase of one dollar of equity value, so just through the repayment of debt, management will have created 3 times EBITDA in additional equity value.
Growth is another factor leading to the creation of wealth in a management buyout. Most private equity investors will have a goal of at least doubling the size of the company while they own it. If the company doubles in size, its EBITDA should also double, leading to a doubling in the value of the company.
The final factor leading to wealth creation in a management buyout is multiple expansion. Buyers are willing to pay higher EBITDA multiples for companies with higher EBITDA levels. Therefore, companies that were purchased for a valuation of 5 times EBITDA and have significant growth in EBITDA will likely receive a valuation of 7 times EBITDA when they are sold by management. This is called multiple expansion, and it has a significant impact on wealth creation.
The table below captures the combination of all the value creating factors using the numbers from our original example. The table illustrates the impact of EBITDA doubling, the valuation multiple increasing, the paydown of the debt, and equity incentives (15% here). In this example, a small upfront investment of $250,000 could grow to over $8.8 million in just five years, increasing the wealth of the management team by almost $8.6 million.
So, management teams, if you sense the owner of the company you work for is nearing retirement, or just isn’t as engaged in the day-to-day operations of the company as he once was, you should give serious consideration to pursuing a management buyout. While everything above might seem a little overwhelming at first, an experienced advisor like Waypoint Private Capital can guide you through the process and put you on the path to creating wealth for your team and your families.