Understanding corporate finance: raising finance: management buy-outs
A buy-out involves the purchase of a company. Where this involves the managers of a company buying the company they work for this may be described as a management buy-out.
Where a company is to be purchased, large sums of money may need to be raised. Mature companies may be able to raise this funding through the stock market but where the business is at the early stages of its development or too small to be launched on the stock market, the funds have to be raised through other means. Typically a new company is formed. Money comes into the new company, which buys the shares in the ‘target’ company.
A very small-scale buy-out might simply be financed by bank borrowings. If more substantial amounts of money are needed, the company might turn to venture capital funds.
Venture capital funds are often offshoots of financial institutions such as banks and insurance companies. They can be formed as companies or partnerships. They attract money from third party investors, then lend money on to businesses which might find it difficult to raise funds. This might be because the business is new, so has no track record, or the company might be carrying on a risky business.
Venture capitalists invest primarily by subscribing for shares in the new company but they may also lend money to the company or provide a mixture of both debt and equity finance.
The shares may be ordinary shares or more typically preference shares. Preference shares ensure that the venture capitalists get a priority call on the profits of the company in the form of dividends. They hope to get an ongoing reward for investing in the company.
If the company is successful, it may seek a listing on the stock exchange. The shares can then be traded, making it easier for the venture capitalists to sell.
Normally venture capitalists will not be looking to invest in the company for the long term, nor to control the company. The aim will be to realise or sell their investment when the time is right. This might be by selling the shares when the company is floated on the stock exchange or selling the shares on to another company. The original managers may choose to sell their shares at the same time. Assuming the company has increased in value large profits can be made at this point.
Where there is a large buy-out, the venture capitalists may be joined by the banks. At this level it is likely that the venture capitalists will invest by subscribing for shares, and the banks will provide the loans. Typically the banks will provide the senior debt which will be secured and be honoured first if there are problems, and there will be some form of mezzanine finance. If the buy-out is very large the loan may come in the form of a syndicated loan, where a bank or other financial institution might take the lead in getting together a group of lenders, or a syndicate. Each lender agrees to lend part of the overall loan going to the company.
In the case of a management buy-out, in addition to this funding going into the company the managers themselves may borrow to finance their own purchase of shares in the new company. The proportion of the shares the managers own will be small, but there may be arrangements which ensure that some of the shares will be passed to the managers if the company does well.