In the daily bustle of running a successful business, few business owners find the time to consider all the potential wealth creation strategies available to them.
The usual suspects, buy another business, buy real estate, or sell your business to Private Equity, are most often talked about, but selling part of your business to management is one of the most popular and least talked about alternatives.
The reason you don’t hear about management buying into businesses is that it’s seamless to the average customer and not many advisors specialize in this area.
The Ins and Outs of an MBI
“This is really a win-win for everyone,” observes Derek Strong, Vancouver-based Regional Director of Roynat Capital, a Scotiabank subsidiary that provides junior capital to mid-market companies. “It’s a popular option for small to mid-sized companies when a long-time owner is thinking about retaining key staff, wealth diversification and the long-term transition of their business.”
As opposed to a Management Buy-Out – when management buys majority interest in a company – a Management Buy-In (MBI) enables the company owner to sell a minority stake in the business to senior level employee(s) and retain control.
Through this potential multi-step process, the owner may later decide to sell the remaining shares to that management team or decide to sell externally, thereby increasing the value of their business and diversifying potential exit strategies.
As the owner, you are enabling senior employees who are very familiar with your business, and aligned with your objectives, to gain equity and possibly buy the whole business down the road. You’re creating a retention strategy for key staff and a succession plan for yourself, with continuity for your customers, employees, and preserving everything you’ve built. And, you’re driving new value into your business, since you’ve got committed, seasoned leadership with ownership to help the company grow.”
Owners turn company equity into wealth
The other, equal benefit of an MBI is the ability of the current business owner to begin converting their considerable equity stake in their company into tangible wealth outside of the business, which they can redirect to other investments to diversify the wealth, without selling the majority of their business.
“Often, owners are so focused on building their business that they have all their wealth tied up in the company and they haven’t prepared an exit strategy or retirement plan,” says Rodney Wendt, Regional Director, Private Banking for Scotia Wealth Management in Western Canada. “Owning a business brings many complexities to your life, so you need to think about how to get the wealth out of the business in a way that is tax efficient and reinvest it to support your retirement or other goals.
An MBI lets you ‘take chips off the table’ and move part of your wealth from your business into other asset classes, to diversify your risk.”
He adds that this approach satisfies many long-time owners on an emotional level. Instead of ‘flipping a switch’, selling the business outright and walking away with a cheque, the owner can stay involved in the business, help the new owner(s) assume leadership over time, and gradually transition into retirement.
Wendt emphasizes that a business owner should begin discussing their options with a wealth advisor as early as possible: “This might be the first time an owner is taking cash out of the business so it’s important to develop a long-term view and a financial plan to prepare for the next stage of your life. A wealth advisor can help you determine how to sustain your lifestyle through the rest of your life, including investment, taxation, and estate and trust considerations.”
Helping management acquire company equity
Quality advice is also essential to help the potential new buyers and owners prepare for an MBI, notes Strong, since management may be intimidated about asking the owner to sell part of their company or management may feel they don’t have the financial wherewithal to buy an ownership stake: “Often, we first hear from the owner who wants to initiate an MBI discussion with their senior staff , but the owner also isn’t sure how to go about offering it especially if managers don’t have the upfront capital to buy in.”
Fortunately, there are several options available to a owners and managers to execute an MBI. While a manager could pay all cash to purchase shares, or seek financing from the owner, these options has challenges for both parties. If the business is sizable, a manager won’t have the cash to buy the shares and the owner shouldn’t become the bank for the management team as it eliminates two of the benefits of an MBI, namely wealth diversification for the owner and committed management.
Fortunately, there are other options that will allow you to structure an MBI the right way. For example, a manager can approach an organization like Roynat to finance a portion of the purchase price with repayment of the loan coming from the management’s share of the earnings of the company they bought into.
The Roynat team can provide capital structuring advice and ultimately the capital to fill the financing gap between what the manager has to invest and what is needed to complete the MBI.”
If a manager has the net worth, they may be able to tap into the equity they have in their other assets, including their home, vacation property, investment portfolio or life insurance policy, to obtain a loan for all or part of the share purchase. Explains Wendt: “Using the assets you already have as collateral can be a flexible means to borrow and take advantage of the MBI. That way, you can invest in the business, and still continue to build equity in your real estate or grow your underlying investments, without liquidating them and triggering capital gains.”
Wendt notes that Scotia Wealth Management, and its Private Banking team, is unique in its ability to help clients tap into the equity they hold across many asset classes to create a single revolving credit facility.
Normally, someone would have to get a home equity line from their branch banker, a margin line of credit on their investments from their broker, and separate lines on their investment or recreation properties. Instead, we can pull it all together in one place under our Total Wealth Credit Solution,TM so clients can take advantage of that next opportunity.”
Advice to help a business gain value
To complete a successful MBI, Strong urges a business owner to first get the proper advice from their financial and wealth advisors, lawyers, accountants and management consultants: “it’s critical to talk to the right people early to start planning this gradual transition process and do it properly.”
A few other words of advice from Strong include: An owner needs to ensure that their management team truly wants to be owners, and that they possess the right desire, leadership and entrepreneurial ability to be successful. Although some of this judgement is subjective, telling your management team they must put their own capital in and borrow additional capital to buy shares quickly separates ‘the wheat from the chaff’.
Also, to manage the risks, an owner needs to put a proper shareholders’ agreement and tax strategies in place as part of an MBI to maximize their proceeds from a partial sale of shares and provide a fair agreement to all shareholders that allow the owner to exit management if it doesn’t work out and deal with other unexpected potential situations that arise in businesses.
In addition, for owners to drive the most value out of an MBI (employee retention, chips off the table, business growth), an owner should not make the mistake of gifting a small amount of shares to managers since it will not provide any of the positive outcomes of an MBI and it won’t be valued by the managers receiving it. Being given 0.5% of a $10 million-dollar private company won’t drive the right behaviour the same way a 30% stake would, nor does it accomplish the owner’s other goals as described above.
Strong recalls many MBIs that have helped drive impressive value into a company.
One owner told us that, instead of selling his company to a third-party someday, he’d rather reward his key manager who was very committed to the business. With a well-structured MBI in place, over the next five years, that manager paid off his initial loan, assumed a leadership role, and helped drive new earnings into the business doubling the business value. By the time the original owner was ready to exit completely from the business, the manager and the original owner together had created so much additional wealth that it was a win for both and also set a solid succession plan in place for the company and its future managers.
“Very often, owners care greatly about the wellbeing of their employees and that the company legacy continues,” sums up Wendt. “An MBI can help that owner walk away from their company with confidence that they’ve left a team in place to build the business. And together, Scotiabank’s Commercial Banking, Roynat Capital and Scotia Wealth Management are uniquely able to provide an integrated solution at each stage of a mid-size company’s lifecycle to achieve exactly that.”