Management buyouts (or MBOs) have become increasingly more popular in recent years, with technology companies a highly represented industry, according to the research centre dedicated to tracking MBO trends, The Centre for Management Buy-out Research.
Studies identified that the number of MBO deals increased year on year, whilst the overall value of MBO transactions fell significantly. However, MBOs have surpassed traditional exits, in both quantity and value, for the first time since 2009.
The increase in MBO activity can often be attributed to more uncertain times; instability can negatively affect arm’s length deal making in the open market, allowing Private Equity (PE) firms the chance to capitalise on market disruption. The increase in MBO deals is also a great indicator of the variety of M&A funding options, as challenger banks entering the market allow for greater competition and, in turn, better access to transaction finance.
An MBO can offer sellers a great alternative to the traditional sale on the open market, instead selling the business to the management team, often using a combination of institutional finance and PE financing. Sometimes there’s also the added feel good factor that as a seller you are helping your management team carve out their future in the industry and become business owners themselves.
Trust is the most valuable thing you can give away
But can you be too trusting of your management team? A recent 2019 commercial court case (Vald Nielsen Holding A/S v Baldorino) has told the story of a seller in an MBO transaction who was defrauded by his management team. The main seller (Peter Johnsen and his family, as the shareholders of a holding company), relying on the information provided by the management team, sold his share of Updata Infrastructure UK Ltd (Target Co) for approximately £5 million. It was later found out that the management team had been deceitful in providing the financial overview and forecast information to Johnsen. Target Co was subsequently sold, less than 5 years after the MBO, for a total price of £80 million. The court found that the £5m MBO price that Johnsen received, had it been fairly represented, should have exceeded £15 million.
This case turns the age old situation of a buyer subsequently finding out the business they have bought is not as attractive as they were led to believe on its head, making it a unique example for us to focus on MBO transactions.
In looking at the facts of this case the court decided that the management team had provided false statements, figures and forecasts, which induced Johnsen to believe Target Co was in a financially worse position than was the case. This, in turn, led Johnsen to accept a lower MBO bid than what was fair.
There are many legal points at play in this case but the key point I want to focus on is the inherent trust between the sellers and the management in an MBO, which inevitably means the transaction does not proceed in a normal arm’s length manor. These are circumstances where an anti-embarrassment clause would have offered protection.
Anti-embarrassment or a second bite of the cherry?
An anti-embarrassment clause seeks to provide a seller with a claw back in the case that they sell their company at a low price, to subsequently find out that there is an onward sale of the company whereby the consideration greatly exceeds the price they received. The seller can then avoid the embarrassment of having “sold too soon”. Anti-embarrassment clauses need to be commercially negotiated; there is a fine balance to strike in fairly compensating a founder whilst not putting off the buyer. For example, where the management purchase a struggling business with a view to turning it around, an anti-embarrassment would not be appropriate as it would potentially allow the seller to then receive the benefit of someone else’s hard work. The balance needs to encourage the management team to be fair to the selling business owners.
In Vald Nielsen, Johnsen would have benefitted from such a clause; instead of a claim for deceit he would have had a simple contractual claim for additional consideration. Although hindsight is a wonderful thing, it does beg the question of whether MBO transactions should consider anti-embarrassment clauses early on in the discussion. If there is an inherent relationship of trust between the management and the sellers, then this should not be a difficult conversation, merely one that identifies early on that the sellers are establishing their management team as the next generation of business owners and they are not looking to be taken advantage of unfairly. Whether PE providers will accept such a clause is highly unlikely – their bargaining position and general approach to transactions would suggest they refuse such clauses where the effect would be to bind the PE provider from capitalising on all of its investment. However, an anti-embarrassment clause could be limited to only capture any uplift in the value of the Management teams’ share. This is just one potential option for the protection of sellers in an MBO deal.
What can we learn?
Vald Nielsen can help us open up the initial discussions involving management, sellers and any corporate finance advisors and consider whether anti-embarrassment clauses are appropriate. Sellers should be aware of the limitations of their knowledge in ascertaining whether they are receiving a fair deal, and managers will receive a timely reminder of the need to act with integrity during the MBO process, or risk a costly claim for deceit.