12 June 2023

Family Buy-Out or Management Buy-Out

Pros and Cons of Different Succession Models

Written by Taro Niggemann

Family Buy-Out or Management Buy-Out

In the ever-changing business world of the 21st century, where companies must continuously adapt their strategies to remain competitive, a central question arisesfor family-owned and owner-led companies: who will take the helm when the current leadership retires? Succession is a crucial moment that can significantly influence a company's future growth and success. Two common models for medium-sized companiesare: the family buy-out and the management buy-out. But which is the right model for your business?

In this article, we will explore both succession models as well as their advantages and disadvantages. We explain how a family buy-out can preserve corporate culture and ensure continuity, while a management buy-out can introduce new perspectives and innovation. Our goal is to provide information and insights needed to make an informed decision about a company's future.

The Family Solution: Family Buy-Out as a Succession Model

The family buy-out (hereinafter also referred to as FBO) is a specific form of business succession within a family. There are several advantages that speak for the FBO as a succession model.

First, the FBO model ensures (as the name already suggests) that the company is continued by members of the family, thus achieving continuity in the company succession. In most cases, the family members involved in the transaction already know the business very well and arethus also familiar with the company's values and business model. As a result, they tend to be better able to continue the business based on this familiarity than, for example, an external successor. Another bonus is that a family succession structure preserves the "life's work" of the preceding generation and prevents it from falling into the hands of others.

Another important point is the long-term goals of the successor. If the successor comes from the same family, he or she will most likely have a long-term perspective and will not be primarily interested in maximizing the company's profits in the short term. It is precisely this perspective that can contribute to the sustainable, stable, and positive development of the company.

In families that choose the FBO model, there is also often a high degree of trust as well as cooperation, which favours faster decision-making and implementation of new strategies.

Designating a family member as successor also saves the time-consuming and usually cost-intensive search for an external successor. Flexible financing options are also available. Possible financing options include an inheritance advance (part or all of the inheritance is transferred to the descendants during their lifetime), a vendor loan with family conditions (lower interest payments or similar), or a regularshare purchase (in the case of FBOs, the transfer is typically conducted at a discount to market value), which in turn can also be financed by external loans.

However, the FBO model (like any model) also has its disadvantages.

These are primarily found in the fact that an FBO is not an option for many family businesses, where the potential successors have taken a different career path and therefore lack the expertise to successfully continue the business. And even if the generation has been involved in the business from an early age, there may be a lack of expertise or new perspectives, leaving new strategies and untapped potential for growth and improvement untapped. The old structure may then simply be carried on by the new generation in the same way as the previous generation set an example for them, making it difficult to innovate.

Choosing a successor within the family also brings an increased risk of potential conflicts. The interests of buying, selling, and uninvolved family members must be considered and balancedout. Loan financing of the purchase price can impose debt and additional risk on individual family members or the business itself (depending on how it is structured), which family and management must deal with.

An FBO is a good fit especially if the acquiring family members have already spent a lot of time in the company and accordingly have a high level of expertise. The desire to continue the business within the family can also be a good motivation for this type of succession model. However, the model makes less sense if the successor generation has little or no connection to the company, or if the monetary aspect plays an overriding role in the search for a successor. In this case, a sale of the company to external parties is potentially much more lucrative.

Family Buy-Out or Management Buy-Out

Sale to Management: the Management Buy-Out as an Alternative

Another succession model is the management buy-out (hereinafter also referred to as MBO), i.e., the purchase of the company by the (non-family) management team, typically in combination with external investors. The rationale for an MBO is often that owner-managed companies (e.g., family businesses) cannot find a successor. For the active management, the purchase bears the prospect of greater income as well as the assumption of entrepreneurial responsibility. In contrast to a management buy-in, where new, external managers buy into the company together with investors, in an MBO the leading participants are already in the management or on the board of the company.

The goal of such an MBO is the continuation of the company by the active management, which has several advantages. First, the management already knows the company very well, resulting in expertise in the respective industry as well as in the company itself. Also, the current management is already very familiar with the corporate culture and integrates the values of the company into their daily work routine. Depending on the size of the company, there are different financing options for the purchase of the company by management. In the case of small companies, the financing of the purchase price can be very flexible and in some cases be financed entirely by equity or loans. For large companies, the purchase usually takes the form of a leveraged buy-out, where a combination of external equity and debt capital is used.

However, there are also disadvantages with an MBO, such as a low valuation of the company. Compared to external interested parties, the active management has more comprehensive insights into the company, and thus tends to know more risks that can justify a lower valuation. In addition, there may also be a conflict of interest for management as they may downplay the value of company assets in order to acquire the company at a lower price.

It is also important to note that an MBO is not the right solution for every company. It depends on a variety of factors, including the size and type of company, the state of the sector, and the specific goals and capabilities of the management team. Therefore, careful review and planning with an M&A advisor is essential before deciding to go down the MBO route.

Finally, it is important to remember that an MBO is only as good as the people who execute it. Management must be able to handle the day-to-day demands of the business as well as manage the long-term strategic direction. It is therefore critical to have a strong and competent management team thatcan handle the additional challenges that an MBO brings.

Conclusion

The choice between a family buy-out and a management buy-out is an important one that needs to be carefully considered. Both models have their merits and challenges, and there are many factors to consider, including the company's culture, family situation, and financial position.

A family buy-out may be the ideal choice if there is a suitable family member willing and able to take over management and finance the purchase. This model can ensure the continuity of the business and maintain the family values and traditions that have shaped the company. However, it is important to remember that the family member in question must have the necessary knowledge and skills to successfully manage the business. In addition, it can be difficult to separate family relationships from business relationships, which can lead to conflicts.

On the other hand, a management buy-out can be a good option if management has the necessary expertise and financial resources. This model can bring in new ideas and perspectives and set the company on new growth paths. However, it also carries risks, as management now has the added responsibility of not only running the company, but also owning and financing it. This can lead to conflicts of interest and make corporate management more complex.

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