MANAGEMENT BUY-OUTTHE WAY FORWARD FOR YOUR BUSINESS?

#HJspotlight

Content

Page 3 Introduction

Page 4 Authors

Page 5 Foreword

Page 6 The Welsh Buy-Out Market

Page 8 Taking Advantage and Competing Nationally

Page 10 Vista Retail Case Study

Page 11 Interview with Keith Brooks

Page 13 Legal Viewpoint on MBOs & Best Practice

Page 14 Key Steps to Undertaking an MBO

Page 16 Legal Viewpoint on MBOs & Best Practice

Page 17 Alternatives to MBOs

Page 19 Conclusion

Introduction

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Owner-managed businesses and the SME market are heralded as ‘the backbone

of the UK economy’. Ensuring those businesses thrive is fundamental to the success of Wales.

So what are the key drivers for business owners and how do they structure the long-term future of their business?

The all-important exit or transition strategies are a key part of the business journey, yet in 2009 and 2010 the number of businesses changing hands plummeted.

That same two-year period saw management buy-outs (MBOs) fall out of favour, with zero transactions in Wales.

As the appetite for MBOs returns, Hugh James has worked with PwC to explore why owners are once again looking in-house for the talent to take their businesses forward.

With additional commentary from respected business leader and MBO veteran, Keith Brooks, both Hugh James and PwC discuss the financial, legal and managerial considerations and ramifications of MBOs.

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Authors

Gerallt JonesPartner and Head of the Corporate & Banking Division, Hugh Jamesgerallt.jones@hughjames.com Gerallt advises on all aspectsof corporate work includingpublic and private mergers andacquisitions, equity and debtinvestments and joint ventures.

Marc DaviesAssistant Director - Corporate Finance, PwCmarc.p.davies@uk.PwC.com Marc advises businessesthroughout their lifecycle,from mergers and acquisitionsto business divestments,investments and strategic advice.

Leslie NicholsSenior Associate - Corporate Finance, PwCleslie.nichols@uk.PwC.com Leslie works in the PwC dealsteam, focusing on advisingbusinesses through mergersand acquisitions, disposals andprivate equity investment.

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Foreword

Data released by the Office for National Statistics supports the much-used claim that the SME

market and owner-managed businesses are ‘the backbone of the UK economy’.

While these 24.3 million people, working across 4.9 million small businesses have reportedly ‘kept the economic engine running’, how many of them would have retired by now but for the economic downturn?

The buy-out market took a sharp downturn after 2008 and it has remained consistently low since. We have recently been involved in a study with PwC to analyse the trends in the market over the past 8 years. The results of that survey are shown on page 7.

The reasons for the slowdown are varied. Our research shows that, while the difficult market conditions were a big factor, the decline in deal activity

could also be attributed to the lack of available funding and the reluctance of business owners to sell their business for what they considered to be a depressed price as compared with ‘pre-crisis’ valuations.

The last year has seen a much greater sense of optimism and people at all levels of the economy are looking to do business once again. We have seen a significant increase in deal activity, including trade sales and MBOs

We have been involved in numerous MBOs and other deals over the last 18 months, one of which is highlighted as a case study on page 12. We were delighted to assist the management team of Vista Retail Support to achieve their long-term business succession goals.

As we emerge from recession, there is a unique opportunity in the market. Many high quality companies that

have consolidated and grown during the last few years still remain in the hands of their original owners. Rather than concentrating on exit plans, such owners focused their attention on getting their business through the crisis.

With the economy picking up pace, and more funding options becoming available to potential purchasers, the time is once again right for business owners to develop succession plans and exit strategies to ensure the business is in the best position possible when an exit opportunity presents itself.

As legal advisers with significant experience of dealing with these matters, we are here to advise and guide you throughout the process.

Gerallt Jones

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The Welsh Buy-Out Market

The 33 deals completed across Wales in 2014 almost doubled the number compared with pre-

recession 2007. The market continues to be dominated by business sales, with the 28 transactions in 2014 accounting for 85% of all activity.

We see a number of reasons for this increase in deals, most notably the availability of funding and the renewed appetite for investment from banks and institutional investors driving a rise in the number of buy-out transactions in Wales.

The economy of Wales is private business driven, with many owner-managed businesses. We believe this up-turn in activity is also driven by a number of private business owners recognising that the economy has

The deals market in Wales during the last eight years has largely remained subdued until last year when the market returned with something of a bang.

started to recover and seeking to realise the value from their business and the hard work that has gone into developing it.

Exit multiples, which have remained low since 2008, are now more attractive as the desire and willingness to pay for quality assets has returned. The average deal value exceeded £30m for the first time in 2014.

There were six buy-outs during 2014, double the number of the previous year and the first year in the period to match pre-crisis volumes.

Our experience, borne out by the figures displayed here, indicates that there was a real appetite to fund from financial institutions throughout 2014.

Average deal size in 2014

£39m

Deals completed across

Wales in 2014

33

*Deal data looks at transactions with an enterprise value above £3m, and excludes real estate transactions.

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throughout the whole of 2009 and 2010, and only one deal in 2011. While Wales is a unique marketplace with its own quirks and nuances, it is clearly not immune to the wider forces at play in the UK and global economy.

The number of buy-outs as a percentage of total activity in Wales remains low at just 21% of all deals in 2014. This is compared to 43% in 2013 and 55% in 2007.

Trade buyers continue to entice business owners. In 2014 they were the big payers with an average deal size of £39m dwarfing the £11m average paid as part of a buy-out. This is in contrast to 2007 and 2008 when buy-outs were the larger deals on average. As buy-out activity increases we would expect to see the differential between the average values for trade and buy-outs begin to close, akin to what was seen in 2013 when the mix of trade and buy-out deals was broadly even.

This increase in the availability of funding allowed for more compelling offers from private equity investors and business owners were more inclined to consider and act.

Contrast that performance with 2009 and 2010 and the difference is stark. In the period post credit-crisis and the notable collapse of Lehman Brothers in September 2008, the effects on the Welsh economy were clear to see. There was no buy-out activity

There is clearly cause for optimism in this return of buy-out activity, especially alongside the upturn in trade sales. There remained a number of uncertainties facing the deals market, most notably the general election in May 2015, however we believe that businesses in Wales should seek the opportunities that come with increases in funding and desire for acquisition from institutional investors.

Deals in Wales with £3m+ EV 2007-2014

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Average Deal Size in £m

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Deal Activity by Buy-Out vs Non-Buy-Out

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Non-buy-out Buy-outs

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Taking Advantage and Competing Nationally

The net figure (i.e. number of births in excess of deaths) shows that 2013 saw a

significant rise in the number of business in Wales, with a net gain of 3,000 enterprises, equivalent to 3.4% growth on the 2012 figure of 88,000. It is fair to expect that the more businesses there are, the more deals there will be, and in turn more buy-outs.

Whilst these figures are positive, in 2013 England and Scotland posted enterprise gains of 4.9% and 4.4% respectively. The result of this is that Wales is still lagging behind, which is consistent with the number of private equity backed business in Wales compared to the rest of the UK. Wales presents an under-utilised opportunity for private equity with many quality businesses ripe for investment.

We can gauge the relative health of the business market in Wales over the period by looking at the number of enterprise formations and dissolutions. The latest available data is for 2013.

In trying to identify why there is a relative lack of buy-outs in Wales compared with the rest of the UK we have examined the age profile of company directors. The average age of a director in Wales is 56.5 years, the youngest of any country in the United Kingdom.

This compares with 57.5 years in Scotland and 58.5 years in Northern Ireland. There are many backable management teams who are hungry and keen for the chance to drive forward businesses and would be ideal candidates for the buy-out journey.

With the right business partner, there is real scope for success stories across all sectors, with many high quality businesses right across Wales.

Average age of a director in Wales

56.5

Average Age of Directors in 2014

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Wales has a unique market landscape and offers a different proposition from the rest of the UK.

Private equity should look to Wales for investment opportunities to take advantage of this management team hunger.

Over the period, private equity fundraising has steadily increased since a sharp drop off during the economic crisis. Aggregate capital raised has risen each year since 2010, peaking at $536bn globally in 2014. With funds available, UK and international PE should be looking to Wales for the next investment.

Wales has a unique market landscape and offers a different proposition from the rest of the UK. Involvement from Welsh Government gives companies access to grant funding that can make a real difference to the success of the business.

There is significant public sector investment throughout Wales with a number of high profile initiatives such as the Cardiff Metro and the Swansea Tidal Lagoon. Private companies are set to benefit from these initiatives and an ambitious management team can really seize this opportunity to build and realise value.

Finance Wales also offer a different proposition for buy-outs, acting as a quasi-governmental private equity investor. For an investor willing to come to Wales, there is a real chance to change the market and be seen as a credible (and desired) alternative to Finance Wales.

Across technology, industrials, financial services, media, medical products and business services, Wales has many great companies that are ripe for investment. With wider market growth beginning to come through, now is the right time to acquire at the right price to maximise returns in the future.

Enterprise Demographics in Wales Private Equity Funds Raised

Company Formations

No. of FundsCompany Dissolutions

Aggregate Capital Raised

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-15

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The deal was complex, taking several months and completing in May 2014

In late 2013 the senior management team at Cardiff-based retail technology company Vista Retail

Support appointed both Hugh James and PwC to advise on a £12.3m secondary management buy-out deal. The transaction became the most profitable equity investment exit ever for Finance Wales.

Vista’s core business is a range of Electronic Point of Sale (EPoS) and support services including hardware support and maintenance, building, cabling and installing EPoS systems and contact centre management.

The £14m business was initially acquired by the team in a Finance Wales backed management buy-out in 2008. The secondary MBO saw a majority shareholding being acquired by the existing senior management,

led by managing director Vince Haffenden, technical services director James Pepper and sales and marketing director Richard Cottrell. In addition, existing chairman Keith Brooks continued in the role.

The MBO was led by WestBridge Capital, with support from Octopus Investments and Clydesdale Bank. The management team, with support from the investors, bought out the existing shareholders, including Finance Wales. The deal was complex, taking several months and completing in May 2014.

Vista Retail Case Study

Interview with Keith Brooks

What are the benefits of a Management Buy-Out?The MBO is a very attractive business concept for both the company and the management team. It provides management with the opportunity to have a significant equity stake in the business in which they are working and, if it is successful, they can share in that growth by making a capital gain. It can be a wonderful opportunity for a management team to make some real personal wealth of a significant kind.

What are the risks of a MBO?Like most things that are worthwhile, there are risks. For example, it will involve some financial investment by the manager. The proportion invested by the manager in terms of the whole deal would be small but investors want to see a real commitment to show that the management team are serious.

Typically it would include a year’s salary as an investment, which the manager might need to borrow, take out a loan or re-mortgage a house in order to obtain that loan. He also needs to be sure that the owner would be receptive to an approach about a sale. If he gets that wrong, the owner might be surprised, alarmed and actually think that the employee is being disloyal.

What are the key milestones?The first milestone is the sounding out: is there a deal to be done? Has the vendor expressed an interest in selling? Then getting an advisor on board very quickly can help you in terms of the valuation and the initial negotiations in drawing up the heads of terms. Once that has been achieved then the business plan is a crucial document.

Keith Brooks has been chair at Vista Retail since 2008 and was involved in the company’s latest MBO in 2014. He remains very optimistic about the future prospects for the business. He talked to us about his experience and thoughts on MBOs.

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From the investors’ perspective they will appoint lawyers and accountants to undertake very detailed due diligence and look at everything to do with the company to make sure they buy what they actually think are buying and there are no black holes. But the best milestone of all of course is the celebratory party once the deal has actually been concluded.

What is the role of the advisor?They are a crucial part of the whole exercise. A good advisor will manage and guide you right the way through. A range of advisors will provide guidance on valuation and on legal matters.

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Investors in such situations will go for as much as they can. It is important for the management team to know how to rebut that and how far we could push back. Gerallt was excellent in knowing just how far to go. For example, he helped us enormously with both the shareholders agreement and the warranties and indemnities.

What finance options are available?The financing can take different forms. Typically there is a gap between what the bank will provide and what you need to buy the business, and that is where you look for some other kind of private investment but with someone whose primary objective is the same as yours.

They will be focused on making a capital gain, so make sure you meet them face to face and ensure you can work with them.

Prospects for Vista following MBO?I am delighted to say this first year after the MBO has been successful. I think that with an improving economy in the United Kingdom, particularly in the retail sector, which is pretty important to us, the prospects for this team, the business and the investors are looking very healthy.

PwC were our lead advisors, undertaking a whole range of activities. Firstly, through their extensive business network, they helped us identify, shortlist and then select the institutional investors who made a substantial investment in Vista to facilitate the buy-out.Secondly, Marc Davies from their Cardiff office acted as ‘Ringmaster’ for the whole process; managing, directing and, where necessary, cajoling the various parties to keep them focussed and coordinated. That role was especially important when marshalling objectives and agendas that were not always synchronised.

In relation to legal work, this can be a minefield. At Vista we used Gerallt Jones of Hugh James; firstly to use his considerable hardnosed negotiating skills, which were enormously helpful to us, but just as importantly, to understand how far we could push it with the investors. He knew the minimum they might accept.

Legal Viewpoint on MBOs & Best Practice

Succession Planning

All business owners should have a comprehensive, formal succession plan that is tax efficient.

The sooner succession plans are put in place, the more successful they can be. Some say that a succession plan should be put in place when the business is started – that may be unrealistic in many cases, but any well established successful business should have a comprehensive exit strategy in place for its owner/managers, regardless of the age of the business or its owners.

MBO

Advantages The advantages for an MBO include: • Knowledge of the business - employees will know how the business works, the customers, suppliers and therefore making for a smoother transition.• Relevant qualifications and/or experience to take the business on.• Commitment - with their own livelihoods at stake, employees have a vested interest in the success of the business, which can be of comfort to an owner manager who has put everything into building the business and making it a success. • Relationship with employees - a management team or group of senior employees will already have a working relationship with the other employees, again aiding a smoother transition.

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Legal Viewpoint on MBOs & Best Practice

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Key Steps to Undertaking an MBO

ConsiderationsThere are several considerations which could mean that an MBO isn’t possible, e.g. if the owner-manager is a one-man-band and has no employees. Even if there are employees, there may be several stumbling blocks which mean an MBO isn’t the ideal option or just isn’t feasible. • Understanding the business - if the owner-manger is the only person involved with customers, suppliers, accounts etc – essentially, the owner IS the business, then the employees may not know enough about the business itself to be able to take it on.• Capability/desire - if staff are merely skilled at their own jobs then they may not have the capability or desire to take the business on.

The Sounding out Process

In order for MBO to be an option, the owner-manager would need to sound out the employees to gauge their interest (without raising their expectations too much), invest time in training the employees and sharing their knowledge on all main aspect of the business, introduce them to key customer and suppliers.

Structure

MBOs usually see the employees/management team form a new company, known as Newco, of which they will be shareholders. The Newco will then acquire the business of the outgoing business owner.

The parties need to consider whether a complete and immediate buy-out would be the best option for the owner and the business (and management), or whether the transition would be easier if the employees were to acquire the business in stages with the owner-manager retaining a share and continuing to participate in the profits until the deal is complete.

If that is the case and the owner-manager retains an element of control/ownership, it would be important for the parties to enter into a shareholders’ agreement to regulate their relationship and provide clarity for everyone involved.

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Availability of funds

In reality, the timing and structure of a deal is likely to be dictated by the terms of the funding available to the employees. Many business owners discount the option of an MBO as they are under the impression that the employees will not have sufficient funds.

Although it is likely that members of a buy-out team will be required to invest a sum of personal funds into the Newco in return for an equitable interest in the business, in most MBOs the vast majority of the consideration is provided by third party financial institutions, such as banks, venture capitalists and even the selling owner themselves by way of deferred consideration.

The sources of finance for an MBO are typically:• Banks - they obtain their return on investment by way of interest on the sum advanced. The availability of bank finance is therefore reliant on the ability of the business to service the future capital and interest repayments following the buy-out.• Private equity - funding from a private equity or venture capital investor, or an institution such as Finance Wales, will be conditional on their taking an equity stake, usually as a minority shareholder, in the Newco.

The investment returns on a private equity investment will comprise interest income on the funding provided and capital growth in the equity stake. Private equity providers make the majority of their money on the sale of their shareholding when

the Newco is sold, typically within a period of three to five years after the MBO. Consequently this type of finance is usually only available in support of those buy-outs where substantial capital growth and a relatively fast exit is anticipated.• Management equity - usually an amount which is meaningful, taking account of their own financial position and personal circumstances, and demonstrates their confidence and commitment in the business to third party funders.• Vendor deferred consideration - a selling business owner who wants the business to continue with the same personnel may need to accept that getting the full consideration at completion is not feasible. As such the business owner ought to be advised to consider accepting an element of deferred consideration. The form of this will depend on the cash flow and debt of the business.

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Next steps... After initial discussion with the employees to gauge their interest, it would be essential for any business owner (and the management team) considering an MBO to:

- engage professional advisers - agree terms and timescales, and set these out within an agreed Heads of Terms- undertake a due diligence exercise. This is the process by which buyers (in this case, the employee and their funders) investigate the financial and commercial activities of the business to ensure they are entering into the transaction with full knowledge of the facts.

The extent of the due diligence undertaken on an MBO will largely depend on how the transaction is being funded.

If there is no (or very limited) third party funding, the employees may be comfortable enough with the state and affairs of the business to proceed with only limited due diligence. However, if private equity funders are involved, the extent of the due diligence is likely to be more extensive and the same as a trade sale, which will inevitably have an impact on timescales.

The more parties are involved, the more time the transaction is likely to take. Therefore, it is important to deal with ‘skeletons in the cupboard’ (or in this case, the filing cabinet). If a business-owner is contemplating an exit by MBO, it is important for them to organise their affairs and ensure any legal or accounting issues have been dealt with expeditiously.

This will make the due diligence/ disclosure process easier when the time comes.

The normal transaction documents for an MBO would be:• Sale and Purchase Agreement (SPA) - the extent of the SPA (and the warranties and disclosure letter) would largely depend on the extent of the involvement of third party funders.• Shareholders’ Agreements/Articles - the management team (and any funders taking an equity stake) will enter into a shareholders’ agreement in relation to the Newco (purchasing vehicle) and if the owner-manger accepts deferred consideration or retains an interest in the business, he may also become a party to this agreement.

Legal Viewpoint on MBOs & Best Practice

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Family succession

Only 30 - 40% of owner-managed businesses make it to the second generation, with only 1 in 10 businesses surviving beyond the third generation.

Advantages• Many people feel they can only trust members of their own family with confidential business information; • There is an assumption that family members will work hard as they have an emotional and personal link to the business;• A family member may already be involved in the business and have the necessary skills and knowledge to take the business forward; and • Creating a recognised family brand can be beneficial to the business from a marketing and customer perspective.

Considerations When considering family succession, there are several potential issues:• Does the family member have the relevant operational knowledge to take the business forward?• Do they have sufficient business experience? Are they capable of running a business? • How will the employees feel about ‘the boss’s kid’ running the place (and potentially jumping over their heads)? This could be a very important consideration if the employees are one of the main assets of the business – will they jump ship? • Does the family member want to be involved in the business? They may wish to pursue a completely different career path. • When should the family succession process begin? Arguably, if this is the desired outcome, the family member should be integrated into the business while the founder is still active in the business and able to train and guide the successor. This is preferable to taking over when the founder retires (or dies).

Trade Sale

Advantages Exiting the business by way of a trade sale is often the best way to achieve a good financial return for the business, particularly if the business is successful and there are several competing buyers. It also gives the owner-manager a clean break and allows them to explore new opportunities or retire.

Considerations A trade sale is only feasible if there is a buyer who wants to take over the business. A business owner should therefore carefully consider the potential buyers and think creatively about creating demand if there is no obvious market (i.e. who would benefit from acquiring the business).

A trade sale will obviously be more fruitful if the business is in a strong saleable condition. It is important for owner-managers to ensure that there are no accounting, legal or tax issues which could cause a problem during the due diligence stage.

Another consideration will be the reaction of the employees to a third party purchaser taking over. This could be crucial if staff are a key asset of the business and there is a risk of them leaving, which would have an inevitable impact on the viability and value of the business.

The same goes for reaction of customers/clients.

Alternatives to MBOsAn MBO may be not suitable for every business, so what are the alternatives?

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Initial Public Offering (IPO)

IPOs were all the rage before the economic downturn. Many SMEs went through the process, but with the benefit of hindsight, have concluded it wasn’t the best option. It often proved expensive, negatively affected liquidity and many companies de-listed and became private again.

However, IPOs still have some advantages and can be a valid option for a business owner to include as part of their succession plan.

Advantages • Access to capital - listing on an investment exchange (stock market) brings with it the opportunity for the company to raise equity finance both at the time of the initial listing and in the future. The broader spread of participants in the company gives existing shareholders an opportunity to realise some or all of their investment in the company.

• Market for the company’s shares. A listing should make the company’s shares more marketable because there is a regulated and liquid market on which they are traded. This gives shareholders the chance to realise the value of all or some of their investment and provides an owner manager with an exit route. • Employees’ commitment - the public market in the shares may encourage employee participation in the ownership of the company through employee share ownership schemes, giving the shares a visible value and employees a liquid market on which to trade their shares. This should in turn help tie in key staff allowing an owner to leave the business in good time. • Profile raising - listing can improve the perception of a company’s financial stability and transparency. There may also be increased public awareness of the company through press coverage. This may help sustain demand for, and liquidity in the shares.

• The fact that a company has undergone the rigorous due diligence and other processes required to obtain a listing may help reassure customers and suppliers as to the company’s financial standing. The company’s position within its industry and among its competitors is enhanced and the perceived risk of default is lower. Considerations• Company suitability - an IPO will only be appropriate for certain companies.• Initial restriction on share disposal - there will be restrictions placed on management shareholders and key employees to stop them selling any or all of their shares for a period after the IPO, in order to help maintain confidence in the newly listed company, which may not be ideal for an owner forced to retire at short notice, e.g. due to ill health. • Value dependant on market - the value of a listed company will be dependant on the state of the stock market.

• Loss of privacy - the decisions of management will be in the spotlight and any failure or under performance may attract press coverage and have an impact on the share price.

Winding up/Liquidation If there are no family members or employees to take over, and there is no market for a third party purchaser (we can assume that an IPO would not be suitable for this business), then there may be no other option but to wind the company up. Although the liabilities of the business owner in relation to the business would end upon winding up/liquidation, the downside is that it brings an end to the business the owner has worked so hard to build.

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Alternatives to MBOs

Listing will improve the perception of a company’s financial stability and transparency

There are also cost implications of appointing a liquidator so this is very much considered as a last resort.

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Creating and running a business can be emotional, stressful, intellectually stimulating and financially rewarding. Business owners invest a great deal of time and energy, sometimes at a

cost to family life, to making their enterprise a success.

It is essential to plan for how all that investment will be realised and the future of the business secured. Early attention to succession planning is vitally important. It is essential not to leave it until the last minute, leaving the business vulnerable to innovations in its sector, market trends, poor health and even death.

What is more, having an exit strategy can be a powerful motivator in the business and can provide you, your senior team and your staff with a clear vision for growth.

Hugh James is here to advise you on planning and effecting a successful exit from your business, so that you can realise the value of your hard work and get on with enjoying your life, retirement or next business venture.

For further information, please contact 0808 2746863

Conclusion

The process of preparing a succession plan is a good way of getting everyone talking about what should happen in the future

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