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MBO, LBO, Boot Strapping

Management Buyout (MBO)

A management buyout (MBO) is a transaction where a company’s management team purchases the assets and operations of the business they manage. A management buyout (MBO) is appealing to professional managers because of the greater potential rewards from being owners of the business rather than employees. MBOs are favored exit strategies for large corporations who wish to pursue the sale of divisions that are not part of their core business, or by private businesses where the owners wish to retire. The financing required for an MBO is often quite substantial, and is usually a combination of debt and equity that is derived from the buyers, financiers and sometimes the seller.

BREAKING DOWN ‘Management Buyout – MBO’

In a management buyout (MBO), a management team pools resources to acquire all or part of a business they manage. Funding usually comes from a mix of personal resources, private equity financiers, and seller financing. An MBO is different from a management buy-in (MBI), in which an external management team acquires a company and replaces the existing management team. It also differs from a leveraged management buyout (LMBO), where the buyers use the company assets as collateral to obtain debt financing. The advantage of an MBO over an LMBO is that the company’s debt load may be lower, giving it more financial flexibility.

An MBO’s advantage over an MBI is that as the existing managers are acquiring the business, they have a much better understanding of it and there is no learning curve involved, which would be the case if it were being run by a new set of managers. Management buyouts are conducted by management teams that want to get the financial reward for the future development of the company more directly than they would do as employees only.

However, there are several drawbacks to the MBO structure as well. While the management team can reap the rewards of ownership, they have to make the transition from being employees to owners, which requires a change in mindset from managerial to entrepreneurial. Not all managers may be successful in making this transition.

Also, the seller may not realize the best price for the asset sale in an MBO. If the existing management team is a serious bidder for the assets or operations being divested, the managers have a potential conflict of interest. That is, they could downplay or deliberately sabotage the future prospects of the assets that are for sale to buy them at a relatively low price.

Leveraged buyout (LBO)

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Diagram of the basic structure of a generic leveraged buyout transaction

leveraged buyout (LBO) is a financial transaction in which a company is purchased with a combination of equity and debt, such that the company’s cash flow is the collateral used to secure and repay the borrowed money. The use of debt, which has a lower cost of capital than equity, serves to reduce the overall cost of financing the acquisition. The cost of debt is lower because interest payments reduce corporate income tax liability, whereas dividend payments do not. This reduced cost of financing allows greater gains to accrue to the equity, and, as a result, the debt serves as a lever to increase the returns to the equity.

The term LBO is usually employed when a financial sponsor acquires a company. However, many corporate transactions are partially funded by bank debt, thus effectively also representing an LBO. LBOs can have many different forms such as management buyout (MBO), management buy-in (MBI), secondary buyout and tertiary buyout, among others, and can occur in growth situations, restructuring situations, and insolvencies. LBOs mostly occur in private companies, but can also be employed with public companies (in a so-called PtP transaction – Public to Private).

As financial sponsors increase their returns by employing a very high leverage (i.e., a high ratio of debt to equity), they have an incentive to employ as much debt as possible to finance an acquisition. This has, in many cases, led to situations in which companies were “over-leveraged”, meaning that they did not generate sufficient cash flows to service their debt, which in turn led to insolvency or to debt-to-equity swaps in which the equity owners lose control over the business to the lenders

Characteristics

LBOs have become attractive as they usually represent a win-win situation for the financial sponsor and the banks: the financial sponsor can increase the rate of returns on his equity by employing the leverage; banks can make substantially higher margins when supporting the financing of LBOs as compared to usual corporate lending, because the interest chargeable is that much higher. Banks can increase their likelihood of being repaid by obtaining collateral or security.

The amount of debt that banks are willing to provide to support an LBO varies greatly and depends, among other things, on:

  • The quality of the asset to be acquired (stability of cash flows, history, growth, prospects, hard assets, etc.)
  • The amount of equity supplied by the financial sponsor
  • The history and experience of the financial sponsor
  • The overall economic environment

Boot Strapping

Bootstrap is a situation in which an entrepreneur starts a company with little capital. An individual is said to be bootstrapping when he or she attempts to found and build a company from personal finances or from the operating revenues of the new company.

Compared to using venture capital, boot strapping can be beneficial, as the entrepreneur is able to maintain control over all decisions. On the downside, however, this form of financing may place unnecessary financial risk on the entrepreneur. Furthermore, boot strapping may not provide enough investment for the company to become successful at a reasonable rate.

BREAKING DOWN ‘Bootstrap’

The term boostrap itself originates from the phrase “pulling oneself up by one’s bootstraps,” and professionals who engage in bootstrapping are known as bootstrappers. These individuals typically rely on personal savings and the earliest instances of revenue to begin funding their own startup companies. This contrasts with other entrepreneurial actions, which may include contacting external investors and other business professionals to begin funding their operations. Studies show that more than 80% of new startup operations are funded through the founders’ personal finances. The recorded median in start-up capital is reported at approximately $10,000.

Pros & Cons of Bootstrapping 

Though not as quick in turning profits, bootstrapping is a steady way to begin compiling revenue and to support future investments by providing the business with a safety net for long-term cost management. Bootstrapping provides professionals with the peace of mind they need to focus on building relations with customers and other professionals.

Because the business does not have to rely on other sources of funding, initial business owners do not have to worry about diluting ownership between investors. Entrepreneurs do not need to issue equity, and they can focus debt on personal sources. Bootstrapping allows business owners to experiment with their brand more, as there is not as much pressure for them to get their product right the first time. With personal startup funds, they can experiment with focus groups until they are satisfied with the results of their venture.

However, this also increases the degree of risk for the starter, because they may need to micromanage their source of income as well as their business venture. When a startup is launched with the starter’s own funds, generating revenue is essential in order to keep the business afloat. A successful profit plan must be operational early, which can lead to growth models that weren’t part of the original plan. Additionally, without large amounts of money from outside investors, some startups might not be able to develop and expand as quickly as desired. For instance, a certain amount of revenue is essential for expanding the team and for adequate marketing. Milestone could take longer to reach. 

Another downside to bootstrapping could be a lack of credibility. Not having outside investors could hurt a company’s credibility in the beginning, because it could seem as though no investors were interested, even if that isn’t case. Being backed by well-respected investors can give potential customers the reassurance to buy in, which self-funding could potentially highlight a company’s lack of resources and experience. 

Examples of Successfully Bootstrapped Businesses 

One example of a successfully bootstrapped business is Electronic Data Systems. Ross Perot first started EDS, an information technology equipment and services company, in 1962 with $1,000 he saved up in personal funds from previous employment arrangements. Through persistence and careful networking, he turned his small startup operation into a multi-billion-dollar company. 

Another example of a successfully bootstrapped business is Spanx. Founded by Sara Blakely, Spanx was launched out of Atlanta with $5,000 of Blakley’s personal savings; she even wrote a patent application for the now-famous women’s undergarment and filed it herself to save on legal fees. Blakely still owns 100 percent of Spanx, which has an estimated $400 million in sales, and has never taken money from outside investors.

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