Considerations in a Management Buy-Out – Part 2: Structure

As a follow up to our blog on “Striking a Balance” in a management buy-out (“MBO”), we concluded that structuring a deal is critical to its success. At WCP, we believe there is an art to deal structuring, so below we offer some high-level insights into three options/scenarios and caution that each deal is different, and that tax advice should always be sought.

Option #1: MBO – 100% Buy-In by Management Group

The Management Group buys into the Company with their personal funds based on the agreed upon price, terms, and conditions, by acquiring 100% of the common shares or assets of the business.

Considerations:

If the Management Group can only inject a percentage of the required equity, the transaction will require alternative sources of capital, which could include one, or a mixture of, the following:

• Bank financing – The Management Group would apply for a loan either personally or through a company set-up to purchase the business.
• Vendor financing/vendor take back (“VTB”) – The Exiting Owners may agree to finance the sale of the business by accepting deferred payments over a period of time. Like bank financing, interest/dividend payments in addition to the principal amounts outstanding can be structured. This form of financing is often used to bridge the financial gap between a buyer and seller in an acquisition and is often viewed as a favourable approach in an MBO. Should a VTB be required to complete the transaction, at least a fifth of the taxable capital gain must be reported in the year of the sale in addition to the four following years (total of 5 years).

Mechanics

• In this scenario, the Management Group typically incorporates a new Holding Company (“HoldCo”) to acquire the assets or the shares of the business.
• The Management Group injects their cash or equity contribution into a new HoldCo; the HoldCo then borrows the remaining funds/money to finance the transaction.
• Advances/dividends flow from the Company (“OpCo) to the HoldCo to fund loan payments; a dividend plan can address how and when funds are distributed to HoldCo (i.e., the profits of the OpCo can move to HoldCo to fund the debt).
• The combined entities (HoldCo + OpCo) need to ensure their bank covenants defined in their loan agreements are met per the terms set out.
• If there is more than one person buying OpCo, the Management Group should consider a shareholder’s agreement for the HoldCo in addition to a shareholder’s agreement for the Company
• If 100% of the shares are acquired, HoldCo & OpCo could be amalgamated.
• The Management Group should address personal tax planning opportunities.

Benefits/Shortfalls – 100% Buy-Out

Benefits	Shortfalls
Exiting Owners: May be able to benefit from their Lifetime Capital Gains Exemption (“LCGE”) should they meet the criteria Get the cash proceeds upfront (depending on the financing requirements)	Exiting Owners: May need to finance the transaction, while having no control over the day-to-day operations VTB amount is at risk until collected
Management Group: Potential to utilize the profits from the Company to fulfill the financing payments	Management Group: Need for bank financing (personal liability/guarantees) Minimal financing flexibility until debt is repaid If a HoldCo is incorporated, the interest deductions may be an issue due to the lack of revenue in HoldCo.

Option #2: MBO – Buy in Over a Period of Time

The Exiting Owners may decide to let the Management Group buy into the Company over a specified timeframe.
This option gives the Exiting Owners the flexibility to be involved in the business or not, receive partial proceeds from the sale of shares (allowing them to use the LCGE), and continue to receive their proportionate share of dividends.
Management would become minority shareholders, receiving their share of voting rights, and proportionate share of dividends.

Considerations:

Effectively this situation sees the Exiting Owners partnering with the Management Group and will require a new shareholders’ agreement that clearly lays out governance, valuation, the share purchase plan, and other key terms and conditions.
Payment terms of the shares over time can be structured in several ways, including:

• Fixed valuation (determined at a specific date) over a fixed or variable number of years
• Variable price (value is reassessed annually) over fixed or variable number of years

The buy-in can be carried out through the following options (not mutually exclusive):

• With cash (personally funded/financed)
• Without cash (i.e., reducing Management Group incentive plans) (1)
• Collectively the Management Group would strive to drive revenue growth or expense reductions to increase net income and their dividend pool.
• Any residual increase in the operating income would be taxed at the corporate tax rate which is effectively lower than dividend or employment income.
• Would need to be clearly articulated in Shareholders Agreement.

Benefits/Shortfalls Considerations– Buy-In Over a Period of Time

Benefits	Shortfalls
Exiting Owners: Maintain control Ongoing dividends May have access to the LCGE If variable price – potential for increased valuation/upside	Exiting Owners: Risk of not transferring the full ownership stake if Management Group changes their minds If variable price – potential for downward swing in valuation More complex ownership structure/decision making process
Management Group: Builds equity over time Proportionate share of dividends May improve the ability to finance the transaction Reduces risk of full ownership	Management Group: If the minority shareholders own less than 10.1%, they can not flow their dividends tax free to another corporation Value fluctuations Salary differential/$ given up may not fully cover buy-in (need to fund the differential personally)

Option #3: MBO – Corporate Share Freeze

Through a corporate share freeze, the Management Group can obtain an equity stake in the future growth of the business with only a nominal cost today (i.e., $1).
100% of the agreed fair market value of the company is frozen and re-classed as preferred shares. The agreed value of the shares is a debt to the Exiting Owners. The Exiting Owners may not want to give up control of the business until some of this debt is repaid. Therefore, some of the rights on the preferred shares could include:

• The exiting owners control the Company until the preferred shares are paid in full (setting up multiple classes of shares, i.e., issuing 100% voting shares, and non- voting common shares)
• Priority distribution relative to the common shares, meaning the Exiting Owners must receive a dividend, or payment, before any other shareholder can withdraw funds or take dividends from the business
• An ability to fix repayment terms

Mechanics

• The flow of funds will depend on the agreed terms of the preference shares; it is possible that no common share dividends are declared until the preferred shares are paid in full

Considerations:

• Clearly defining payment terms is important to guarantee full and timely payment.
• The cash flow generation of the business will be vital in determining the timeline to fully fund the preference shares.
• A partial freeze could also be an option if the owner wishes to participate in the upside of the business post transaction.

Benefits/Shortfalls Considerations– Corporate Share Freeze

Benefits	Shortfalls
Exiting Owners: Crystalizes value Maintain control until shares are paid in full Priority distribution Predictable income stream during redemption of the preference shares Potential LCGE use	Exiting Owners: Depending on transactions structure, may not be able to utilize LCGE – leading to proceeds being taxed at dividend rates Deferred payment Limited/no cash up front Payment stream is at risk if the business does not perform
Management Group: Obtains an equity position at a nominal amount Not “out of pocket”	Management Group: Minimal financial flexibility/upside until debt is repaid Does not “feel” like ownership – no equity in the game

Deal structuring is complex, and Owners should rely on trusted professionals for advice. One of Welch Capital Partners’ strengths is our relationship with Welch LLP, the 14th largest accounting firm in Canada, who have been successfully helping clients navigate these tax strategies for over 100 years. WCP and Welch LLP are adept at quarterbacking the right teams to help you address the people and legalities of getting a deal done, which we will discuss further in Part 3 of our MBO series on Roles & Responsibilities and Shareholder Agreements.