How do managers finance a management buyout?

The usual capital stack

Most management buyouts in the lower middle market are built from the same five layers. What varies is how big each one is, and that depends on the business's cash flow, the price and, above all, the seller.

The senior loan is set by what the business earns, not by the price. Where a business lands inside the 2x to 3.5x range depends on the steadiness of its earnings, its customer spread and how much it must reinvest; how much debt a business can carry walks through the tests. A company large enough for this kind of buyout has usually outgrown SBA lending, whose 7(a) loans go up to $5 million, so the senior loan comes from a bank or a credit fund. Everything above it has to come from somewhere, and the managers are usually the smallest source. Financing an acquisition without a private equity sponsor covers the wider version of the same problem.

Two worked stacks

The same business financed two ways, in plain numbers. It earns EBITDA of 3,000 and the agreed price is 12,000. In the first stack the seller carries most of the gap and a small partner fills the rest, so the managers keep control. In the second an equity partner leads, and some lenders will go further on senior debt for a buyer with an institutional partner behind it; both senior loans sit inside the 2x to 3.5x range.

In the first stack the seller, through its note and rollover, is the second-largest source after the senior lender, and the managers' cash is the smallest line. The seller's note is also debt the business must service once the senior lender allows it, so the lender will test coverage with the note's payments included and will want the note's terms settled before it commits. In the second stack the managers put in the same cash but own far less of the company: the partner's 2,400 buys control, and the managers' upside comes mainly through incentive equity. The difference between the two columns is almost entirely the seller's willingness to wait for part of the price.

How lenders underwrite managers who have never owned the business

Lenders financing a first-time buyer usually worry about whether the buyer can run the business. In an MBO that question is half answered: the managers already do. What lenders test instead is whether the business runs without the seller, and whether the managers can do the jobs the seller did.

• Inside track record. How long each manager has run what part of the business, with profit-and-loss responsibility where possible, and a resume for each.
• Where the relationships sit. If the largest customers, the banking relationship or the key suppliers deal with the seller personally, the lender wants a plan to move them before closing.
• Depth behind the new owners. The operations executive who becomes chief executive leaves a job behind. Lenders ask who fills it.
• The team's own arrangement. With several managers buying together, who leads, who decides, and what happens if one leaves. A shareholders' agreement answers this before the lender asks.
• Personal commitment. Lenders judge the managers' cash against what they have, not against the price. A manager putting in most of their savings is more committed than a wealthier buyer putting in more.
• Guarantees. These vary. Lenders to sponsor-backed buyouts rarely ask for them; lenders to a company owned by its managers without an institutional partner sometimes ask for a limited guarantee. See personal guarantees on business loans.

The managers' insider position also cuts the other way. They negotiated the price with the person they report to, and they prepared or oversaw the figures being lent against. Lenders lean on independent checks for that reason: a quality of earnings report from an outside firm, figures that tie to the tax returns, and a clear record of which add-backs the seller's own costs account for. An MBO file that invites those checks rather than resisting them moves through credit committee faster.

Why the seller's paper decides the deal

The arithmetic is simple. The senior lender stops where cash flow stops supporting more debt. The managers can add a little. Outside equity can close the rest, but it takes control and a return that the managers pay for with their own ownership. The seller is the only party that can fill a large gap without taking the company away from the people buying it.

Sellers who choose a management buyout often have reasons to carry that paper: a business they want to go on in the hands of people they trust, employees they want protected, a price they could not get from an outside buyer without offering financing, and the tax treatment an installment sale can bring. A seller note also tells the lender the seller believes the managers will pay it.

If the seller will not carry paper, most management buyouts need an outside equity partner, and the managers stop being the majority owners.

The terms matter as much as the amount. The senior lender will set subordination terms: when the note may be paid, what stops payment, and whether the seller can act on a default. Seller note terms in conventional deals covers what lenders usually accept, and subordination terms covers the agreement itself. Where buyer and seller disagree on what the business will earn, an earnout can bridge part of the gap, subordinated to the senior loan like the note. Rollover equity does something a note cannot: it keeps the seller invested in the upside, which lenders read as confidence.

When a capital partner comes in

When senior debt, seller paper and management cash still leave a gap, the managers need a partner. The usual candidates are an independent sponsor who raises equity deal by deal, a family office, an SBIC fund, or a mezzanine lender that sits behind the senior loan.

Each changes what the managers own. An equity partner will usually take a majority or a preferred return, often with incentive equity for the managers that grows if the business performs. Mezzanine leaves ownership largely with the managers but adds a costly layer of debt and sometimes warrants. The right choice depends on how large the gap is and how much control the managers are willing to give up. Where the seller's goal is to reward a broad group of employees, an ESOP may fit better; ESOP vs management buyout sets the two side by side.

Preparing the file

Managers have one advantage no outside buyer has: they know where the figures are. The seller still has to authorize sharing them with lenders, and that conversation should happen early. For a term loan, lenders will expect:

• The P&L and balance sheet, and a year-to-date P&L through last month-end
• The latest full year of figures for the company being bought, never an older year
• A debt schedule for the business, with copies of any notes being refinanced
• The signed letter of intent, showing the price, the seller's note and any rollover
• An AP aging, if the lender asks for one
• Each manager's resume, and a short narrative of how the business will run after the seller leaves

Once the documents are in, Midas Partners builds the full lender package — financing model, lender presentation, blind teaser and underwriting memo — in a day; built by hand, the same package takes at least a week. The model shows each stack side by side, so the managers and the seller can see how much seller paper each route needs before they settle the letter of intent. Senior bankers run every engagement, and lenders that fit see the blind teaser first: the managers approve each lender by name before it learns who the company is, which matters when the seller's customers and staff do not yet know a sale is under way. What lenders need to finance an acquisition covers the wider checklist.