Dr McDeal title Buy-out blues

My venture capitalist has talked to me about the potential of a secondary buy-out.What is it?

A secondary buy-out is a transaction whereby your initial private equity partner is replaced by new venture capital funding, with the incumbent management team remaining broadly similar in make up. With the current shut down in the IPO market and the difficulty in finding willing trade buyers who are prepared to make acquisitions at the present time, secondary buy-outs have become increasingly common over the last few years to the extent that they now account for over a quarter of all venture capital exits.

I don’t understand why my venture capitalist wants to explore a secondary buy-out.

Most private equity investors, having made an investment, are looking for that investment to be realised over a three to five year period. Unless a venture capitalist sees the potential to sell at a significantly higher price in a year or so, then the longer he or she holds the investment, the worse the rate of return. Also, many investments are made from funds which have a finite life span of between eight to ten years. As such, in order to close down these funds and realise returns to the original investors, venture capitalists are often potentially willing to enter into discussions with management on a secondary buy-out.

Are there likely to be any opportunities to increase my own equity stake going forward?

In a secondary buy-out, as well as replacing your existing venture capitalist, you can also look to re-leverage the business either with your existing bank or a new debt provider. This obviously gives the management team the potential to receive a larger amount of equity. A number of banks look on secondary buy-outs as less risky than an initial buy-out as they are lending money to a proven team who have worked with a debt funder since the original deal.

In certain instances, it has been possible for management teams to leverage up the deal completely so that no private equity funding is required, thereby giving management complete control of the business. This is potentially a route to consider, but will probably not be looked on particularly favourably by your current investor as it is unlikely that this will give them the greatest value for their existing stake.

I have been involved in a successful buy-out,my investor wants to sell and
my stake will be worth a tidy sum. How much will I need to re-invest?

There is no hard and fast answer to this, but obviously any new venture capitalist will want to ensure that you and the rest of the remaining management team are fully incentivised to make the secondary management buy-out even more successful than the initial one. As such, they will look for you to “roll over” a relatively significant proportion of your proceeds into the secondary buy-out. However, both you and your fellow management shareholders should be able to crystallise some gain at the point of the transaction. Typically this may involve a release of enough cash out in order to be able to repay any sort of major outstanding financial liabilities, such as your mortgage.

Is it possible for some members of the original buyout team to leave and for new members to replace them?

Absolutely. Injecting “new blood” into a successful management team is generally seen as a positive sign by an incoming venture capitalist as long as their skills are complementary to the incumbent team. However, you need to think carefully both about the type of person you want to join your team and also the amount of money that the new person has available to invest in a secondary buy-out. It does sometimes cause issues when newcomers join an existing management team as the newcomers will not have built up any equity value from the initial MBO. This can be solved in part by the existing management "rolling over" their stake into both ordinary equity and loan stock (thus giving them some security), as opposed to the newcomer who may only be able to invest in ordinary equity.

I am currently going through a secondary buy-out and am being asked to give warranties to my new funder.This doesn’t seem fair.

One of the major points for discussion in any sale process is the perennially thorny issue of warranties. This is potentially a major issue in all secondary buy-out situations as a result of the initial private equity funder not being willing to give any warranties. Any new funder will require certain warranties from the management team as vendors. This obviously has the potential to get somewhat nasty should issues arise after the investment, as the funder may need to sue their own management team - not a very tenable situation. These issues can be mitigated by using warranty insurance, but the costs and timing implications of this need to be fully considered at an early stage in the secondary buy-out process.

I have already been through a secondary buy-out and am now looking to exit.What can I do?

Tertiary or even quaternary buyouts are becoming increasingly prevalent across all deal sizes, so this route should not necessarily be viewed as a last resort. However, as in any secondary buy-out, you do have to consider the eventual exit route very carefully as any incoming venture capitalist will be keen to realise the investment via a trade sale or flotation. Therefore questions will inevitably be raised if no trade exit has been achieved a number of times.

My new funder also wants to put in place a draconian shareholder agreement that is similar to the one we signed for the initial buy-out. Is this right?

Although this might not seem fair as you have proved yourself as a management team already, any new funder will still require a detailed shareholder agreement setting out the rights and duties of all the investors (including yourself).

There is no way of avoiding this agreement, but you will need to get a commercial and pragmatic lawyer to work on your behalf to ensure that you get the maximum protection for your investment going forward.