Managers want to buy out a company from its founder – how to structure and finance an MBO
A management buy-out has one weakness both sides discover late: the buyers know the business better than anyone, but they do not have the money. The whole deal therefore turns on how it is financed and on what happens if the company underperforms once the founder steps back. This article sets out how to structure it and what to avoid.
Key takeaways
Decision-making framework: who pays for the transaction
In a management buyout, the issue is not whether the price is right, but where the money will come from. In practice, there are four sources, and they are almost always combined.
The first is the management's own funds. This is usually the smallest part, but both the bank and the seller see it as proof that the buyer believes in their own plan.
The second is a bank loan. This relies on the company's ability to generate cash, and its amount therefore sets the ceiling for the entire transaction. The bank will want collateral, typically a pledge of the acquired share, and will impose conditions on profit distribution and further indebtedness. If the target company itself is to provide security with its assets, this constitutes financial assistance with a special regime, and this is a point to be discussed with the bank from the beginning, not on the day of signing.
The third is a deferred portion of the price paid to the seller from future profits, possibly linked to performance. This tool is the most valuable for the management because it shifts part of the risk back to the founder, and the most sensitive for the founder because their money depends on how someone else runs the company.
The fourth is the involvement of an investor, who provides the missing capital in exchange for a minority stake. The price for this is sharing control and usually an agreed-upon horizon for a future sale. An overview of the phases of the entire deal can be found in the article How to sell a company: the phases of a company sale from LOI to post-closing.
The decision on the mix of these sources will also determine the structure of the transaction. The larger the share of bank debt, the more often an acquisition vehicle is created, to which the bank lends and which buys the share.
Besides money, the second axis of decision-making is the division of roles within the management. Unequal contributions from individual managers lead to unequal shares, and this is something that must be resolved before the group presents an offer to the founder. The agreement also includes what happens if one of the buyers leaves after a year.
Step-by-step procedure
A management buyout has the first steps in reverse order compared to a standard sale. The buyer knows the company, so it doesn't start with due diligence, but with an agreement on the rules of the game.
The first step is a written agreement between the founder and the management that negotiations are taking place, who is participating, and what will happen if they fail. Without this, there is a risk that unsuccessful negotiations will turn into a personnel crisis, and the company will lose both its management and the buyer.
The second step is addressing the conflict of interest. The manager who is buying remains a statutory body and runs the company whose price they are negotiating. The law has its own procedure for this: the conflict is notified, not approved. Therefore, the documentation should include a written notification of the conflict of interest, a record of how the relevant body handled it, and rules for access to information. The general meeting's consent is a separate matter and relates to the transfer of the share, not the conflict of interest.
The third step is the valuation and its method. In a management buyout, the valuation is most often based on a multiple of operating profit adjusted for one-off items. It is essential to agree in advance on who proposes the adjustments and how disputes about them are resolved. The valuation and its pitfalls are also described in a book written by our firm's managing partner, available at knihaoprodejifirem.cz.
The fourth step is the financing model and negotiations with the bank. The bank assesses the company without the founder, so its first question will not be about the price, but about how much revenue is personally tied to them. The answer to this question determines the loan amount more than the accounting results.
The fifth step is the contractual documentation. The share purchase agreement, shareholders' agreement, pledge agreements, the agreement on the deferred part of the price, and the agreement on the founder's role after closing. This last one is often underestimated, yet it determines whether the business team will manage the transition.
The sixth step is the closing and transition. Handover of relationships with key customers, change of signing rights, transfer of bank authorisations, and notification to banks and major partners. We discuss the practical implementation of the transfer in the article How to transfer a share in a limited liability company step by step.
The seventh step is the post-closing period. The founder usually remains in an advisory role for a period of months to two years, and it is reasonable to link part of their remuneration to the handover of relationships, not just the passage of time.
The order of these steps cannot be reversed. Anyone who starts with the price and only then deals with financing usually negotiates the same thing twice, because the bank will not support the offered price.
What is standard in the market and what is a warning sign
It is standard for the price to be divided into a part payable at closing and a deferred part, linked to the results of subsequent periods. It is also standard for the founder to remain with the company for a transitional period, and to receive separate remuneration for this, distinct from the share price.
A non-compete clause for the founder for an agreed period and to a certain extent is also standard. The clause must specify what activity and to what extent the founder is not allowed to perform; the scope can be defined by territory or by a circle of customers. A clause for a period longer than five years is prohibited, and an unreasonably broad one can be limited by a court.
With bank financing, it is common for the bank to restrict profit distributions, further indebtedness, and the sale of significant assets during the repayment period. The extent of these restrictions is negotiated, not their existence.
There are three warning signs, and they all relate more to relationships than to numbers. The first is a situation where the management negotiates as a group without an internal agreement, because at the moment of signing, it turns out that everyone was expecting a different share and a different role. The second is a founder who wants to sell the company but not leave, which leads to dual leadership and decision-making paralysis.
The third sign is a deferred price without rules on how the company should be managed in the interim. A seller whose money depends on profit but has no influence on investments is almost certain to end up in a dispute. The solution is a set of restrictions for the repayment period, not good will. The article How to buy out a share in a company is also related to the buyout structure.
Where the legal line is drawn
A management buyout encounters three sets of rules, all of which can be addressed if they are considered in advance. Below is the regime for a limited liability company (s.r.o.), which is the most common case; for a joint-stock company (a.s.), the conditions are stricter and are mentioned separately.
The first set of rules concerns financial assistance. According to Section 41 of the Czech Business Corporations Act, this includes providing an advance, loan, credit, or security by a business corporation for the purpose of acquiring its shares. Therefore, pledging the target company's assets as collateral for an acquisition loan is not ordinary security, but financial assistance. At the same time, the rule from Section 40(3) applies, according to which a corporation must not provide a performance if it would thereby cause its own insolvency. The insolvency test is therefore the first, not the last, step.
The conditions for a limited liability company are set out in Section 200 of the Czech Business Corporations Act. Financial assistance can be provided if it is on fair terms, especially regarding interest and security for the benefit of the company, and if the executive director prepares a written report in which they substantively justify it, including the advantages and risks, and explain why it is not in conflict with the company's interest. The company files the report in the Collection of Deeds after the financial assistance is approved by the general meeting.
For a joint-stock company, the regime is stricter. According to Section 311 of the Czech Business Corporations Act, the articles of association must permit financial assistance, the statutory body must investigate the financial capacity of the recipient, the general meeting must approve it in advance by at least a two-thirds majority of the votes of the shareholders present, the equity must not be reduced below the subscribed registered capital increased by non-distributable funds, and the company must create a special reserve fund.
The second set of rules is the conflict of interest of the buying manager. According to Section 54 of the Czech Business Corporations Act, a member of an elected body shall inform the body of which they are a member, and the supervisory body, or otherwise the supreme body, of a possible conflict of interest without undue delay. The supervisory or supreme body may then suspend their function for a specified period. The law therefore does not require the conflict of interest to be approved by anyone, but for it to be notified and recorded.
The third set of rules is the transfer of the share itself. According to Section 207, any shareholder may transfer a share to another shareholder, whereby the memorandum of association may make the transfer conditional on the consent of a company body. According to Section 208 of the Czech Business Corporations Act, a transfer to a person who is not a shareholder requires the consent of the general meeting, unless the memorandum of association provides otherwise, and the transfer agreement does not become effective until such consent is granted. According to Section 209, the agreement must be in writing with officially certified signatures, and the transfer is effective towards the company upon delivery of the effective agreement.
The last point concerns the acquisition vehicle. According to Section 199, unless the memorandum of association provides otherwise, an executive director may not engage in business activities that are the subject of the company's business, nor be a member of a statutory body of another legal entity with a similar subject of business. Therefore, before establishing an acquisition vehicle, it is necessary to check what the memorandum of association of the target company says about the non-compete clause and what the new company's subject of business will be.
Contact our experts
Potential problems | How ARROWS can help (consultation@arws.cz) |
|---|---|
Unlawful financial assistance: the company participates in financing its own buyout without meeting the conditions | We will prepare the director's report, the general meeting resolution, and the insolvency test. We will propose a structure that meets the legal requirements |
Conflict of interest of the buying manager: the executive director negotiates the price of the company they manage | We will prepare the notification of conflict of interest and the record of its settlement. We will set rules for access to information during the negotiations |
Dispute over the deferred part of the price: the results did not meet the plan and the parties disagree on the cause | We will set up the calculation mechanism and restrictions for the repayment period. We will lead negotiations and any potential dispute |
Invalid share transfer: missing consent from a company body or certified signatures | We will ensure the documentation and corporate steps are in the correct order. We will verify the memorandum of association before signing |
Founder's departure without handing over relationships: key customers leave with them | We will prepare a post-closing service agreement linking remuneration to the handover. We will add a non-compete clause with a valid scope |
Final summary
A management buyout stands or falls on financing and the founder's departure, not on price negotiations. First, calculate how much the company can bear from its operations, how much the bank will lend, and how much the founder is willing to leave as a deferred payment. Only then should you discuss the multiple. And include in the documentation what the founder will be doing for a year after signing.
The legal boundaries for this type of deal are stricter than for a standard sale because the buyer is sitting on both sides of the table. Financial assistance has statutory conditions, including an insolvency test, conflicts of interest must be notified, and the share transfer requires consent and proper form. The Prague-based law firm ARROWS handles these transactions as part of its Company Sales and Transaction Advisory service and is insured for professional liability up to a limit of CZK 350,000,000. Write to us at consultation@arws.cz.