How much equity a management buyout needs. What the team puts in, and where the rest of the price comes from.

Price and costs, less the prudent debt and the vendor paper.

The funding requirement is the agreed price, any of the company’s existing borrowing the price does not already cover (change-of-control clauses make it repayable at completion), the costs of completing, and any cash the business needs to trade from the first day. The senior or unitranche debt the company can prudently carry comes off it, and so does the vendor paper the seller leaves in. What is left is the equity gap. Take a company earning £2m of EBITDA, with no borrowing of its own, sold for £10m with £2m left in as vendor loan notes. Bought by its own management, it carries senior debt at 3 times EBITDA; bought by an outside team, a bank underwrites toward the lower end of its 2.5 to 3.5 times range, say 2.5 times.

On these numbers the half turn the bank takes off for the outside team, £1m, passes directly to the buyers, whose equity gap is half as large again. Every pound the lender will not advance has to be found as if the price had risen by the same amount, which is why a team should know what the business can prudently carry before it agrees a price. A gap of £2m to £3m is more than most management teams can fund alone at this size, so in practice the seller leaves more in or an equity partner takes part of it, as section 05 sets out.

A unitranche fund will stretch to 4 to 4.5 times EBITDA, occasionally to about 5 for a strong sponsor-backed credit, and each extra turn comes off the gap until the lender’s own floor stops it. Lenders want a minimum of equity and subordinated paper beneath their debt as a share of the price: at 4 times, the example’s £8m of debt plus the vendor notes would fund the whole price and leave the buyers nothing at risk, which no lender will accept. Size the debt on the downside case, with covenant headroom of at least 25 to 30% against the base case, and let the equity be whatever that leaves. An asset-rich target can sometimes carry more through asset-based lending, and our guide to how much your business can borrow sets out what a business should carry.

Lenders judge the cushion against the price and each cheque against the manager’s means.

The whole cushion beneath the debt, the equity and the seller’s subordinated paper together, matters as a share of the price, because it absorbs a fall in the company’s value before the debt is at risk. Each manager’s own cheque is judged differently, against what that manager is worth: a credit officer wants the people running the business to stand to lose something that matters to them. A cheque that looks small against a £10m price can be most of a manager’s liquid wealth, and a lender reads it that way. An outside team is asked for more, both because a lender gears a buy-in more conservatively and because its own capital at risk is one of the few signs the lender can test that the buyers believe in their plan, as our guide to financing a management buy-in explains.

Most lenders accept money a manager has borrowed personally, and check that the salary in the plan covers the repayments without pressure for dividends the facility agreement will restrict. The equity is a condition of the lender’s first drawdown, so any personal borrowing has to be in place before completion. Where a manager’s contribution is secured on the family home and the bank also wants a guarantee backed by a charge over property, the same house stands behind the deal twice, which is a strong case for capping the guarantee and carving the home out, as our guide to personal guarantees works through.

Most of the investor’s money ranks ahead of the ordinary shares the team buys.

When a private-equity house backs a management team, most of the house’s money goes in as loan notes or preference shares, which carry a fixed return and rank ahead of the ordinary shares, and a small slice goes into ordinary shares. That package is often called the institutional strip. The managers subscribe for ordinary shares alongside it, so a small cheque buys a much larger share of the ordinary equity than of the money put in. That disproportion is what the market calls sweet equity.

On a sponsored deal the investor funds whatever the debt and the vendor paper leave, so the team’s cheque is no longer the residual worked out above. Investors want hurt money from each manager, a sum that matters to that person, commonly framed against salary; a manager who already holds shares or is receiving part of the sale proceeds should expect to put some of that value back in.

The ordinary shares are the most exposed layer in the structure, and the shareholders’ agreement’s leaver terms decide how much of a departing manager’s cheque comes back. A senior lender treats the institution’s loan notes much as it treats equity, provided the intercreditor subordinates them, their interest rolls up while the senior debt is outstanding, and they mature after it. The tax treatment of management shares needs specialist advice from the first draft of the structure.

The structure changes who can contribute, and in what form.

An incumbent who already owns shares can often contribute some of them in place of cash, subject to the tax advice that step needs, while incoming managers on a buy-in start from cash and face the larger gap in Fig. 01. A BIMBO combines the two. Incoming managers buy in alongside insiders who stay, the continuity lets a lender gear more comfortably than for a pure buy-in, and the equity is shared between the two groups. Who puts in what, and what happens to a manager’s shares if they leave, then becomes a negotiation among the buyers as well; settle those terms in the shareholders’ agreement before completion.