In the course of a management buy-out, does it make sense from the shareholders’ point of view to pay executives part of their performance-related remuneration in the form of company shares at an early stage?

A management buy-out (MBO) is a form of corporate succession in which the management takes over the shareholders’ shares in the company. This can be an attractive succession solution, especially for small and medium-sized companies. In this size category, financing can often be realized without external co-investors. The management, together with an outside investor (e.g. a bank), can provide the financial resources required for a takeover. Above a certain size, it becomes challenging for the management to handle an MBO alone. Accordingly, it is dependent on financial investors (e.g. private equity investors).

MBO can have a positive impact on financing

Consequently, from the point of view of both the shareholders and the management, an MBO should be decided on as early as possible and appropriate structures for the transaction should be created. This is particularly advisable if it is foreseeable that management will not be able to meet the shareholders’ purchase price expectations in the short term. However, since the management is already very familiar with the company and its structures in the run-up to a possible takeover of the business shares, banks generally take a rather positive view of the financing of such a transaction.

Determining an appropriate enterprise value

However, it is much more difficult to determine an appropriate enterprise value when a company is taken over by its management. The difficulty in ensuring a fair purchase price for all parties lies in the different interests and information of shareholders and management in the course of a transaction process. The science treats this problem on the basis of the principal-agent theory. The theory, discussed by Michael Jensen and William Meckling in 1976, essentially states that conflicts can arise between the agent and principal due to information asymmetries and opportunistic actions.

In the case of an MBO, the management (the agent) is much better informed about the economic situation of the company than the shareholders (the principal). Therefore, there is an information asymmetry between the two parties. The less informed shareholders are dependent on information from management in their decisions and thus also in determining a selling price. Since management aims to achieve the lowest possible purchase price, the shareholders run the risk of being disadvantaged when a company is sold to management.

Transfer of company shares can be an advantage

To prevent such conflicts during a possible MBO, it makes perfect sense from the shareholder’s point of view to pay executives part of their performance-related compensation in the form of company shares at an early stage. If the management itself owns shares in the company, it has a greater interest in high returns and thus also tends to increase the value of the company. Furthermore, management can grow into the role of shareholder and does not have to change roles completely in the course of the MBO.

In addition, a performance-related remuneration of the management in the form of company shares facilitates the financing of an MBO. Transactions often fail due to the lack of liquidity of the management. If an MBO does take place, it is often largely financed by debt. As a result, management often takes on considerable debt. However, if the management already holds shares in the run-up to the company takeover, only less capital needs to be spent on the actual MBO.

Initiate MBO at an early stage

In all cases, it makes sense to initiate measures for an MBO as early as possible, as this ensures that the transaction is as smooth as possible. This ensures that the transaction is as smooth as possible. In order to define these measures and prevent conflicts between management and shareholders in the purchase price determination, it is generally advisable to involve an external partner in the transaction. As a neutral party, this partner can mediate between management and shareholders and work out a transaction structure that suits both sides. Frequently, legal advisors with appropriate expertise in corporate law and consulting firms with experience in various M&A or corporate finance topics are used for such structures.