Currently, just under 40,000 companies in Germany are looking for a successor or a succession solution each year. This means that over 150,000 business transfers are expected by 2026. Due to the baby boomer generation, this number is rising steadily and has increased by more than 20 percent compared to the period from 2018 to 2022. It goes without saying that not every business owner finds a successor within their own family. On average, this applies to half of these businesses; the other 50 percent of companies ready for a handover are sold to external buyers. Of these, slightly less than half involve so-called management buyouts (MBOs), meaning a transfer to employees and/or management. In a management buy-in (MBI), external managers—often in partnership with (financial) investors—acquire a stake in the company.
The advantages of an MBO are obvious: the existing management or executives know the company’s value, its processes, its customers, and its potential for optimization. Employees are familiar with the management team, and the new shareholders can seamlessly take over and further develop the business without friction. A relationship of trust exists, and the entrepreneur can, if desired, avoid a time-consuming sales process. At the same time, this prevents competitors from using due diligence solely for the purpose of obtaining confidential information and trade secrets (e.g., customer data and terms) or to identify and subsequently poach valuable employees.
However, MBOs in particular require long-term preparation by the family business owner to ensure targeted and successful implementation. In addition to building up the acquiring management team, relationships with suppliers, customers, and other stakeholders must be transferred to managers who are fundamentally open to the idea of “joining” the family business. This is often difficult for “true” entrepreneurs, and at the same time, not every motivated and capable manager is willing to assume the entrepreneurial risk. An MBO can only be carried out economically to the satisfaction of all parties involved if the day-to-day operations are no longer dependent on the current owner. Potential co-investors will also expect a certain track record, meaning that the family business owner has already stepped back from day-to-day operations for some time, yet the company continues to develop positively. Dependencies on the current owner—whether regarding customers, expertise, or creativity—are viewed as a risk by potential investors and either diminish the company’s value (known as “enterprise value”) or stand completely in the way of an MBO.
From the family’s perspective, a management buyout can also have disadvantages. Management is generally aware of potential future problems or other details regarding the company’s development that would not be disclosed during due diligence, and these factors can unduly depress the company’s value. Furthermore, contrary to the assumption made above, the sale process may drag on due to the buyers’ inexperience.
More often than not, however, management simply lacks the financial resources to pay the purchase price “in one lump sum” or to acquire all shares in the company. If the seller then defers payment of the purchase price (a so-called “vendor note”) or sells the shares only in installments at a variable purchase price yet to be determined, the very outcome the entrepreneur sought to avoid occurs: he continues to bear a financial risk and thus remains indirectly responsible for operations.
If the acquisition of the family business by the existing management exceeds its financial capacity, the management will seek an investor (often a private equity firm) who will take an equity stake in the target company or an acquisition vehicle alongside the management. In terms of procedure, there are then only marginal differences between an MBO and an MBI. Due to the leverage effect of equity capital achieved by raising debt, this is also referred to as a leveraged buyout (LBO) or leveraged buy-in (LBI).
Management’s participation generally takes place through a newly established limited liability company (NewCo), whose shares are held by the managers and the financial investor. Typically, the NewCo also raises debt financing to pay the purchase price. In theory, the original owner or their heirs may also hold an interest in the NewCo (roll-over), which preserves business partners’ confidence in the company and facilitates financing for management.
The NewCo is then owned by various shareholders, some of whom have diverging interests. While managers and (financial) investors both aim for the company’s positive development, from an economic perspective they often have differing views on the path to that goal, expected returns, and dividend policy. Depending on the investment time horizon, the question also arises as to when and under what conditions a future sale or resale of the company can or should take place (known as an “exit”). In the event of an exit, it is particularly important to agree on any tag-along rights and obligations of the NewCo’s shareholders, as well as the distribution of the exit proceeds (“waterfall”/“liquidation preferences”). Provisions are also required regarding a potential transfer of shares to the investor and, conversely, to management (“call option”), as well as the valuation of the stake in NewCo if the manager leaves the management team (good- and bad-leaver arrangements). Financial investors typically view the retention of the existing management team in the target company as particularly valuable, so that this team should remain tied to the company—either in fact (through leaver provisions and restrictions on disposal, at least within a minimum period, “lock-up period”), are intended to be bound to the company—at least in terms of value (bad leaver). This means that the management’s departure from the operational management prior to this period (which cannot be prevented in practice) is financially penalized. All these issues are set forth in a shareholders’ agreement, which exists alongside the actual articles of incorporation of NewCo.
In addition to the Shareholders Agreement to be negotiated by the parties, the articles of incorporation, executive employment contracts, rules of procedure for management, shareholder loans (if NewCo finances the purchase price through loans from its shareholders), and, depending on the specific case, other supporting documents. At the outset of any negotiations between the future partners, specialized tax advisors must be consulted to determine whether the chosen tax structure is in the best interest of the respective client and of all parties involved. The structure and the ratio of equity (including subordinated shareholder loans), debt, shareholder buyback, and/or vendor loan depends on the stability of earnings, the market environment (seller’s/buyer’s market), and the interest rate environment.
In an MBO, management faces several conflicts of interest. The managers naturally have an interest in keeping the purchase price as low as possible, in part to minimize the debt of the NewCo or the company and to remain financially viable. In addition, the managers are the key sources of information regarding the seller’s guarantees in favor of the (financial) co-investor and, in their own interest, owe the co-investor the best possible disclosure regarding the subject of the purchase. At the same time, as the executive board or management, they are “still” obligated to the company and continue to “serve” the previous owner until the transaction is completed. In this process, the executive board is a “servant of two masters,” which often leads to stumbling blocks—particularly during negotiations of the company purchase agreement—regarding the immensely important attribution of knowledge. This raises the question of to whom the knowledge of the executive board or management is attributed: to the family-owned company as the seller (in which case there is liability for breaches of warranty) or to the financial investor as the (co-)buyer (in which case there is an exclusion of liability due to knowledge of the breach of warranty).
In principle, it is possible that the buyer may be required to accept the knowledge of the target company’s managing directors regarding false information under the principle of attribution of knowledge, analogous to Section 166(1) of the German Civil Code (BGB), due to prematurely transferred loyalty (OLG Düsseldorf I-6 U 20/15). However, this always depends on the specific provisions of the business purchase agreement, the interests involved, and the facts of the individual case. In the cited ruling by the Higher Regional Court of Düsseldorf, the investors (i.e., NewCo, acting as the buyer) were ultimately able to assert claims because, according to the court’s interpretation, the parties to the purchase agreement had excluded the attribution of knowledge to the seller’s detriment only with respect to the list of warranties, but not for the intentional breach of pre-contractual disclosure obligations (c.i.c.)—so the devil is in the details here. In principle, however, the attribution of management’s knowledge is left to the discretion of the contracting parties; they can therefore determine to which party management’s knowledge should be attributed. If the owner of the family business and the current management decide to carry out an MBO with the assistance of a financial investor, the parties involved should agree early on—preferably as early as during the negotiation of the Letter of Intent (LoI) — on how they intend to handle the “dual role” of the existing management. In this situation, a so-called “management letter” can be helpful, in which the management explicitly reaffirms and, if necessary, guarantees the accuracy of the representations made to the financial investor. Given that management often lacks the financial resources to back up these guarantees, the psychological aspect of this declaration naturally takes center stage in the end.
From an operational perspective, a management buyout of the family business—when there are no successors within the family—is often the best solution for all parties involved and for the company itself. However, since the involvement of a financial investor is necessary once the company reaches a certain size, the structuring and legal issues involved in an MBO are often more complex than in a “simple” sale of a lifetime’s work to a strategic investor. These additional issues can, however, be resolved to the satisfaction of all parties involved with sufficient preparation and expert advice.
