What do management teams expect when they start the management buy-out trail? Is it really possible to trouser a million quid at the end of three years if you don’t have a pile of cash to put into the business? Apart from the Lottery and winning Pop Idol, there are few quicker ways to make a fortune and stay out of jail.
This is crudely how it works. Two managers buy out a company for £1.4m; the managers put in £50,000 each, the bank puts in £300,000 and the VC puts in £1m.
The VC wants an internal rate of return (IRR) of 30% and an exit after three years, by which time they reckon the company will be worth £5m. On that IRR, the VC’s stake ‘grows’ each year by a compound 30%, so in Yr 1 it is £1m; in Yr 2 it is £1.3m, in Yr 3 it is £1.69m, and at the end of Yr 3 it is £2.2m. That is 44% of the company‘s £5m value. So although the VC has put in far more cash than the management, they take a 44% stake, leaving the managers with 56% of the business.
So if, after three years, they sell the business for £6m, slightly more than estimated, the VC will get £2.64m, and the managers will walk away with £1.68m each.
Dividing the equity pie is not necessarily down to personal wealth, either. VCs look to buy-out candidates to put up enough of their own cash to motivate them, but the stake is also based on non-financial contributions, recognising leadership, for instance, or IP ownership. The man with the million-pound brain may be worth at least the same stake as the one with all the cash.
• After the buy-out of the camping equipment chain Milletts, every £100,000 invested by the management team turned into about £40 million at exit. No chickenfeed.