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by Barrie Pearson - Wednesday, 29th August 2007

And the incumbent management already knows the business well, so there will be no surprises to them arising from due diligence; it's unlikely that the deal will fail or require last-minute price surgery. But the reality is different.

Far too often, I have seen the managers become the enemy within.

Pandora's box is open as soon as you invite a management buy-out, or agree to one, without strict conditions attached. The management will pick advisers and then approach three or four venture capitalists.

They will be seeking the maximum possible equity stake for themselves, so it will push down the price any venture capitalists will pay for your business. Then the management will tell you that your business is only worth £xm, because that is the highest price anyone would finance the purchase.

You may think you can outsmart the management team by inviting competitive bids from trade buyers. But I always warn vendors that the management team will easily and quickly turn those tables on you.

Most trade buyers will simply not bid against a management team, because they are not prepared to buy a business and inherit disaffected managers who may leave to seek a buy-in opportunity elsewhere.

Even if some buyers are prepared to bid against the management, they are likely to insist on meeting them before making a written offer. The management, in turn, are likely to give a downbeat view of future business prospects.

Tell the management team that you will give them only six weeks to make a detailed written offer on the letterhead of a private equity firm at an absolute minimum price of £ym. If they cannot find a backer at that price, then you expect their total support to sell the business to a trade buyer.

In these circumstances, it is quite usual to offer a bonus to, say, the managing director and the finance director ranging from six months to two years' salary, based upon the price achieved.

Instead of going to venture capitalists and saying, "we want the maximum possible amount of equity so how much will you pay for the business?" the flip side applies. They will have to say, "as the purchase price is £ym, what percentage of the equity will you allow us to have?"

Venture capitalists are prepared to buy businesses worth £5m or more themselves, as principals. You may think that is no different from backing an MBO. But it is. Venture capitalists accept they may be required to bid not only against trade buyers but also against other venture capitalists. More important, trade buyers may compete directly with venture capitalists.

By acting as principals, venture capitalists are able to compete on price with trade buyers. Once they have agreed a deal with the vendors, only then will they decide on the management's equity stake. Inevitably, it will be a much smaller stake than if management had initiated a buy-out. If appropriate, the venture capitalist will inject external managers into the business, because they are calling the shots.

A management buy-in team may make an unsolicited approach to buy your business. They could well show you a letter from a venture capitalist offering to back them to buy a business, possibly up to much more than your business is worth.

It is not a blank cheque, waiting to have your name filled in. It's more like a letter of comfort, distributed like confetti, to persuade the buy-in team to come back to the venture capitalist when they find a business to buy.

Don't rule out buy-in teams, but do recognise that venture capitalists have to be hard-nosed and dispassionate buyers. They invest purely on the merits of the management team, the business opportunity, and only if the price is attractive to them.

The vendors of a private company telephoned me to say that the trade press had published an article claiming that their business was about to be sold to the management team.

The truth was, they had received an unacceptable offer from management and a decent offer from a trade buyer. The owners were convinced that the management team had deliberately leaked the story to kill off the sale. Why did they call me? To say: please help.

So appoint experienced corporate finance advisers. If a buy-out fails, the business will never be the same again.

Apart from the fact that venture capitalists now generally tend to be called private equity investors, little has changed since we first published this in December 1997.

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