A management buyout occurs when the existing management team of a business buys the company from its shareholders. This can generate substantial wealth for the management team, and can also be a useful exit strategy for larger companies wanting to spin off certain divisions.
The team usually brings in outside financing to pay the investors, since team members do not usually have sufficient personal wealth to buy the company. Since this outside financing is usually in the form of debt, the resulting financial structure of the business is highly leveraged. A variation on the funding concept is to obtain equity financing from a private equity fund, which profits from any subsequent uptick in the value of the shares.
A management buyout is most likely to occur in a smaller business when the owner/shareholders know the management team well, and trust them to carry on the business. It also helps if offers from outsiders are well below the seller's expectations regarding the value of the business.
In a larger business, a management buyout may be triggered by an offer from senior management to spin off an unwanted division. This situation can arise when the corporate parent wants to go in a different strategic direction, and so makes an offer to the existing managers of a division targeted for elimination. In some cases, the corporate parent may even offer to fund the buyout.
A management buyout works well when there is a history of steady cash flows that can be used to pay off the debt over a period of time. However, doing so means that little cash will be available to maintain the competitive position of the company until the debt is paid off. Also, unexpected declines in subsequent cash flows can trigger a payment default. Thus, a likely outcome of a management buyout is an underfunded business or one that is teetering on the edge of bankruptcy.
A leveraged management buyout is more likely to succeed than a leveraged purchase by a third party, since the management team has a much better knowledge of the organization, and so is more likely to be able to operate the business tightly enough to pay off the debt.
A variation on the management buyout concept is when all employees are involved in the purchase. In this case, the buyout is called an employee buyout.