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What Is a Leveraged Buyout?

Personal and professional factors go into the decision to sell a small business. It's not uncommon for small-business owners to expect the next generation of management to step up to carry on their company's legacy.

However, that takeover is not easy when that younger small-business manager needs a significant source of equity to purchase the target company. Sometimes, a buyer wants to go through with the business acquisition, but interest rates from typical lenders are too high. Then, you have the scenario where the potential buyer has a high debt-to-income ratio and would not qualify for a loan.

That's when business owners and someone looking to acquire a company turn to a leveraged buyout (LBO). An LBO considers working capital, previous mergers and acquisitions success, and the buyers' potential accounts receivable.

Learn what an LBO is and when it makes sense for small-business owners to consider below.

What is a leveraged buyout (LBO)?

An LBO is when someone (a buyer who can be a small business or individual) takes over a company (acquired company) at the purchase price by putting up just a small amount of money. The buyer borrows the rest of the purchase price through a loan. That loan comes from the acquired company's owner (the seller). This makes the seller the lender and is why you often hear it called seller-financing.

With an LBO, a buyer does not have to use a significant amount of their own money. Nor do they have to raise large sums or borrow from private investors. Instead, the seller reviews the company's cash flow, real estate market, and equity ratio of both the buyer and the acquired company. After all, who knows the acquired company better than the seller?

What is the rate of return?

If the seller feels there will be future cash, and enough cash, under good management with the buyer, they will authorize an LBO. The rate of return is the time it takes for the seller to get their total asking price.

What is equity?

Equity is the valuation of a company. For small businesses, this includes the money value of:

  • An interest in the company
  • Real estate
  • Stocks

How does equity work in an LBO?

The buyer leverages its own equity to make a large purchase with a small amount of seller financing. Ordinarily, the ratio is about 90% debt to 10% equity, but this can change based on the economy and industry.

The assets of the acquired company are collateral. This is known as private equity. The acquired company expects to generate enough revenue to pay off the debt. This gives the parties a high rate of return while risking only a small amount of capital.

How does an LBO benefit a smaller business?

Smaller companies like LBOs because they allow them to sell their business without requiring a large cash payment from the buyer. For this to work, the target company has to be profitable, growing, and able to produce sufficient cash flow.

There are a variety of motivations for using LBOs to acquire a company. The most common three reasons for a leveraged buyout are:

Taking a Public Company Private

A common use for leveraged buyouts is taking a publicly traded company private. This occurs when an investor or group uses leveraged loans to buy all outstanding stock in a company. This takes a publicly traded company private. These sorts of buyouts are often hostile takeovers. It is usually when an outsider buys, reorganizes, and resells a company for a high return.

Spinning off a portion of the business

Companies use leveraged buyouts to spin off a portion of the existing business. They will then sell it. This sometimes occurs when a leveraged buyout purchased the seller itself earlier. It is now spinning off assets to repay the investors.

Private transfers

Private transfers are where an investor group acquires a privately held organization. This will sometimes occur when a small-business owner reaches retirement age. They either don't want to sell the company or need help finding a corporate buyer. In this situation, the company's employees, management team, or others associated with the owner buy the company.

Leveraged Buyout Risks and Considerations

As discussed above, there are many benefits to a leveraged buyout. However, there are also a few risks and other considerations, including:

  • Increased debt liabilities like senior debt, which must be paid first
  • Potential conflicts of interest
  • Financial and operational challenges
  • Possibility of subordinated debt in a spin-off
  • The need for careful financial forecasting using the correct debt and accounts receivable numbers
  • Due diligence

Find a Leveraged Buyout Lawyer

Before agreeing to an LBO, speak with an experienced mergers and acquisitions attorney. You need to evaluate all options available to you and get your LBO in writing.

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