Most people consider leveraged buyouts to be an option that can be used only to acquire larger businesses. However, nothing about a leveraged buyout (LBO) is specific to larger businesses. The concept can be used to acquire smaller businesses, and often is. In this article, we discuss:
- What is a leveraged buyout?
- How much will you actually pay for the business?
- Acquisition financing vs. operational financing
- Acquisition financing options
- Operations financing options
- Common deal structure
- Risks of a small business leveraged buyout
1. What is a leveraged buyout?
A leveraged buyout is a strategy that allows you to acquire an existing business while minimizing the amount of buyer’s funds used for the transaction. The idea is to use financing that is secured by the acquisition target and other assets to cover most of the acquisition price. The financing acts as “leverage” that allows you to acquire a larger business with as little as 10% down.
Many small business buyers use leverage because it is their only option. They don’t have substantial assets that they can use to buy a business. A leveraged buyout provides them with an option to buy the business of the size they want to acquire. Though not commonly known, many small business acquisitions qualify as leveraged buyouts.
There is another reason why some small buyers opt for a leveraged buyout. If the transaction works as expected, it provides an opportunity to get an excellent return on equity. When an LBO is executed correctly, the business should generate enough cash flow to cover all regular business expenses in addition to the debt service from the buyout.
2. How much money will you need to buy the business?
Small business acquisitions require that the buyer contribute funds to the transaction. This often raises the question about the amount of money buyers must contribute to buy the company. In an LBO, the amount of money you need to make the purchase is called an equity injection. The equity injection usually covers 10% to 20% of the total project cost. The injection amount cannot be financed or paid by the seller. It must come from the buyers.
The total project cost includes items such as:
- Cost of business
- Capital expenditures (e.g., improvements)
- Working capital (operations)
- Closing costs
- Other items that vary by transaction
3. Acquisition financing vs. operational financing
Most small leveraged buyouts are funded using two categories of financing. The first category is the funding used to buy the business and take ownership. The second category is operational financing, which helps cover the initial cash flow needs of the company. Operational funding is often a critical piece of a successful buyout.
Getting any kind of additional financing after an acquisition is complicated, if not impossible. The business assets are already leveraged and cannot be used as collateral for any other financing. Consequently, most buyers are better off negotiating a financial package that covers both the acquisition and operations when they buy the business. In most cases, you should negotiate and get acquisition and operational financing at the same time.
4. Acquisition financing
There are a few alternatives that buyers can use to finance their acquisition. The most common options to finance a small LBO are as follows.
a) Seller financing (deferred consideration)
Seller financing is one of the most important types of funding you can use in an acquisition. This option provides buyers with some comfort, as it implies that the seller expects the business to have enough money in the coming years to satisfy the buyer’s debt to the seller.
Sellers would prefer to get paid immediately and not have to offer financing to their buyers. Unless their business is in high demand, sellers usually have to provide some financing to get the deal done. In our experience, sellers usually offer to finance 5% to 10% of the acquisition. Keep in mind that it’s unusual to find a seller willing to offer a substantial amount of financing. This reluctance could indicate that they are having trouble selling the business.
b) Buyer’s funds (equity injection)
The buyer needs to contribute a portion of the purchase price from their funds to handle the equity component of the transaction. As a result, they may need to tap into their savings, sell investments, access retirement funds, or take a home equity loan. It’s not unusual for buyers to use all or most of their assets to make the business purchase. The equity injection usually covers 10% to 20% of the project cost. Learn more about equity injection sources.
c) SBA-backed financing
The Small Business Administration (SBA) does not provide financing. Rather, they offer incentives to lenders that provide funding to small business buyers. These incentives lower the lender’s risk. Ultimately, this program helps small business buyers get financing at market prices.
SBA-backed financing is usually easier to get than conventional lender financing since it has more flexible qualification requirements. These loans are the most common source of financing for small business acquisitions.
Loans have a maximum of $5,000,000 and can cover 80% to 90% of the project cost. For more information, read “How to Get a Business Acquisition Loan.”
d) Non-SBA lender financing
Buyers who can’t get SBA-backed financing or need more than five million dollars can consider conventional lenders. Qualifying for a loan from a conventional lender is more complicated than obtaining an SBA-backed loan. These lenders have more stringent requirements regarding assets and buyer experience since they can’t rely on the SBA guarantee if things don’t go well.
e) Private investors and family offices
Well-connected buyers may have the option to partner with private investors or family offices. These sources are hard to find and are very selective. However, they can finance unusual opportunities that don’t fit conventional criteria and have great potential.
5. Financing business operations
Most small business buyers tend to commit most of their assets when buying a business. This commitment can leave few resources to run the business after you purchase it.
Getting financing after you have gotten a business acquisition loan is nearly impossible. The reason for this difficulty is that the primary lender has already encumbered all the assets for the LBO. This situation leaves no assets for any subsequent fundings. Consequently, consider negotiating for operational financing along with your acquisition financing efforts.
Most lenders that provide acquisition loans also provide working capital loans. This is the simplest way to get operational financing since it avoids the challenges of negotiating inter-creditor agreements between different lenders. Some transactions may qualify for a line of credit instead of a loan, though those are unusual.
b) Accounts receivable factoring
Factoring is a financing option for small businesses that sell to commercial or government clients. It helps companies handle the cash flow problems from selling products and services to clients on net-30- to net-60-day terms. Invoice factoring finances your accounts receivable and provides funds for payroll and other business expenses.
c) Vendor credit
One source of financing that should not be overlooked is your own vendors. Vendors may be more willing to extend terms to your business than they were to the prior owner. Negotiating better payment terms, such as going from net-30 to net-45, or even net-60, can dramatically improve your cash flow.
6. Deal structure
Most small business leveraged buyouts that we see use two or three sources of financing. The most common structure we see is:
- Buyer’s equity injection: 10%
- Seller financing: 5% to 10%
- SBA-backed loan: 80% to 85%
Keep in mind that these figures are averages. Individual components may have higher or lower percentages. However, the SBA-backed component can’t exceed 90% of the transaction total, and an equity injection is required.
7. Leveraged buyout risks
Every acquisition has risks. However, leveraged buyouts have a higher risk of failure because of their debt load. The level of debt puts a heavy burden on the business to make the monthly payments. This situation leaves the new business owner with little room to maneuver if things don’t go well. Every buyer that plans to use a leveraged buyout should be familiar with its risks and rewards before using this type of financing.
a) The debt load is unrealistically high
The most serious mistake that buyers can make is placing an unrealistically high debt burden in the acquisition. In these situations, regular company revenues are not sufficient to cover the debt service and other expenses. The business will fail unless this issue is resolved quickly. Unfortunately, the only way to fix this problem is to restructure the debt.
b) Business assumptions don’t work out as expected
Making assumptions about the future performance of an acquisition is always challenging. Buyers should always add a safety cushion to their estimates to handle unplanned circumstances. This is where buyers who use an LBO run into problems. Unless they are carefully structured, LBOs leave little room for mistakes because cash is always tight.
c) The buyer does not have enough working capital
This problem affects many small business acquisitions, regardless of their financing structure. Most buyers seem to focus solely on buying the business but don’t adequately anticipate the future cash flow needs of the business. Since the business is underfunded, it soon experiences cash flow problems. Businesses that are not fully leveraged and don’t have a heavy debt burden may be able to get additional financing to handle the problem. However, transactions that used an LBO may not be able to get financing due to their existing leverage. This scenario can lead to business failure.
Need to finance a leveraged buyout?
The first step to work with us is to submit this form. Once we review it, one of our associates will contact you to discuss the specific details of your acquisition.
Given the complexity of how businesses can be purchased and the products that are used, this document is not guaranteed to be 100% accurate or cover every potential option. However, we make every effort to provide the best information. If you have comments, suggestions, or improvements, contact us via LinkedIn.