Leveraged buyouts (LBOs) are a popular way to finance business acquisitions by using debt financing. This article focuses on the pros and cons of using an LBO to buy a small business. We discuss the following:
- Advantages of using an LBO
- Disadvantages of this strategy
- Common misconceptions
For a detailed explanation of LBOs, read “What is a leveraged buyout?”
Leveraged buyout advantages
When used correctly, leveraged buyouts can be an effective way to finance a small business acquisition. This section covers the most important advantages of this strategy.
1. Allows you to buy the largest possible business
One of the main advantages of using an LBO is that it enables entrepreneurs to use financial leverage (e.g., debt) to acquire a larger business than they otherwise could purchase. This aspect of LBOs can be an advantage for some buyers. Acquiring a larger company is preferable because they are usually better established and have a greater chance of success.
2. Increases your rate of return
Investors like that leveraged buyouts amplify their rate of return. This is a fundamental principle of using financial leverage. A smaller investment allows investors to control a larger business. Consequently, their potential rate of return also increases.
3. Minimizes the size of your equity contribution
Using the largest possible amount of leverage allows buyers to minimize their equity contribution. This feature is important for buyers who don’t have much money or who want to diversify investments.
4. Can be financed using SBA-backed loans
Many small business leveraged buyouts can be financed using an SBA-backed loan. This is because SBA loans allow individuals to buy a company with only a 10% equity injection. Keep in mind that the objective of the SBA is to help individuals become business owners.
Disadvantages of LBOs
Leveraged buyouts also have risks that entrepreneurs must consider. Some of the risks are substantial and should be considered carefully. Here are the most important disadvantages.
1. Minimal financial cushion to manage problems
Acquiring a company with an LBO often leaves the business without a reasonable financial cushion. This limitation creates problems if the company encounters problems at a later time. Many entrepreneurs underestimate this problem, which leaves them unprepared.
This situation is often aggravated when buyers invest all their assets into the acquisition. The buyer and the company are left financially exposed and without the resources to manage a downturn.
2. Equity can quickly disappear
Investors use leveraged buyouts due to an LBO’s ability to maximize returns. Unfortunately, investors often overlook the opposite side of this coin. An LBO can also eliminate their returns and wipe out their equity just as quickly.
Investors must remember that leverage is a double-edged sword. The aggressive use of leverage rewards acquisitions that succeed and harshly punishes those that fail.
3. Obtaining additional financing is impossible
Most leveraged buyouts try to take up as much debt financing as possible. Consequently, all assets are pledged as collateral for their loans. This situation leaves companies unable to secure any additional financing after the acquisition. Companies that face challenges after the acquisition may not be able to secure the funding they need to manage them.
Buyers should assume they won’t be able to get additional financing for many years. Consequently, they should attempt to secure a provision for growth financing at the time of the acquisition.
Small business LBO misconceptions
Unfortunately, small business owners often misunderstand how leveraged buyouts work. This misconception is mostly due to how these transactions are portrayed in the popular media.
Buyers must keep in mind that some of the benefits associated with larger transactions don’t apply to small LBOs. Two myths seem to persist in the marketplace:
Myth #1: Buyers don’t need an equity injection
One of the major misconceptions about small business leveraged buyouts is that buyers don’t need to use any of their own money in the transaction. While this may be true for large acquisitions, it is not true for small leveraged buyouts.
We are not familiar with any lender that finances 100% of a small business acquisition. Lenders require the buyer to put a 10% equity injection into the purchase of the company. The equity injection cannot be financed or come from seller financing.
The equity injection can be reduced to 5% only if the seller agrees to a “standby clause.” A standby clause states that senior lenders must be paid off first before the seller is paid. In our experience, few sellers agree to this condition.
Myth #2: Buyers can use unsecured financing
Small business lenders, including those who provide SBA-backed loans, require the buyer’s loan to be secured by the buyer’s assets. Keep in mind that the SBA guaranty is designed to protect lenders and not buyers. It covers the lender by guaranteeing the loan if the buyer is unable to pay it.
This protection provides an incentive for lenders to work with “less-than-perfect” borrowers. Borrowers with limited assets who meet the SBA’s requirements can usually qualify for an acquisition loan.
Learn more by reading “Can I get a business acquisition loan with no collateral?”
Why are an equity injection and buyer’s collateral required?
Buyers often question why lenders require buyers to secure and contribute to a transaction. After all, the buyer wants a business loan and not a personal loan. Lenders request collateral for one simple reason – it protects them.
Remember that companies don’t manage themselves. Buyers, or their employees, operate the company. Lenders want the buyer to be responsible for the company. From a lender’s perspective, the buyer’s equity injection and personal guarantee provide three essential protections.
1. Equity injections provide a financial cushion
A lender that finances 100% of an acquisition is exposed to substantial losses if the target company has a small decrease in its value. Lenders ask for the equity injection because it offers financial protection. The equity acts as a cushion that can absorb small losses if things don’t go as expected.
2. Buyer’s commitment to the business
The personal guarantee and equity injection commit the buyer to the transaction. After all, the buyer now has personal funds invested in the transaction. A buyer will not walk away from the company if things get difficult. Instead, they will do their best to ensure the business succeeds.
A buyer with nothing at stake has no reason to stay with the business during hard times. They could walk away and let the lender keep the business.
3. Encourages prudent decision making by buyers
Buyers who share the financial risk with the lender will also manage the company more carefully. They are less likely to make careless or reckless decisions because their money is also at stake.
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Note: This article is for informational purposes and is not intended to provide financial advice. If you need financial advice, please consult a professional.