What is a Leveraged Buyout (LBO)? How Does it Work?

A leveraged buyout, commonly referred to as an LBO, is a type of financial transaction used to acquire a company. Buyouts are highly leveraged transactions. They use equity from the buyer and debt secured by the target company’s assets. Most small business LBOs aim for a ratio of 90% debt and 10% equity, though these figures vary. In this article, we discuss:

  1. Common structures
  2. Advantages and disadvantages of leveraged buyouts
  3. Financing alternatives
  4. Post-acquisition financing

Additional resource: Here is a LBO case study of a transaction we did.

Acquisition structure

Business acquisitions are usually structured in one of two ways. The buyer can buy the seller’s assets and put them in a brand new company. Alternatively, the buyer can acquire the shares of the target company and keep it as is.

1. The buyer purchases the assets

In this structure, the buyer purchases only the assets of the target company. The assets are placed in a new corporate entity designed to hold the assets and operate the business. Commonly, the selling company is referred to as “Oldco” (“old company”). The new company that will hold the assets is referred to as “Newco” (“new company”).

The main advantage of this structure is that it allows the buyer to purchase the assets cleanly. Buying the assets limits potential liabilities from the old company’s past operations. Basically, the Newco gets a clean slate. This model is the most common we see in small leveraged buyouts.

Note: This description is an oversimplification of the matter. In some instances, lawsuits could invalidate this protection.

2. The buyer purchases the whole company

Another way to acquire the business is to purchase the company’s shares. Buying the company’s shares gives the buyer full control of the business, along with all its assets and liabilities. The main disadvantage of this strategy is that it does not provide the company a clean slate. Consequently, the liabilities from the company’s activities under the previous ownership remain.

Advantages and disadvantages of an LBO

Leveraged buyouts have several advantages, which make them an attractive option to buyers. However, they also have some significant disadvantages. The decision to use an LBO must weigh these aspects carefully.

Advantages

Leveraged buyouts allow the buyer to acquire a business without investing more than 10% to 15% equity. LBOs enable buyers to use equity efficiently. Buyers can buy larger companies than they could otherwise buy if they used lower levels of debt. Low equity requirements also increase the buyer’s potential returns. The size of these potential returns makes leveraged buyouts attractive to some entrepreneurs.

Smaller leveraged buyouts require some seller cooperation. Many sellers view leveraged buyouts with skepticism. They don’t believe these buyers have a good chance of completing the acquisition. However, most sellers will accept an LBO if it allows them to sell at their desired price.

Willingness to work with a leveraged buyout has some advantages for sellers too. LBOs may allow sellers to find buyers for challenging or hard-to-sell businesses. Lastly, they provide sellers with an exit vehicle to leave troubled companies that need to be turned around.

Disadvantages

Leveraged buyouts can be risky for buyers. The high amount of leverage leaves the target business in a financially weakened position. A problem with liquidity, such as losing a few key customers, could put the company in severe distress. Basically, LBOs leave operators little margin for error.

Leveraged buyouts have some disadvantages for sellers as well. The high levels of debt require lenders to be comfortable with the transaction. Consequently, there is a higher chance that the transaction will fall through during due diligence.

Additionally, target businesses undergo substantial scrutiny by lenders during due diligence. This process consumes the seller’s time and resources, which could be deployed elsewhere.

How are leveraged buyouts financed?

Leverage buyouts can use various types of financing based on their size and complexity. Investment bankers and private equity firms are mostly interested in larger transactions. Consequently, larger acquisitions have more financing options available to them than smaller ones.

Smaller leveraged buyouts

Smaller leveraged buyouts, those under 5 to 10 million dollars, are financed using some or all of the following options.

1. Seller financing

Smaller transactions usually have a seller financing component. Most sellers offer this option as a way to accommodate buyer demands. Buyers like to use seller financing in the transaction because it ties the seller to the business’s performance during the term of the loan. Sellers are less likely to oversell the transaction if some of their compensation will be held for years after the sale. Seller financing usually accounts for less than 20% of the transaction’s financing.

2. SBA-backed loans

The most effective way to finance a transaction under 5 million dollars is with an SBA-backed loan. These loans are offered by lenders that have SBA backing and incentives to provide loans to small businesses. The SBA enables lenders to provide entrepreneurs with business acquisition loans with competitive terms and flexible collateral/credit requirements. SBA-backed loans are a common tool to finance both LBOs and management buyouts.

3. Conventional loans

Transactions that fall outside the qualification requirements of SBA-backed loans often use conventional bank loans. These loans don’t have the $5 million limit that SBA-backed loans have. However, they are harder to obtain. The borrowers often need to have impeccable personal credit and substantial assets.

4. Small investors and family offices

Some transactions are funded through loans from individual investors and family offices. The terms are often competitive, and they can offer more flexibility than conventional loans. However, finding this type of lender is challenging. They are usually found through personal connections, recommendations, and networking.

Mid-sized and large leveraged buyouts

Larger transactions have more financing options due to their ability to generate more fees and potentially more returns than smaller transactions. Consequently, most investment banks, private equity firms, and lenders focus on these. Their financing alternatives concentrate on three types of debt.

1. Senior debt

Senior debt has the priority of repayment over other types of debt. Senior debt examples include bank financing and bonds. This debt often has the strictest terms and is well secured with the assets of the company. As such, it has the lowest cost.

2. Mezzanine and subordinated debt

Mezzanine debt is in a subordinate position to senior debt and, thus, is considered junior debt. In a liquidation or bankruptcy, this type of debt gets paid only after senior debt has been paid. Consequently, it has a much higher risk and financing cost. It may also require that warrants/options be issued.

3. Seller financing

Larger transactions can also use seller financing. With this form of funding, the existing ownership group provides financing to the buying group. Seller financing is usually a form of debt financing amortized over several years.

Post-acquisition operations financing

Post-acquisition financing is an important area that is often overlooked by buyers. However, it can be essential to the success of the business. Remember that the new owners are faced with paying for regular operating expenses – plus the cost of any acquisition financing.

It is best to negotiate post-acquisition financing while negotiating the buyout. Once the buyout concludes, the company will be highly leveraged and unable to get financing for some time. Common financing options include:

1. Bank financing

Buyers who foresee needing financing in the first few years of operation should get post-acquisition funding combined with their business acquisition loan. This step is usually taken by directing a portion of the loan proceeds toward operational expenses.

2. Accounts receivable factoring

Companies that sell to business or government clients often face cash flow pressures due to the 30- to 60-day payment cycles. Factoring receivables allows companies to improve cash flow by financing their invoices. These lines provide the funds to cover payroll and operational expenses.

Smaller facilities are usually handled through conventional factoring. Larger facilities typically get funding through an asset-based loan with borrowing base certificates.

Ready 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.