What is a leveraged buyout?
Have you been thinking about your business exit strategy? If so, you’ve probably considered multiple options from initial public offerings to liquidation. But if you’re like many business owners, simply shutting the doors for good isn’t what you had in mind when you started your company. As Tony says, “business is for gladiators.” You put in the hard work, and you deserve a reward.
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Life cycle of a business
There are five typical phases in the life cycle of a business. Knowing which phase your company is in can help you decide whether a leveraged buyout is the right option or if you should postpone selling. The first phase is the launch phase, where sales are typically low but increasing. In the second phase, called the growth phase, sales increase rapidly and you begin making a profit. This is the stage where you hone your offerings and attempt to make your business talkably different. In the third stage, the shake-out, sales peak or grow slowly and profits decrease due to new competitors entering the market and market saturation. Maturity, the fourth stage, is where many businesses begin to stagnate and profit margins get thinner. Some business owners are able to extend this stage of the cycle, though, by adopting new technology or entering new markets. The fifth and final phase is decline, which is marked by shrinking profits and sales and usually ends with the business owner getting out of the market.
Whether your business is at peak performance and you want to capitalize or your business is reaching the fifth stage of the life cycle and you’re thinking about retirement, a buyout could be a good option for you. In particular, a leveraged buyout provides a means of exit that is realistic for many companies.
What is a buyout?
A buyout, as a general financial term, is when one company acquires all or a majority of the stock of another company. The company that acquires the stock is the buyer; the company that sells its stock has been “bought out.” This gives the buyer controlling interest – that is, the majority vote within the company. As you can imagine, this gives the buyer massive influence, which is typically their goal. However, it may not benefit you as the seller as much as you’d like, especially if you’re planning to use the buyout to pursue a new project that has meaning for you.
If you’re considering a buyout, the plan should ideally achieve three goals. First, it should minimize your risk as the owner. Second, it should ensure that you receive full value for your company. Finally, it should minimize the income tax consequences for both you and the buyer(s). In many instances, a leveraged buyout becomes the most attractive option when trying to achieve these goals.
What is a leveraged buyout?
A leveraged buyout is when one company acquires another using a significant amount of financing, meaning the buyout is funded with debt. The company doing the acquiring in a leveraged buyout, typically a private equity firm, will use its assets as leverage. The assets and cash flows of the company that is being acquired (called the target company or seller) are also used as collateral and to pay for the financing cost.
The purpose of a leveraged buyout is to allow a company to make a major acquisition without committing a lot of capital. In the most typical leveraged buyout example, there is a ratio of 90% debt to 10% equity. While a leveraged buyout can be complicated and take a while to complete, it can benefit both the buyer and seller when done correctly.
Why are leveraged buyouts used?
A leveraged buyout is often part of a mergers and acquisitions (M&A) strategy. They’re also sometimes used to acquire the competition and to enter new markets to help a company diversify its portfolio. Buyers like leveraged buyouts because they don’t have to put in very much of their own money, allowing them to report a higher internal rate of return (IRR). In short, a leveraged buyout allows firms better equity returns.
Why would a target company want to sell via a leveraged buyout? It’s actually a relatively common method for selling a business. The seller is able to get the price they want for the business and has a way to exit the company with a solid plan in place. A leveraged buyout is an ideal exit strategy for business owners looking to cash out at the end of their career.
Here are some additional reasons why a business owner would consider a leveraged buyout:
To make a public company private
If you run a publicly traded company, you can use a leveraged buyout to consolidate the public shares and transfer them to a private investor who takes the shares off the market. The investors will then own a majority of or all of your company and will assume the debt liability of the transaction. This is a good leveraged buyout example if the business needs to be repackaged and returned to the marketplace after adjustments are made to make the business more marketable. When the company is returned to the market as an initial public offering (IPO), it can be done so with fanfare, renewing the public’s interest in the company.
To break up a large company
Many business owners have used efficiency strategies to make their companies profitable and attractive to potential buyers. However, some companies grow so large and inefficient that it becomes more profitable for a buyer to use a leveraged buyout to break it up and sell it as a series of smaller companies. These individual sales should be more than enough to pay off the loan of purchasing the company as a whole. If you have a company with different target markets for various products, this might be a good option. A leveraged buyout of this type can then give the smaller companies a better chance to grow and stand out than they would have had as part of an inefficient conglomerate.
To improve a company that is underperforming
If an investor believes your company could eventually be worth much more than it is currently, a leveraged buyout could be a good option. The investor would assume the debt with the belief that holding onto the company for a certain amount of time will increase its value and allow them to pay off the debt and make a profit. In this leveraged buyout example, you as the business owner would want to exit the company before it becomes profitable, but not sacrifice the profit that is likely to come in the future. Taking the leveraged buyout money from the purchaser helps you realize part of that profit now so you can turn your sights to other ventures.
To acquire a competitor
Another common leveraged buyout example is when a smaller company wants to be acquired by a larger competitor. This allows the smaller company to grow dramatically and can help them gain new customers and scale more quickly than they would be able to without the acquisition. Typically, the acquiring company will keep your key staff in place so you don’t have to worry that the team you carefully chose will be left without a job. You may also be able to stay on in a part-time consulting role if you don’t want to lose all connection to the business you helped build. If you want to exit your company to pursue one where you have more passion as well as profitability, this could be a good option for you.
What are the advantages and disadvantages of a leveraged buyout?
No discussion of what is a leveraged buyout is complete without going over the advantages and disadvantages. The advantages to the buyer are clear: they get to spend less of their own money, get a higher return on investment and help turn companies around. However, there are also risks to the buyer. The same leverage that allows greater reward also comes with greater risk. There is little margin for error, and if they’re not able to pay back the debt, they’ll get no return at all. Depending on how the buyer defines risk and how risk-tolerant he or she is, this could be attractive or it could be a source of anxiety.
For the seller, one of the main advantages of a leveraged buyout is the ability to sell a business that might not be at its peak performance but still has cash flow and the potential for growth. This type of buyout also allows groups such as employees or family members to acquire the company, if, for example, the current owner is retiring. One final benefit: If the target company is privately held, the seller will be able to defer capital gains taxes.
The risks of a leveraged buyout for the target company are also high. If they’re unable to service the debt, the end result is bankruptcy. This is why it’s important to consider all the pros and cons of a leveraged buyout before signing on the dotted line.
Is my company a good candidate for a leveraged buyout?
Thinking about selling your company through a leveraged buyout? If your business has a positive balance sheet, you’re on the right track. This means you have things like tangible assets, good working capital and positive cash flows. Having a positive balance sheet means lenders are more likely to lend to you. Firms looking to acquire companies through a leveraged buyout typically also look for proven management and a diverse, loyal customer base. They’ll want to see ways to reduce costs quickly, selling off non-core assets or finding synergies.
Your company doesn’t have to be operating at maximum performance in order to be a good candidate for a leveraged buyout. Companies that may be struggling due to a recession in their industry or poor management but still have positive cash flow are also good candidates for a leveraged buyout. Investors may see an opportunity to create efficiencies and improve the business and therefore be interested in acquiring it.
Making the decision to consider a leveraged buyout of your company is not something to be taken lightly. If you’re weighing the pros and cons of a leveraged buyout, you would benefit from working with a business coach who can help you consider all angles and make the best decision for you and your company. A business coach can look at the prospect objectively and without the emotion that you as the business owner will bring to the decision. With their help, you can make a solid decision that is best for your future.
Despite some bad press in recent years, a leveraged buyout is a viable exit strategy in many situations. As with any business decision, weigh the pros and cons before making your decision. With a little intuition, a lot of research and the help of a business coach, you’ll make the right choice and see significant personal and financial rewards.
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