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.

Whether your business is at peak performance and you want to capitalize or you’re thinking about retirement, a buyout could be a good option for you. In particular, leveraged buyouts provide a means of exit that is realistic for many companies.

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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. That’s where the option of a leveraged buyout becomes attractive.

why are leveraged buyouts used

What is a leveraged buyout?

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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, 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.

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 will be able to get the price they want for the business and will have 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.

what is a leveraged buyout

To break up a large company

what is a buyout

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.

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.

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To acquire a competitor

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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. 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 – like many things in life. 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 leveraged buyouts 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 leveraged buyouts. Investors may see an opportunity to create efficiencies and improve the business.

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 and a lot of research, you’ll make the right choice and see significant personal and financial rewards.

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Learn about the advantages and disadvantages of a leveraged buyout, along with other exit strategies, with Tony Robbins’ 7 Forces of Business Mastery free content series.