What is a leveraged buyout?
Selling a small business can be extremely difficult, as the prospect pool for potential buyers in that particular niche is going to be small. Finding financing for a small business is challenging, as well, due to banks typically wanting to deal with larger transactions. Even if a potential buyer is found, they may be wary of any debt or other operational red flags that may cause them to have to come up with a lot of cash in the acquisition phase of the transaction. This is where a leveraged buyout might come in to play.
A leveraged buyout involves using a combination of the buyer’s equity and the company’s assets as a means of collateral in financing the purchase of a business. Typically, this type of transaction is done when one business is buying out another. Leveraged buyouts are a way for the purchaser to leverage assets (a big, expensive machine for manufacturing a product, for example) and cash flow to cover a large portion of the purchase price of the business, mainly to avoid having to come up with a significant cash contribution at the beginning of the transaction.
One common way that a leveraged buyout is structured is where the buyer buys only the assets of the company being acquired, which can decrease the liability of the buyer should the company have been in previous financial trouble. The business that is purchasing the other can also just absorb the target company as a whole, although this will increase the liability of the buyer.
A leveraged buyout of a small company usually involves two different kinds of financing: the money borrowed to acquire the business and the money borrowed to pay for the operating expenses until the company is relatively financially stable. Finding a small business loan through traditional methods (going to the bank and getting a loan) can be difficult, as lenders tend to want to work with larger transactions with less risk. Companies can get creative when coming up with financing leveraged buyouts, however, and it’s common to use a combination of two or more sources of funding. Here are a few ways that companies can finance the leveraged buyout of a small business:
● Debt assumption - this is where the buyer assumes the seller’s debt, sometimes just paying off that debt amount as repayment.
● Using assets as collateral - things such as machinery, or even real estate, can be used as collateral to secure a loan.
● Seller financing - this can be reassuring to the buyer, as a seller willing to finance the transaction usually knows that the business will make money in the future, allowing the buyer to repay the loan.
● Factoring - using the company’s accounts receivable and cash flow numbers to secure a loan. Factoring is usually used when trying to secure a loan to cover operating costs.
● Traditional bank loans - these can be hard to get, depending on the credit of the company or person who is buying the business. Bank loans can also carry rules as to certain levels that the company must maintain financially.
Leveraged buyouts can be mutually beneficial to the buyer and seller, as long as the transaction is structured in a way to limit the liability of both parties. Selling a small business can be difficult, and using this type of transaction can drum up interest in buyers that might not be able to get a traditional loan and buy the company outright. Using a business’s equity to purchase another can reward the buyer with large returns (although the debt level will be relatively high), meaning more money to spend on operations and expansion. There are also tax benefits involved with a leveraged buyout, which you can read more about here.
The biggest disadvantage of this type of transaction is that the business is heavily leveraged until loans are paid down, meaning that the new owners will be running with a very thin margin of error financially. With the assets of the company already being used as leverage, there won’t be a lot of wiggle room should sales or production slow down.
Also, with funding usually coming from multiple sources and areas, leveraged buyouts tend to have a lot of moving parts, which can escalate the risk involved for both the buyer and the seller. Because of the abundance of steps in the purchasing process, the due diligence period (where the buyer conducts inspections on the physical assets of the business and investigates finances and debt) can be lengthy and tedious. This could be time spent on the operations of the business and actually making money.
With sources of funding for small businesses being limited, it helps to be able to use what you have around you to make things happen. In the case of leveraged buyouts, companies can use their equity to purchase other businesses. Funding will still have to come from somewhere, however much it may be. Contact one of our small business loan experts at LoanMe if you’d like to learn more about leveraged buyouts and how a small business loan can benefit you in the process.