Basic Leveraged Buyout (LBO)

The mechanics of a simple leveraged buy-out

Let's say that many years ago,

you started yourself a
nice little business.

You have no debt and
your business every year

generates a pre-tax income

of a million and a half a year and a

third of that goes to taxes.

So you get a nice one million dollars

a year of net income and
it's a super stable business,

nothing risky over here.

Just by virtue of what your business does,

the odds of this one million a year

changing for the better or
the worse isn't that likely.

So this is essentially your ...
This is what your balance sheet

would look like.

These are your assets.

You have no debt.

Let's assume you have no liabilities

and so you own all of the equity.

You essentially own all of the assets,

but you're nearing retirement

and you want to kind of cash out.

You don't necessarily want
to sell to your competitors

or maybe there aren't any
natural competitors to sell to

because you've been comp
... Well, you don't want to

sell to them if they exist
because you've been competing

with them for your ... for your whole life

and this isn't the type of
business that you can IPO

because it's not quite big enough.

So maybe we bump into
to each other and I say,

"Hey, this business looks
interesting. I like the idea that"

"your business is stable and
can generate a lot of income"

"year after year after year."

So what I say is, "Hey,
would you be willing to take"

"10 million dollars for your business?"

So I offer ... I offer 10 million dollars.

And to you that sounds pretty good.

That's about ten times ...
That's exactly ten times

your yearly net income.

This isn't a growing
business, just very stable.

Seems like a reasonable deal to you.

On the other hand for
me, I'm like you know

paying 10 million dollars
and getting a million dollars

a year, that's kind of 10% on my money.

That's okay, but maybe I
can get some leverage here.

Maybe I don't have to put
all of the 10 million in

maybe I could borrow some of it

and maybe I'll get a
better return that way.

So when it comes time to closing
... When it comes time to

closing, so I'm buying the assets.

So these are the same
assets that I'm buying

and I'm gonna give them ...
and the money that I raise

for these assets are gonna go to you,

the person who started this business.

So here are the assets.

So instead of me putting up
the entire 10 million dollars,

what I do is I put up one
million dollars myself

So I put up one million dollars myself,

one million from ... from me.

And I go to a bank and I say,

"Look, will you lend me 9
million dollars? I'm going to

"put a million dollars of my
own money. Will you lend me"

"9 million dollars to
help borrow ... to help"

"buy this business for
10 millions dollars?"

and the banks says,

"I don't know. That's a lot of money."

"We're putting a lot of money at risk."

and I'l say, "Look, you can
charge me a decent interest rate,"

"maybe a 10% interest rate
and this is a super stable"

"business, so clearly I'll
be able to pay the interest"

"on that money from the business
and if for whatever reason"

"I'm not able to pay you the money,"

"you can get the business. So,
I'm essentially giving you"

"the business as collateral."

So you find some bank to agree to it

and so they will lend
you 9 million dollars.

They will not lend you 9 million dollars.

Nine million dollar loan

and let's say that it is at
a 10% ... 10% interest level.

So now, after I have ...
So 9 million from the bank,

one million from me. That goes to you.

You can now retire and buy your dream home

or whatever else you
might have needed to do

with that money.

You could leave it for your
children, whatever you might ...

Donate it to charity,
whatever floats your boat

but now the capital
structure of the business

looks like this.

I now do have a lot of debt.

I bought you out using leverage.

This is a leveraged buyout.

So now, there is one
million dollars of equity

that came from me

and there's 9 million dollars
of debt that came from the bank.

That's 9 million dollars of debt.

Assets, at least what I paid
for it was 10 million dollars.

Liabilities are 9 million dollars.

So what's left over is one million.

And let's think about how this investment,

assuming the business keeps
generating a million a year,

let's think about how good
of a payoff this might be

for my one million dollar investment.

So before I had a pre-tax
income of 1.5 million.

So 1.5 million pre-tax. Pre-tax before.

Now I'm going to have
to pay some interest.

So now I'm going to have to
pay ... So 9 million dollars

at 10%, that is $900,000 in interest.

So now my pre-tax won't be 1.5 million.

I'm also going to have
to pay 900k in interest.

So minus 900k means that I have 600,000,

so 1.5 - 900k is 600,000
per year pre-tax income,

600,000 per year in pre-tax income

and then I will pay taxes on that.

The cool thing about corporate interest

is that it's tax-deductible.

It's deducted from your pre-tax income.

So you take the 900 from
the 1.5, you have 600,000

leftover and then you pay taxes on that

and let's say it's
still the same tax rate,

so roughly one-third of
it goes to the government

and so that you are left
with 400,000 net income

and if you look at the
math, this is actually

a pretty good deal for me or
I should ... I was saying you,

but I'm the guy who bought it.

You're the guy who sold me the business,

so this is me now.

I am left with $400,000
net income per year,

which is pretty good because I only made

a one million dollar investment.

So even though this looks
like a sleepy business,

even though it looked
like it was only getting

a 10% yield on it, because
I was able to leverage up.

I was able to do this leveraged buyout,

I'm now able to make $400,000 per year

on a one million dollar investment

and now all of a sudden that is
a not so sleepy annual return.