There are advantages & disadvantages of a leveraged buyout to finance a small business acquisition. An LBO is a type of transaction in which the buyer takes out a loan to help cover the purchase price. The business being acquired is used as collateral for the loan, and the buyer pays back the loan over time using the cash flow from the business.
On the plus side, an LBO can help the buyer stretch their budget and increase their buying power. In addition, interest rates on business loans are typically lower than those on personal loans, making an LBO an attractive option for many buyers.
However, there are also some risk involved in using an LBO to finance a business acquisition. If the business being acquired does not generate enough cash flow to make the loan payments, the buyer could find themselves in financial trouble.
In addition, if the value of the business declines, the lender may require the buyer to put up additional collateral, which could put even more stress on their finances. As with any type of financing, it’s important to carefully consider the pros and cons of using an LBO before signing on the dotted line.
Advantages of Leveraged buyout
One of the most important advantages of a leveraged buyout is that it allows a small business to acquire another company without taking on large amounts of debt. By using the target company’s assets as collateral, the acquiring company can obtain financing a small business acquisition without putting its own credit at risk.
1. Allows you to buy the largest possible business
One of the main advantages of using an LBO is that it enables entrepreneurs to use financial leverage (e.g., debt) to acquire a larger business than they otherwise could purchase. This aspect of LBOs can be an advantage for some buyers because acquiring a larger company is preferable. They are usually better established and have a greater chance of success.
In addition, the economies of scale that come with a larger company may also be appealing to buyers. However, it’s important to remember that leverage also creates risk. If the business does not perform as well as expected, the buyer may be forced to sell the business or declare insolvency.
2. Increases your rate of return
When done correctly, leveraged buyouts can be a great way to amplify your rate of return as an investor. By putting down a smaller amount of money and borrowing the rest, you’re able to control a larger business. And since you own a larger percentage of the business, your potential rate of return also increases. Of course, there is more risk involved in taking on debt, but if the deal is successful, the rewards can be substantial. For this reason, leveraged buyouts continue to be an attractive option for many investors.
3. Minimises the size of your equity contribution
Minimising your equity contribution is an important consideration for buyers who want to maximise their return on investment. By using the largest possible amount of leverage, buyers are able to reduce the size of their investment and increase their potential return. This feature is especially important for buyers who don’t have much money to invest or who want to diversify their investments. By using leverage, buyers are able to reduce their risk and potentially increase their returns.
4. Can be financed using UK Government backed loans
UK Government back loans to leverage into a business such as the Northern Powerhouse Investment Fund, supported by the European Regional Development Fund, provides commercially focussed finance through Microfinance, Debt and Equity Finance funds. NPIF is a collaboration between the British Business Bank and ten Local Enterprise Partnerships (LEPs) in the North West, Yorkshire, the Humber and Tees Valley.
Disadvantages of Leveraged buyout
While a leveraged buyout can provide many pro’s to entrepreneurs, it is important to be aware that there is a number of disadvantages. One of the most significant risks is the possibility of defaulting on the loan. If the business is unable to make the required payments, the lender may foreclose on the property or impose other penalties.
Here are the most important disadvantages:
1. Minimal financial cushion to manage problems
One of the biggest dangers of acquiring a company using an LBO is that it often leaves the business with very limited financial resources. This can be a problem if the company encounters any unexpected problems down the road. Many entrepreneurs underestimate this risk, which can leave them unprepared.
This situation is often aggravated when buyers invest all of their assets into the acquisition. This leaves both the buyer and the company financially exposed and without the resources to manage a downturn. This can be a recipe for disaster if the company hits some bumps in the road. Acquiring a company using an LBO can be a great way to grow your business, but it’s important to be aware of the risks involved. Make sure you have a solid plan in place to protect yourself and your investment.
2. Equity can quickly disappear
Equity can quickly disappear in an LBO. Equity is the portion of the business that is owned by the shareholder. Equity represents the amount that would be left over if the business sold all of its assets and used the proceeds to pay off its liabilities. Equity is at risk in an LBO because the debt used to finance the buyout puts a strain on the business’s finances. The interest payments on the debt eat into cash flow, and if the business cannot generate enough cash flow to make the interest payments, the creditor may foreclose on the property.
In a foreclosure, the creditor seizes all of the assets of the business and sells them to repay the debt. The shareholders are left with nothing. Equity is also at risk because leveraged buyouts often involve adding debt to finance the purchase price. This increases financial leverage, which means that a smaller change in operating results will have a larger effect on equity.
For example, if earnings before interest and taxes (EBIT) decline by 10%, equity will decline by more than 10% if the company has high financial leverage. Financial leverage is risky because it amplifies both gains and losses. Equity is also at risk because an LBO typically involves paying a large amount of cash for the business. This leaves little room for error, and if things go wrong, equity can quickly disappear. Equity holders should carefully consider these risks before investing in an LBO.
3. Obtaining additional financing is impossible
Obtaining additional finance is impossible due to most leveraged buyouts try to take on as much debt financing as possible. Consequently, all assets are pledged as collateral for their loans. This situation leaves companies unable to secure any additional financing after the acquisition. Companies that face challenges after the acquisition may not be able to secure the funding they need to manage them, which can put them at a disadvantage.
To avoid this situation, buyers should assume they won’t be able to get additional financing for many years and attempt to secure a provision for growth financing at the time of the acquisition. By doing so, they can ensure that they have the resources they need to manage any challenges that may arise
Small business LBO misconceptions
Small business owners often mistakenly believe that a leveraged buyout (LBO) is a simple way to get rich quick. While it is true that an LBO can be a highly profitable transaction, there are a number of risks and challenges that must be considered. For one thing, buyers must have a sound understanding of the business and the market in order to successfully complete an LBO.
In addition, buyers must be prepared to invest significant time and resources in the business in order to make it successful. Finally, buyers must be aware of the potential for leverage-induced financial distress, which can occur if the business is not able to meet its debt obligations.
While an LBO can be a great way to build equity and create value, it is not a quick or easy path to riches. There are a few myths that seem to persist in the marketplace:
Myth #1: Buyers don’t need an equity injection
Buyers don’t need an equity injection for a small business leveraged buyout. While this may be true for a large acquisition, it is not true for a small leveraged buyout. We are not familiar with any lender that finances 100% of a small business acquisition. Lenders require the buyer to put a 10% equity injection into the purchase of the company.
The equity injection cannot be financed or come from seller financing. The equity injection can be reduced to 5% only if the seller agrees to a “standby clause.” A standby clause states that senior lenders must be paid off first before the seller is paid. In our experience, few sellers agree to this condition. Buyers should be aware that they will need to have some equity in the company in order to successfully complete a small business leveraged buyout.
Myth #2: Buyers can use unsecured financing
Though small business lenders typically require a buyer’s loan to be secured by the buyer’s assets, there are some cases where unsecured financing can be used.One such instance is when the buyer is able to provide evidence of strong financial standing through things like a solid business plan, good credit score, and/or sufficient liquid assets. In these cases, lenders may be more willing to take on the risk of an unsecured loan.
Alternatively, government loans are sometimes available to buyers as a way to secure financing without using personal assets. These loans typically come with more stringent requirements than private loans, but they can still be a viable option for buyers who meet the eligibility criteria. Buyers should weigh all their financing options carefully before making a decision in order to choose the best option for their unique situation.
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For a detailed explanation of LBOs, read “What is a leveraged buyout?”
F.A.Q’s
What are the advantages and disadvantages of leverage?
The advantages and disadvantages of leverage may increase an investment's returns, there is a drawback: if the investment does not work out, it may increase the potential risk and loss of the investment. Leverage is the use of borrowed capital (debt) to fund an investment or project. As a result, the potential returns from a project are multiplied.
What are the advantages of a leveraged buyout?
The advantages of a leveraged buyout are they get to spend less of their own money, get a higher return on investment and help turn companies around. They see a bigger return on equity than with other buyout scenarios because they're able to use the seller's assets to pay for the financing cost rather than their own.
Seasoned professional with a strong passion for the world of business finance. With over twenty years of dedicated experience in the field, my journey into the world of business finance began with a relentless curiosity for understanding the intricate workings of financial systems.