How to do a Leverage Buyout for Small to Medium Sized Enterprises?

When I am talking with individuals about purchasing an existing business to run themselves, leveraged buyouts come up with frequency. If my questioner asks with some hesitation, I tend to find that the term leveraged buyout still carries a negative connotation for many people. This is understandable, as the media often plays up the concept of a leveraged buyout as necessarily hostile and anti the little man. Yet, a leveraged buyout is simply another legitimate way for someone to acquire a business. Certainly, many such buyouts appear to be or truly are hostile, but the methodology is quite common and can just as easily lead to a win-win scenario for both buyer and seller.

Very simply, when an interested individual does not possess the requisite cash or personal equity, or cannot attract investors, one option is to borrow a portion of the purchase price against the target business’ current assets and/or projected cash flow.

The basic leveraged buyout equation considers assets, cash flow, and debt within the company in question. First, assets, cash flow and sale price must be in agreement. Lenders look carefully at the relationships between these three factors, and if one number does not support the other two in typical leveraged arrangements, the deal will likely not be made.

For example, if cash flow will support the asking price but assets could not liquidate for enough, lenders will likely not finance the purchase, unless outside collateral is brought in. Likewise, if projected cash flow, after the senior and subordinated debts are paid, is not enough for the buyer to live on, the contract is probably not a good idea.

Assets must be reasonably calculated. Balance sheet entries read one way for inventory, long-term assets and accounts receivable, however, lenders have their own ideas about whether certain assets are actually worth listed values, and about how to calculate the value they will lend against.

Cash, of course, is liquid and immediately available to pay against the purchase price. Accounts receivable are factored or pledged. Factoring, usually for companies with little net worth, comes with high financing rates. More favorably, lenders may offer up to 70% or 80% of the receivable’s value through pledging. Eligibility of the receivables is usually subject to a number of conditions, primary of which is invoice age, which ostensibly indicates recoverability. Lenders may altogether refuse to consider pledging on receivable for service companies, arguing that there is no recoverable collateral in service.

Inventory - raw materials or finished goods - may be loaned upon, work-in-progress so rarely as to say never. Terms for raw materials are based on re-sellability: high liquidity means more favorable financing, up to 50%. Terms for finished goods are largely based on whether a warranty is issued. Finished goods issued with a significant warranty are viewed with suspicion, while lack of warranty may bring, again, terms as generous as 50%.

Equipment can support financing amounts up to on average 70% of their value, although said value of equipment is subject to a range of valuation techniques which always provide numbers below valuation in balance sheet conditions. Land values the least variably, sometimes, although rarely, supporting up to 90% of value into the loan amount.

Hockable assets comprise only a part of the equation. Many business owners request a sale price that does not reflect existing debt, but common sense dictates that subtraction of debt from current value is a more accurate reflection of a loan outcome. In this vein, distressed businesses are generally not attractive candidates for leveraged buyouts. Even though the asking price may be exceptionally low, cash flow is a problem, accounts receivable may be part of the problem, and the assets may already be collateral. The three properties against which the lending is leveraged are already compromised and no lender will touch the deal.

These notes, to be sure, draw only the barest picture of a leveraged buyout. I detail them to assure potential buyers that a leveraged buyout is a legitimate possibility when an equity or venture capital purchase is not. It need not be hostile to any party involved. A buyer must look carefully at the spreadsheet and ask smart questions about whether assets can be valued sufficiently to make the deal worthwhile.