What is a Leveraged Buyout (LBO)?

You can think of a Leveraged Buyout, or LBO, in the same way you think about buying a house to rent it out. You put down a small amount of your own cash. You borrow the rest from a bank. The rent you collect pays the mortgage.

In the business world, an LBO is the acquisition of another company using a significant amount of borrowed money to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loans.

The ratio of debt to equity in these deals is usually high. It is common to see a mix of 90 percent debt and only 10 percent equity.

The goal is simple. By using less of your own money to buy the asset, you can achieve a much higher return on equity if the business succeeds.

There are three main players in most LBO scenarios.

First is the financial sponsor. This is usually a Private Equity firm. They provide the equity portion of the capital.

Second are the lenders. These are investment banks or other financial institutions that provide the debt. They are looking for interest payments and return of principal.

Third is the target company. This is the business being bought. In an LBO, the target usually has strong, reliable cash flows.

Reliable cash flow is a requirement. The debt has to be serviced immediately. If the company is burning cash or is pre-revenue, an LBO is mathematically impossible. The math only works if the acquired company can pay for its own purchase price over time.

It is important to distinguish this from the Venture Capital model most founders know.

In VC, investors inject cash in exchange for equity to fund growth. There is no debt service. The risk is that the equity becomes worthless.

In an LBO, the capital structure changes entirely.

• VC Model: High equity, zero or low debt, focus on growth.
• LBO Model: Low equity, high debt, focus on cash flow optimization.

VCs bet on potential. LBO sponsors bet on predictability.

You might be wondering why you need to know this if you are building a startup. You are likely focused on product and growth rather than financial engineering.

There are two specific scenarios where this becomes relevant.

First is the exit. As your company matures, you may not sell to a strategic competitor like Google or Apple. You might sell to a Private Equity firm. They will likely use an LBO structure to buy you out. Understanding how they value your cash flow helps you negotiate.

Second is the acquisition strategy. You may reach a point where you want to buy a competitor or a complementary service. If you do not want to dilute your own shareholders by issuing more stock, you can use debt financing to buy that company. You effectively perform a mini-LBO.

The danger in an LBO is the leverage itself.

Leverage acts as a magnifier. It magnifies returns when things go well. It magnifies losses when things go poorly.

If the company experiences a downturn, the debt payments do not stop. This can lead to bankruptcy for companies that were otherwise operationally sound but financially overextended.

It forces a question you must ask yourself. How stable are your future revenues? If the answer is anything other than rock solid, leverage is likely the wrong tool.