1. Cash-Flow and Asset-Based Leveraged Buyouts
2. Hockable Assets
3. Risks of Leveraged Buyouts

Updated July 28, 2020: 

A fully leveraged buyout (LBO) is a type of business acquisition transaction in which the purchaser acquires the business by contributing a minimal amount of their own funds. The purchaser gains financing, or leverage, on the business assets they purchase. This type of transaction is only effective if the company can generate enough cash flow to pay for its expenses and debt services. Afterward, the acquired business can become the means of acquisition for other businesses. Companies often use some of the newly acquired company's assets as collateral to secure the debt used in a leveraged buyout.

Similar to other such transactions, a leveraged buyout requires a comprehensive business analysis, which means that the company to be acquired must be financially secure and have promising long-term income and profit growth expectations.

From the purchaser's perspective, the most significant reason to use a leveraged buyout is that successful buyouts offer the opportunity for a promising return on equity. If the transaction is structured well, the company will generate enough of a return to cover all normal expenses plus the debt service from the transaction. Put simply, it's the well-known business concept of maximizing leverage. Offer a minimal amount of equity and borrow the rest. Once the transaction works out as planned, you'll make a valuable profit.

The situation is slightly different from the seller's perspective. A leveraged buyout offers a way to sell the business. The reality is that securing a purchaser for a small company can require a significant amount of time and effort. Under some circumstances, you might have few options and will need to be flexible to accommodate a potential purchaser. Of course, finding a willing party is even more difficult if your company is struggling and trying to turn its outlook around.

Cash-Flow and Asset-Based Leveraged Buyouts

In every transaction that involves a leveraged buyout, whether cash-flow or asset-based, the main priority is to meet the lender's requirements in order to make the deal a reality. Along with numerous other factors, lenders examine the relationship between cash flow, assets, and price. Like any recipe for success, each of these elements must be in sync for the deal to be worthwhile. The incoming cash must be sufficient to service the debt, the assets must be enough to protect the loan, and the selling price must be promising in regards to both the cash flow and the assets.

After calculating the cash flow, if there is not enough left to service the senior debt, to service the subordinated debt, and to pay the investor or entrepreneur a decent, living salary, then it doesn't make sense to try and make the deal happen. Although it seems obvious, sometimes the excitement of potentially owning your own company can make this detail seem so irrelevant that it's forgotten.

Hockable Assets

The most valuable type of assets when it comes to leveraged buyouts are those that can be easily liquidated (hockable assets). Such assets include:

  • Cash. Naturally, the most hockable asset is cash. If you purchase a business through stock acquisition, you'll receive all of the assets, including cash. Although capital gains tax rates can be detrimental, cash is always 100 percent hockable.
  • Accounts receivable.
  • Inventory. Although works in progress are considered a type of inventory, only raw materials, and finished goods have any value in this kind of transaction.
  • Equipment. Most banks will demand an appraisal.
  • Real property (land and buildings). Like equipments, banks will require an appraisal for property value.

Risks of Leveraged Buyouts

Like all transactions, leveraged buyouts come with their own risks, including the following situations:

  • The buyer might over-leverage the entire transaction leaving the company without adequate preparation to deal with unexpected issues, which are more than likely to arise.
  • Over-leveraging can also mean using operational financing to cover part of the actual purchase cost. For example, a business might factor all outstanding receivable during the initial time of purchase and then utilize those funds to pay the seller. As a result, the company will be left with minimal operational capital, since the bulk of invoice payments for the next month or two have already been allocated to pay the seller. This might mean delaying employee payroll or supplier payments, which, in turn, may cause a downward financial spiral for the business.

If you're considering participating in a fully leveraged buyout or need help understanding this type of transaction, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.