What is a Leveraged Buy Out (LBO)?
As its name implies, the use of financial leverage, or debt, is one of the primary elements distinguishing an LBO from a traditional acquisition executed with cash or stock. Leverage can enhance equity returns to the Buyers, who have discretionary control over all cash flows that exceed the debt payments incurred. Because interest payments on debt are tax-free, leverage improves equity returns by reducing the amount of equity required to acquire a company and furthers those returns through the favorable tax treatment interest payments receive in the tax code.
Free Cash Flow
Free cash flow is king in an LBO; free cash flow is generally defined as the amount of cash a business generates in excess of its requirements to maintain its current operations. The reason this is so critical is because the free cash flow of the business determines how much leverage the business is capable of supporting without imperiling the business’ ability to stay solvent in a downturn.
What is an Earn-out?
An earn-out is a way for the buyer to pay part of the purchase price on the future performance of the company. The buyer pays a portion of the purchase price upfront, and pays the rest if and when the company meets specified goals. For example, if the seller thinks the business is worth $2 million and the buyer believes it is worth $1.5 million, they could settle on an initial price of $1 million, and the earn-out would provide the seller with another $1 million if the seller meets the goals specified. Earn-out periods tend to be spread over several years (usually 2-3 years). Usually 15-30% of the total is contingent on an earn-out, but that number can be as high as 50% in some deals.
Why Use an Earn-out?
Many times buyers and sellers cannot agree on a company’s value. The seller will usually point to strong growth trends, and the acquirer will emphasize the uncertainties and risk in the marketplace. If the seller’s representations about future growth and revenue are correct, then the seller should reap the reward. However, if the company experiences a massive downturn in sales or if key employees leave after the acquisition, then the acquirer will have overpaid. Hence, the earn-out is a mechanism to share the risk so that the seller is rewarded if the company does well and the buyer can mitigate some of his/her risks if sales fail to materialize. Earn-outs are particularly common for companies where success depends on a small group of key employees, where the assets acquired are a small portion of the transaction, or where the majority of the value is based on future growth.