At Unbroker, we’ve seen many entrepreneurs dream of owning a business but struggle with financing. The good news? You can buy a business using its own cash flow.
This strategy, known as a leveraged buyout (LBO), allows you to acquire a company with minimal personal investment. In this post, we’ll break down the process, helping you understand how to make this powerful financial tool work for you.
What Are Leveraged Buyouts?
The Basics of LBOs
Leveraged buyouts (LBOs) involve the acquisition of one company by another using a significant amount of borrowed money or debt to meet the cost of acquisition. This financial strategy empowers entrepreneurs to acquire businesses without substantial personal capital. The target company’s assets and future cash flows serve as collateral for the loans, allowing you to acquire a business that’s significantly more valuable than what you could afford with your own resources.
How LBOs Work
In a typical LBO, you might put down a portion of the purchase price, with the rest financed through various forms of debt. This approach maximizes your potential returns while minimizing your initial investment. For example, you could acquire a business with just a fraction of your own capital (plus borrowed funds).
Advantages of Using LBOs
LBOs offer several benefits for aspiring business owners:
- Lower initial investment: You can acquire larger, more established businesses.
- Tax benefits: Interest payments on the debt are often tax-deductible.
- Increased returns: Leverage can potentially boost your equity investment returns.
- Operational focus: Debt repayment pressure often leads to improved efficiency.
Understanding the Risks
LBOs come with inherent risks. High debt levels can strain cash flow, especially if the business underperforms. Economic downturns or industry-specific challenges can make debt repayment difficult. It’s essential to analyze the target company’s financials and market position thoroughly before proceeding.
Identifying the Right Target
The success of an LBO depends largely on choosing the right business. Look for companies with:
- Steady cash flows
- Strong market position
- Opportunities for operational improvements
- Valuable assets that can serve as collateral
The ideal target should have cash flows that comfortably cover both operational expenses and debt payments while still providing you with a healthy return on your investment.
As we move forward, we’ll explore how to assess a business’s cash flow for acquisition, a critical step in ensuring the success of your LBO strategy.
How to Assess a Business’s Cash Flow for Acquisition
Analyze Historical Cash Flows
Start your assessment by examining the business’s cash flow statements for the past 3-5 years. Look for consistent positive cash flow and steady growth. A recent study found that 78% of small business owners use their own funds to launch their businesses, highlighting the importance of personal financial investment in early-stage success.
Focus on these key areas:
- Operating cash flow: This shows the cash the business generates from its core operations.
- Free cash flow: This represents the available cash after accounting for capital expenditures.
- Cash flow trends: Identify any seasonal patterns or long-term trends that might affect future performance.
Create Future Cash Flow Projections
While historical data provides valuable insights, projecting future cash flows is equally important. Create realistic projections for the next 3-5 years, considering:
- Industry trends and market conditions
- Potential changes in the business model
- Planned expansions or contractions
- Expected changes in operating costs
Try to be conservative in your estimates. A Harvard Business Review study found that when pessimistic opinions are suppressed while optimistic ones are rewarded, an organization’s ability to think critically is undermined.
Evaluate the Debt Service Coverage Ratio
The Debt Service Coverage Ratio (DSCR) is a critical metric in assessing whether a business can support the debt you’ll take on to acquire it. Calculate DSCR by dividing the business’s annual net operating income by its annual debt service.
A DSCR of 1.25 or higher is generally considered good, indicating the business generates 25% more cash than needed to cover its debt obligations. However, many lenders prefer a DSCR of 1.5 or higher for leveraged buyouts.
Spot Operational Improvement Opportunities
Identify areas where you can enhance cash flow post-acquisition. Common opportunities include:
- Streamlining operations to reduce costs
- Improving inventory management
- Negotiating better terms with suppliers
- Expanding into new markets or product lines
A recent McKinsey study found that entry EBITDA multiples in the buyout sub-asset class reverted to 2021–22 levels after decreasing in 2023, indicating potential opportunities in the current market.
As you complete your cash flow assessment, you’ll gain a clear picture of the business’s financial health and potential. This information will prove invaluable as you move on to the next step: structuring the deal.
How to Structure Your Business Acquisition Deal
Negotiate the Purchase Price
Start with a fair purchase price based on your cash flow analysis. The price should allow for debt repayment while providing a reasonable return. A recent BizBuySell report states the average sale price for small businesses in 2022 was $324,000.
Prepare to negotiate. Many sellers expect some back-and-forth. Justify your offer with concrete data from your cash flow analysis. If the seller’s asking price is too high, propose an earn-out structure where part of the payment ties to future performance.
Balance Debt and Equity
Find the right debt-to-equity ratio for a successful leveraged buyout. While no one-size-fits-all approach exists, financial experts often suggest a range of 1.0 to 1.5 as a balanced approach for many businesses. This can vary widely depending on the business and industry.
Excessive debt can strain cash flow and increase risk, while insufficient debt may limit potential returns. Try to achieve a ratio that allows comfortable debt service while maintaining enough cash for operations and growth.
Explore Financing Options
Don’t limit yourself to traditional bank loans. Consider a mix of financing sources to optimize your deal structure. Some options include:
- Senior debt from banks or alternative lenders
- Mezzanine financing for additional leverage
- Seller financing to bridge gaps and align interests
Seller financing can be particularly attractive. Businesses that include seller financing sell for 20% to 30% more than businesses that sell for all cash.
Evaluate Online Lending Options
If you explore online lending options, consider platforms that offer competitive rates and flexible terms tailored to business acquisitions. Some platforms (like Unbroker) can connect you with multiple lenders, increasing your chances of securing favorable financing.
Model Various Scenarios
Each financing source will have different terms, interest rates, and repayment schedules. Model various scenarios to find the optimal mix that balances cost, flexibility, and risk. Take your time and seek professional advice when needed. Don’t rush into an agreement that doesn’t align with your financial goals and risk tolerance.
Final Thoughts
Buying a business using its own cash flow empowers entrepreneurs to acquire companies that might otherwise be out of reach. This strategy requires careful planning, thorough analysis, and a deep understanding of the risks involved. Scrutinizing the target company’s financial statements, market position, and growth potential will help ensure the business can support both its operational needs and debt obligations.
High debt levels can strain cash flow, especially during economic downturns or industry-specific difficulties. Working with experienced professionals who can guide you through the complexities of the acquisition process will help mitigate these risks. At Unbroker, we understand the intricacies of business acquisitions and offer modern solutions for buying and selling businesses.
Our platform provides transparent, low-cost options that eliminate high brokerage fees, making the process more accessible for entrepreneurs. We have options to suit your needs, whether you prefer a hands-off approach or a more DIY method with expert support. Buying a business using its own cash flow can transform your entrepreneurial journey, allowing you to leverage your skills and vision without substantial personal capital.
