2 Tips for Structuring the Deal in an LBO

Two of the most common questions I get from potential buyers looking to buy their first business is:

1) What should I offer?

2) How should I structure the deal?

There are several books that will give you multiples and, while useful as a guide, the structure of the deal depends upon a few things. A couple of books I've read and found authoritative and helpful in the valuation process:

Tom West's "Business Reference Guide"

Stephen Bethel's "Business Valuation Rules of Thumb & Formula Resource Guide"

However, as useful as the reference guides listed above are, they don't dive into how best to structure the deal.  Most of the businesses I buy I try to structure with an LBO (leveraged buyout) mindset, which really is the best approach when trying to protect your downside.  This approach won't work well for service-based businesses or businesses with few or difficult-to-quantify assets.

Here's a general guide for buying a business and you want to protect your downside (hint: you should always protect your downside).
 
1) Look to the balance sheet for your downpayment.  

Additionally, be prepared to discount the assets to create a floor.  Anything below this number, the seller is better off simply liquidating himself.  In most small-business situations, you don't want to put down more than the assets of the business are worth at face value.

For example, a small manufacturing business I helped someone evaluate today has $650K in equipment and about $100K in inventory in the asset column.  Not sure how they figured its worth at $650K, but let's assume I can buy most of the major equipment units off ebay or through a liquidator for $350K.  The $350K would be my floor.  Assuming I could buy the equipment new for $500K, the $500K would be my ceiling.  So my downpayment is going to be between $350-$500K.  We'll say $400K as an example.

2) Look at the income statement for the debt service.

The company we looked at today is doing $1.2M in sales and is throwing off a steady $200K per year in positive cashflow.  $200K is the most it can afford to pay in debt service.  Of course, the business will also be required to support a new owner-manager's salary - say $40K/year for the first year.  And we have a minimum ROI on our capital invested, of say 25%, or $100K per year.  That leaves us with a cap of $60K per year in 'leftover' cashflow available for servicing debt.

We could offer the Seller a note for $300K at 6% for 6 years and that would bring our annual debt service to about $60K/year.


Total offer price: $400K down + $300K note = $700K.


Their asking price?


$850K.


So there's a gap there.


Either the Seller will bend and accept the offer as it's going out, or the Buyer will need to come up a bit more on an earnout basis.


In any event, the point here is that you need to know what a business can realistically support from an income/debt standpoint, and what the business is worth from a balance-sheet/downpayment standpoint.