A leveraged buyout model is a way to determine how much it would cost to buy a company in current market conditions using a combination of your own equity and debt so you and your lenders will have some assurance of making money on the deal. The LBO process usually spans a period of anywhere from three to five years, which gives you enough time to do what you need with the company to increase its profitability so you can pay back the lenders and make money on the purchase yourself.
Understanding a Leveraged Buyout
A buyout simply means you are buying out the owner of a company to take possession of it yourself. A leveraged buyout means that you are borrowing money to make that purchase. That is, you are leveraging a small amount of your own equity with a loan to make a much larger purchase, just as you might leverage your own muscle power with a crowbar to open a heavy crate.
If you were buying a company with your own funds, a buyout could be much easier to calculate than an LBO. However, because you are using a bank's money, it becomes more complicated. First, you need to show your lenders that they will get their money back plus interest. Secondly, you need to assure yourself that the business you are buying will generate enough money to stay profitable while paying for the interest on your debt.
Basic Principles of an LBO in a Simple Scenario
If you have ever bought a house, you already have a basic understanding of the principles behind an LBO. Instead of a house in which to live, however, imagine you wanted to buy a house, fix it up and flip it for a profit.
The house costs $80,000, and you put 10% down, financing the remaining $72,000 with a mortgage. After a year, your total investment in renovations, fees and mortgage interest is $12,000. With your original down payment of $8,000, this gives you an investment cost of $20,000.
If you sold the house for $110,000, you would make $10,000 profit. You've bought out the original owner and made a 50% return on your $20,000 investment.
A Slightly More Complicated Scenario
Now, let's add a bit more complexity to our basic example. Instead of flipping the house, suppose you wanted to turn it into a rental property. You're no longer asking yourself how much it will cost to fix it up and sell it at a profit. Now, the question is: For how much can you rent it so that you can pay off the mortgage in five years?
To increase the complexity just a bit — and the profitability — imagine that when you inspect the house, you notice that the attic is stuffed with antique furniture, old oil paintings and an old stamp collection. The owner is happy to leave this stuff behind for an extra $1,000.
The questions to ask yourself now are:
- For how much can you sell those unwanted assets?
- For how much can you rent the house?
- What's the best rate you can get on a five-year mortgage?
- Should you put in the minimum down payment?
- Would a higher down payment give you a better interest rate?
- What would be the cost to add a kitchen and bathroom to the basement?
- How much would you earn to rent the basement separately compared to the cost of the renovations?
Understanding LBO Models
Deciding whether or not to buy a rental property has many of the same characteristics as an LBO model. The main question is whether or not the purchase price makes sense based on what you can make back from your investment. The same question is central to an LBO analysis except there are a few more complications to get to that answer:
- What is the target company's cash flow now? This will help you determine the purchase price.
- What will the target company's cash flow be in the next several years? This will help you determine how you will pay back your loans and what the value of the company will be at your exit period.
- How much equity will you invest, and how much will you need to borrow?
- What will be the financing structure? Specifically, what will be your interest rate, and what will the lenders require from you to approve the deal?
Because of the risks involved, investors will typically want a high rate of return. This is why you need to know the equity value of the target company when you exit. An exit could be your decision to sell the company to someone else, but this isn't always the case, so think of it in terms of exiting your relationship with the lenders.
Using LBO Model Templates
Creating an LBO model is something you should probably do on a spreadsheet. You will need to make a lot of assumptions at the beginning that will likely need to be changed and recalculated.
There are templates available online, but unless you have some background in accounting, they can be very confusing at first. You should expect it to take you some time and research before you feel confident in creating an advanced LBO model. Use the following steps to draft an LBO model.
Calculate the Purchase Price
The first step is to determine the purchase price of the company. If it's a public company, this could just be a matter of looking at the current stock price, but for a private company, you will have to make an educated guess.
One way to calculate the company's value is to estimate the company's earnings before interest, tax, depreciation and amortization (EBITDA) and then multiply this number by five years. For example, if the company's revenue is $1 million with an EBITDA margin of 15%, then a good purchase price might be $750,000 ($150,000 x 5).
Calculate Debt and Equity Funding
Determine how much of your own money (equity) you will be using and how much you will borrow. For example, assume you were putting up 50% equity and borrowing the remaining $375,000. This may be a good ratio for some deals, while another deal may require less of your own money.
Create an Income Statement
Assuming that your creditors want their investment back in five years, you will need to create an income statement for that period to determine the company's cash flows and how much debt will be paid down each year. Note that if the company isn't going to generate enough cash to pay the debt payments, you can probably stop here.
Calculate the Exit Value and Returns
While you're certainly not required to sell the company, calculating its value at an assumed exit time (such as five years) is an important part of the LBO model. Not only will it help you to determine if it's a good investment or not but it will show your investors that they can get back their money at the exit point.
To calculate the exit value, use the same EBITDA multiple you used for the purchase price based on the company's projected revenue in five years' time.
Calculate the Internal Rate of Return
Once you have the exit value of the company, you can use this amount to determine your internal rate of return on your initial investment. To determine the IRR, you will need to calculate the net debt at exit, the company's equity value and then the multiple-of-money return:
- Net Debt at Exit = Beginning Debt - Debt Payments
- Equity Value (EV) = Company Exit Value - Net Debt at Exit
- Multiple-of-Money (MoM) Equity Value = Ending EV / Beginning EV
If the beginning EV was $750,000 and the ending EV is projected to be $1,500,000, then the MoM equity value would be 2.0x.
Determining the exact IRR based on the MoM multiple usually requires advanced software like that used by investment bankers. However, in most cases, you can use a table to estimate the IRR from the MoM over the number of years until the exit period. A table provided by Street of Walls for a five-year period reveals that the IRR for a MoM of 2.0x would be about 15%.
- Be sure to compare the return on investment you calculate in the final step to your desired rate of return based on the riskiness of the investment. Do not invest in the company if the LBO model gives you an unsatisfactory rate of return.
- Make sure that you have enabled circular references in Excel. Linking the interest expense back to the cash flow statement will create a circular reference, which Excel will not be able to handle unless it is set to manual calculation. Click the "Microsoft Office" start button and select "Excel Options." Then select "Formulas" and check the "Manual" box under "Calculation Options."
A published author, David Weedmark has advised businesses on technology, media and marketing for more than 20 years and used to teach computer science at Algonquin College. He is currently the owner of Mad Hat Labs, a web design and media consultancy business. David has written hundreds of articles for newspapers, magazines and websites including American Express, Samsung, Re/Max and the New York Times' About.com.