An Interactive Conversation
Let me walk you through how an LBO actually works with real numbers.
So imagine there's this company called ABC Manufacturing. It's worth $100 million, and it's generating about $14 million in EBITDA every year. Pretty stable business, right?
Now here's where it gets interesting. A private equity firm wants to buy this company, but they don't want to use $100 million of their own money. Instead, they only put down $30 million—that's just 30% of the purchase price. Where does the other $70 million come from? They borrow it. That's the "leveraged" part of the buyout.
So they're borrowing 5 times the company's EBITDA?
Exactly! That $70 million loan means they're using 5.0x leverage. The company itself has to service that debt—about $7 million per year in interest and principal payments. It's aggressive, but that's the whole strategy.
Now here's what happens over the next 5 years:
The PE firm works with management to improve operations. Maybe they streamline processes, expand into new markets, or improve margins. EBITDA grows from $14 million to $20 million. Meanwhile, they're using some of that cash flow to pay down the debt from $70 million to $50 million.
And then they sell it?
Right! After 5 years, they find a buyer who'll pay 8 times EBITDA—that's $160 million for a company now making $20 million in EBITDA. But remember, there's still $50 million in debt. So the equity value is really $110 million.
Wait, so they invested $30 million and got back $110 million?
Exactly. That's a 3.7x return, or about 27% annually. That's why PE firms love LBOs—the leverage amplifies their returns.
Okay, now let's look at something completely different—a strategic acquisition.
Picture this: TechCorp is a big, established software company making $40 million in EBITDA. They spot this smaller company called DataSolutions—an analytics firm making $10 million in EBITDA. DataSolutions is doing well, but TechCorp sees something bigger.
What do they see?
Synergies. TechCorp has 5,000 customers who would love DataSolutions' analytics tools. DataSolutions has technology that would make TechCorp's existing products way more valuable. Plus, if they combine the companies, they can eliminate duplicate costs—maybe they don't need two HR departments, two sets of office leases, two separate R&D teams.
So how much do they pay?
They offer $80 million for DataSolutions. But unlike the PE firm, TechCorp uses less leverage—only $30 million in debt, and $50 million from their own balance sheet. That's just 3.0x DataSolutions' EBITDA. They're being more conservative because they can afford to be.
Now here's where the magic happens:
Within two years, they start cross-selling DataSolutions to their existing customers—that brings in new revenue. They eliminate about $2 million in duplicate overhead. They combine their R&D efforts and save another $1 million. All together, they're creating $10 million in new annual value.
So the combined company isn't just worth $40 million plus $10 million?
Nope! It's $40 million plus $10 million plus $10 million in synergies. That's $60 million in EBITDA. The acquisition basically paid for itself through those synergies. And TechCorp never plans to sell—this is their business now, forever.
Alright, last one—growth capital. This is different because nobody's buying anybody.
Think about FastGrow Retail. They've got 15 stores across the region, they're doing $25 million in revenue, making $3 million in EBITDA. They've proven the business model works, but they're not big enough yet to get cheap bank loans. They need money to expand.
So what do they do?
They go to a growth capital lender and say, "We need $10 million to open 10 new stores." The lender looks at their track record and says, "Okay, but this is risky. You're not fully mature yet. So here's the deal: we'll lend you $10 million at 12% interest—that's higher than a normal bank loan—and we want 5% of your company in warrants, just in case you become huge."
That sounds expensive.
It is! But it's the only option at this stage. A bank won't touch them, and they don't want to sell to private equity yet.
So what do they do with the money?
They spend $7 million opening those 10 new stores, $2 million on inventory for those stores, and $1 million on marketing. The plan is to grow revenue from $25 million to $40 million in two years, and double their EBITDA to $6 million.
But here's the catch:
The lender doesn't just hand over $10 million and walk away. They put in covenants. FastGrow has to keep at least $2 million in cash at all times. They have to hit $35 million in revenue by Year 2. They have to reach $5 million in EBITDA by Year 3. If they miss these milestones, the interest rate jumps to 15%.
And then what?
If everything goes well, after 4 years FastGrow is big enough and stable enough to refinance that expensive $10 million loan with a traditional bank loan at 7%. The growth lender gets paid back, earns all that interest, and their warrants might be worth $3 million on top of that. FastGrow gets cheaper financing going forward. Everybody wins.
But they still own their company?
Exactly! Unlike the LBO, the founders and existing shareholders still control FastGrow. They just borrowed money to grow.
So let me make sure I understand the differences:
In the LBO, the private equity firm used maximum leverage—70% debt—to buy ABC Manufacturing outright. They're planning to sell it in 5 years for a big return.
In the strategic acquisition, TechCorp used moderate leverage—37% debt—to buy DataSolutions. They're keeping it forever and combining it with their existing business to create synergies.
In growth capital, FastGrow didn't sell anything. They borrowed expensive money to expand, with the plan to refinance into cheaper debt once they're bigger. The owners still control everything.
Exactly! Three completely different situations, three completely different financial structures.