What is a Buyout?
A buyout refers to an investment transaction where one party buys all or the majority of a company’s shares (at least 51%) in order to gain control of the target company. The acquirer buys out the current holders of the equity of the target company and the former owners lose control in exchange for compensation. Usually, a buyout also includes the purchase of the target’s outstanding debt, which is also known as assumed debt by the acquirer.
The transaction often takes place in situations where the purchaser considers a firm to be undervalued or underperforming and shows a potential of improving operationally and financially under their new ownership and control. Like any other investment, a buyout will take place when an acquiring party sees that there is an opportunity of making a good return on their investment. A buyout offer may be one of the main goals of a business owner or an unforeseen opportunity.
The Buyout Process
The buyout process typically commences when an interested acquirer formally makes a buyout offer to the board of directors of the company, who represent the shareholders of the company. Negotiations will then ensue, after which the board of directors will provide insight to shareholders on whether to sell the shares of the company or not.
The money to be used in buyout transactions is usually supplied by private individuals, companies, private equity firms, lenders, pension funds and other institutions. Buyout firms focus on facilitating and funding buyouts and may do so with others in a deal or alone. Such firms normally acquire their money from wealthy individuals, loans, or institutional investors.
Types of Buyouts
1. Management Buyouts (MBO)
A management buyout occurs when the existing management team of a company acquires all or a significant part of the company from the private owners or the parent company. An MBO is attractive to managers since they can expect greater potential rewards by being the owners of the business instead of employees.
An MBO is also a preferred exit strategy for private companies where the owners want to go into retirement or large organizations that want to sell some of the divisions that aren’t part of their core business. The transaction often requires substantial financing, which is normally a combination of equity and debt.
2. Leveraged Buyout (LBO)
A leveraged buyout occurs when the purchaser uses a huge loan to gain control of another company with assets of the firm under acquisition often acting as collateral for the loans. Leveraged buyouts allow purchasers to acquire large companies without the need to commit huge amounts of capital. CFI has an applied LBO Modeling Course, the course will cover how to build a Leveraged Buyout model from scratch.
Advantages of Buyouts
1. More Efficiency
A buyout may get rid of any areas of service or product duplication in businesses. It can reduce operational expenses, which in turn can lead to an increase in profits. The business taking part in the buyout can do a comparison of their individual processes and select the one that is better. The company that is formed will be in a better position to acquire insurance, products, and other things at better prices.
2. Reduced Competition
A business can increase its profits by buying its competition. The buyout will offer the newly formed company increased economies of scale, as well as eliminate the need to get into a price war with a competitor. The move will lead to reduced prices for the products or services of the company, which will be beneficial to its customers.
3. New Technology or New Products
A big and established company may want to buy a smaller company with a new technology or a promising product, a move that will benefit both companies. The smaller company that is being bought will benefit by getting access to better and more resources, as well as the opportunity to offer its technology or products to a customer base that is larger than the previous one.
The larger company will also benefit by incorporating the new technology or products of the smaller company into its current product line, which is possible without the need to pay to license the technology or product of the licensed company.
Disadvantages of Company Buyout
1. Increase in Debt
The acquiring company may need to borrow money to finance the purchase of the new company. The move will affect the debt structure of that company and lead to an increase in loan payments on the company’s books. It may force the company to cut on their normal expenses.
For instance, they may be required to lay off some employees or even end up selling a part of the business so as ensure they remain profitable. Moreover, the funds used by the company for the business buyout takes money away from internal development projects.
2. Loss of Key Personnel
Sometimes company buyouts may be regarded as a time for some of the key personnel to quit and retire or find a new challenge. Depending on their existing contract with the company, they may choose to sell their interest to the business or another company outside. Finding other personnel with equal experience and knowledge can be a tough challenge.
Integration of the personnel and procedures of the two companies is going to take time. Even though the two companies may be doing comparable things, they may have corporate cultures that are opposite to each other. They may result in a resistance to change within the company that can cause many serious problems which will be costly. The result could be a loss in the company’s productivity.
A buyout involves the process of gaining a controlling interest in another company by purchasing a majority of its stake instead of just offering growth equity to the present ownership group. Buyouts may happen because of different reasons. Some occur because the acquirer has confidence that the assets of a company are undervalued and, therefore, can have a profitable resale.
Others may happen since the purchaser has a vision of it gaining strategic and financial benefits such as new market entry, better operational efficiency, higher revenues, or less competition. Ultimately, most buyouts take place as a result of the purchaser’s belief that the transaction will create more value for the shareholders of a company than what is possible under the current management of the company.
During a buyout, both sides will see advantages and disadvantages. There are several things that need to be taken into consideration to make the transaction successful. The agreement should ensure the needs of both parties are met. It is, however, unrealistic for both sides to achieve everything they desired. The pros and cons of the buyout will need to be considered wisely on both sides.
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful: