LBO basics explained simply for buying an SME or a startup

LBO stands for leveraged buyout. Behind that intimidating acronym sits a simple and powerful idea: you buy a company by borrowing most of the price, and it is the acquired company that repays that debt out of its own profits. So you do not need to have the full price, only a fraction of it in equity. An LBO is not an investment fund technique reserved for large deals: it is exactly the mechanism any buyer uses when acquiring an SME or a startup on credit. This article explains how the structure works, what makes a target financeable through an LBO, and how to avoid turning leverage into a trap.

The principle: the company pays for its own purchase

The heart of an LBO fits in one sentence: you set up a holding company that borrows to buy the shares of the target, then the target pushes its profits up to the holding to repay the loan. You, the buyer, own the holding with a limited contribution. The debt is not secured against your personal wealth but against the flows and assets of the acquired company. In plain terms, the company finances its own purchase. That elegance is what makes the LBO so widespread, and it is also what makes it dangerous when the target lacks the flows to keep up.

In practice the structure always follows the same sequence. You set up a holding. The holding raises acquisition debt from a bank and receives your equity contribution. With those funds it buys 100 percent of the target’s shares. Once it owns the target, the holding pulls up the target’s dividends each year and uses that cash to pay the installments on the acquisition debt. In France, tax consolidation between the holding and the target often lets you offset the interest against the target’s profit, which cuts tax and improves the cash available to repay.

Why leverage multiplies your return

Leverage is well named: it amplifies the return on your equity. If you buy a company entirely in cash and it gains 50 percent in value, you earn 50 percent. If you bought it with 20 percent equity and 80 percent debt, the same rise in value, once the debt has been repaid by the company, multiplies your initial stake far more. The debt acts as a mechanical lever: a small contribution lifts a large value. But a lever works both ways. If the target disappoints, it is your equity that absorbs the loss first, and it can vanish entirely before the bank loses a single cent.

Leverage does not create value, it concentrates it. On a good target it multiplies your return, on a bad one it speeds up your ruin. The quality of the business always matters more than the cleverness of the structure.

What makes a target financeable through an LBO

Not every company lends itself to an LBO. The structure rests entirely on the target’s ability to generate stable, predictable cash flow to repay the debt, year after year. A bank does not look at potential, or at the story you tell it. It looks at the regularity of the flows, full stop. The targets that pass share a recognizable profile: profitable for several years, not dependent on a single client or on the departing owner, with modest investment needs and demand that does not collapse at the first recession. On the buyer files we work, French banks balk hardest on two things, client concentration and key person dependence, well before the level of debt itself.

• Recurring, predictable profits: an LBO hates cyclicality and jagged revenue, which jeopardize repayment in the bad years.
• Low capital intensity: if the target swallows its cash in machines and heavy investment, little is left for the debt.
• Limited dependence on the owner: if the value leaves with the seller, the flows that repay the debt leave with them.
• Low starting debt: a target already loaded with debt leaves little room for the acquisition debt.
• Controlled working capital: working capital that swells with growth devours the cash meant to repay the holding.

Conversely, be wary of targets that are attractive but unsuited to leverage: a hypergrowth startup burning cash, a seasonal activity, a company where half of revenue rests on a contract up for renewal, or an industrial workshop needing heavy reinvestment. These companies may be worth buying, but not with 80 percent of debt on their back.

A worked LBO, from structure to return

Take a target priced at 2 million euros, a profitable services SME with normalized EBITDA of 500,000 €. You build the LBO this way: 400,000 € of equity injected into the holding (20 percent), 1.3 million of senior acquisition debt (65 percent), and 300,000 € of subordinated vendor loan (15 percent). The holding buys 100 percent of the shares. Your personal stake is 400,000 € to control a company worth five times that.

Now let us see whether the target can carry the leverage. Start from EBITDA of 500,000 €. Subtract maintenance capex, the change in working capital, tax and your own pay as the manager: say 280,000 € of cash is genuinely free to service debt. If the annual senior debt instalment runs around 200,000 €, the coverage ratio (DSCR) comes out at 1.4, inside the acceptable zone, provided the vendor loan is in grace for the first few years. Over seven years the company repays the senior debt out of its own flows. At exit, assuming a steady value of 2 million and the debt extinguished, your starting 400,000 € is now worth most of the 2 million in shares. Leverage has turned a modest contribution into far greater wealth, without your adding a single euro.

This calculation shows the magic of the LBO, but also its fragility. If EBITDA falls 20 percent to 400,000 €, the available cash may drop to 200,000 €, barely half the safe DSCR: the company no longer covers its installments comfortably, and it is your equity, then your sleep, that pay the bill. The same leverage that multiplies your gain multiplies your exposure to the slightest disappointment.

The traps that derail an LBO

Most LBOs that go wrong do not die of a bad idea. They die of excess leverage laid on too fragile a target. And the same mistakes recur, file after file: stacking too much debt against the real flows, reasoning on a reported rather than a restated EBITDA that overstates repayment capacity, forgetting that working capital and capex draw on the cash before the debt does, keeping no reserve after closing, underestimating the risk of clients or key people leaving once the seller is gone. An LBO does not forgive optimism.

• Never set your debt on raw EBITDA: restate pay, non recurring charges and exceptional items to get the true recurring cash.
• Keep after closing a reserve worth six to twelve months of debt service, never zero.
• Stress test the structure: if cash falls 20 to 30 percent and the DSCR drops below 1.1, the structure is too tight.
• Make the subordinated, grace period vendor loan a cushion for the first year, the riskiest in any takeover.
• Check client concentration and dependence on the owner before signing, not after.

The LBO is a remarkable tool for buying a business, provided you place it on a target that produces regular cash and never push beyond what its flows can repay. Before signing a letter of intent, the decisive step is to size the target’s debt capacity coldly, layer by layer. Our guide on estimating debt capacity before buying a business walks through exactly that test, and it is what separates an LBO that pays itself down quietly from a structure that chokes you at the first hard winter.

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