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Basic leveraged buyout (LBO) | Stocks and bonds | Finance & Capital Markets | Khan Academy - YouTube
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Let's say that many years ago,
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you started yourself a
nice little business.
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You have no debt and
your business every year
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generates a pre-tax income
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of a million and a half a year and a
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third of that goes to taxes.
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So you get a nice one million dollars
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a year of net income and
it's a super stable business,
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nothing risky over here.
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Just by virtue of what your business does,
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the odds of this one million a year
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changing for the better or
the worse isn't that likely.
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So this is essentially your ...
This is what your balance sheet
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would look like.
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These are your assets.
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You have no debt.
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Let's assume you have no liabilities
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and so you own all of the equity.
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You essentially own all of the assets,
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but you're nearing retirement
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and you want to kind of cash out.
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You don't necessarily want
to sell to your competitors
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or maybe there aren't any
natural competitors to sell to
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because you've been comp
... Well, you don't want to
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sell to them if they exist
because you've been competing
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with them for your ... for your whole life
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and this isn't the type of
business that you can IPO
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because it's not quite big enough.
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So maybe we bump into
to each other and I say,
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"Hey, this business looks
interesting. I like the idea that"
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"your business is stable and
can generate a lot of income"
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"year after year after year."
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So what I say is, "Hey,
would you be willing to take"
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"10 million dollars for your business?"
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So I offer ... I offer 10 million dollars.
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And to you that sounds pretty good.
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That's about ten times ...
That's exactly ten times
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your yearly net income.
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This isn't a growing
business, just very stable.
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Seems like a reasonable deal to you.
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On the other hand for
me, I'm like you know
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paying 10 million dollars
and getting a million dollars
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a year, that's kind of 10% on my money.
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That's okay, but maybe I
can get some leverage here.
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Maybe I don't have to put
all of the 10 million in
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maybe I could borrow some of it
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and maybe I'll get a
better return that way.
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So when it comes time to closing
... When it comes time to
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closing, so I'm buying the assets.
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So these are the same
assets that I'm buying
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and I'm gonna give them ...
and the money that I raise
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for these assets are gonna go to you,
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the person who started this business.
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So here are the assets.
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So instead of me putting up
the entire 10 million dollars,
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what I do is I put up one
million dollars myself
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So I put up one million dollars myself,
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one million from ... from me.
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And I go to a bank and I say,
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"Look, will you lend me 9
million dollars? I'm going to
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"put a million dollars of my
own money. Will you lend me"
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"9 million dollars to
help borrow ... to help"
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"buy this business for
10 millions dollars?"
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and the banks says,
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"I don't know. That's a lot of money."
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"We're putting a lot of money at risk."
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and I'l say, "Look, you can
charge me a decent interest rate,"
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"maybe a 10% interest rate
and this is a super stable"
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"business, so clearly I'll
be able to pay the interest"
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"on that money from the business
and if for whatever reason"
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"I'm not able to pay you the money,"
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"you can get the business. So,
I'm essentially giving you"
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"the business as collateral."
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So you find some bank to agree to it
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and so they will lend
you 9 million dollars.
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They will not lend you 9 million dollars.
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Nine million dollar loan
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and let's say that it is at
a 10% ... 10% interest level.
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So now, after I have ...
So 9 million from the bank,
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one million from me. That goes to you.
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You can now retire and buy your dream home
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or whatever else you
might have needed to do
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with that money.
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You could leave it for your
children, whatever you might ...
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Donate it to charity,
whatever floats your boat
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but now the capital
structure of the business
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looks like this.
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I now do have a lot of debt.
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I bought you out using leverage.
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This is a leveraged buyout.
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So now, there is one
million dollars of equity
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that came from me
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and there's 9 million dollars
of debt that came from the bank.
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That's 9 million dollars of debt.
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Assets, at least what I paid
for it was 10 million dollars.
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Liabilities are 9 million dollars.
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So what's left over is one million.
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And let's think about how this investment,
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assuming the business keeps
generating a million a year,
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let's think about how good
of a payoff this might be
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for my one million dollar investment.
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So before I had a pre-tax
income of 1.5 million.
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So 1.5 million pre-tax. Pre-tax before.
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Now I'm going to have
to pay some interest.
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So now I'm going to have to
pay ... So 9 million dollars
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at 10%, that is $900,000 in interest.
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So now my pre-tax won't be 1.5 million.
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I'm also going to have
to pay 900k in interest.
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So minus 900k means that I have 600,000,
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so 1.5 - 900k is 600,000
per year pre-tax income,
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600,000 per year in pre-tax income
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and then I will pay taxes on that.
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The cool thing about corporate interest
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is that it's tax-deductible.
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It's deducted from your pre-tax income.
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So you take the 900 from
the 1.5, you have 600,000
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leftover and then you pay taxes on that
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and let's say it's
still the same tax rate,
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so roughly one-third of
it goes to the government
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and so that you are left
with 400,000 net income
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and if you look at the
math, this is actually
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a pretty good deal for me or
I should ... I was saying you,
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but I'm the guy who bought it.
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You're the guy who sold me the business,
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so this is me now.
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I am left with $400,000
net income per year,
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which is pretty good because I only made
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a one million dollar investment.
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So even though this looks
like a sleepy business,
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even though it looked
like it was only getting
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a 10% yield on it, because
I was able to leverage up.
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I was able to do this leveraged buyout,
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I'm now able to make $400,000 per year
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on a one million dollar investment
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and now all of a sudden that is
a not so sleepy annual return.
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