If you're seeing this message, it means we're having trouble loading external resources on our website.

If you're behind a web filter, please make sure that the domains *.kastatic.org and *.kasandbox.org are unblocked.

Main content

Video transcript

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