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Current time:0:00Total duration:5:35

Video transcript

let's say that many years ago you've started yourself a nice little business you have no debt and your business every year generates pre-tax income of a million and a half a year and a third of that goes to taxes so you get a nice 1 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 1 million year changing for the better or the worst 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 compelled or you don't want to sell to them if they exist because you've 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 each other and say hey this this business looks interesting I like the idea that your business is stable it 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 10 times that's exactly 10 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 in 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 going to give them and the money that I raise for these assets are going to 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 1 million dollars myself so I put up 1 million dollars myself 1 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 nine million dollars to help borrow to help buy this business for ten million dollars in the bank to say I don't know that's a lot of money we're putting a lot of money at risk and I'll say look you could charge me a decent interest rate maybe a ten percent 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 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 nine million dollars they will not lend you nine million dollars nine million dollar loan and let's say that it is at a ten percent ten percent interest level so now after I have so nine million from the bank 1 million for 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 for your 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 1 million dollars of equity that came from me and there is 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 nine million dollars what's left over is 1 million and let's think about how this investment assuming the business keeps generating million-year let's think about how good of a payoff this might be for my 1 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 nine hundred K in interest so minus nine hundred K means that I have 600,000 so 1.5 minus nine hundred K 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 night you take the nine hundred from the one point five you have six hundred thousand left over and then you pay taxes on that and let's say still the same tax rate so roughly one third of it goes to the government and so that you are left with four hundred thousand 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 were the guy who sold me the business so this is me now I am left with four hundred thousand dollars net income per year which is pretty good because I only made a 1 million dollar investment so even though this looked like a sleepy business even though it looked like 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 1 million dollar investment and now all of a sudden that is a not so sleepy annual return