“Leveraged Buy Out” (LBO) is a specific finance engineering operation used to acquire businesses. It is often used by financial investment institutions such as private equity firms. Despite it delivers powerful means to accelerate external growth, LBOs are not so often considered by start-up entrepreneurs.
In this “Fairval Tips & Tool” article, we explore why and how LBOs could specifically be used by disruptive start-ups to acquire incumbents.
But first, why should disruptive start-ups consider buying incumbents?
Disruptive start-ups are these start-ups aiming at creating new markets and disrupting existing ones, usually through a mix of product, busines model, customer experience and technology breakthrough innovation.
So, these start-ups have the potential to dramatically disrupt incumbents once they have found the perfect “product/market fit” and once they raised sufficient money to scale and unlock targeted incumbent markets. Yet rarely these players consider acquiring incumbents. It’s just not in their mindset as after all, their mission is to disrupt these incumbents (hopefully before being acquired by them…).
However, there are various benefits for disruptive start-ups to acquire incumbents. Let’s list a few:
-Market access. One of the hardest things to achieve in disruptive innovation is to scale “customer innovation”, i.e., sufficiently incentivizing the behavior of conservative customers to adopt new ways of doing things or adopt unusual new solutions. By acquiring an incumbent, you acquire its customer base on which you have access to and therefore have more chances to influence and incentivize to progressively adopt change.
-Acquisition of facilities and know-how which may still be relevant. Take the example in aviation – if you are building a new disruptive electric aircraft, i.e., eVTOL (electric Vertical Take-Off Landing), you might still need some standard manufacturing facilities and certification internal services to be able to build, sell and operate your aircrafts. As well, if you designed a new travel physical shop concept providing semi-virtual @destination experiences for people to be more inspired before booking a trip, it might still be relevant to buy an incumbent that owns brick & mortar travel agency offices which are very well located.
-Gain credibility and customer trust through brand and reputation acquisition. Imagine that you are offering a new travel-fintech service thanks to open banking protocols; trust and credibility is key within financial services, not only vis-à-vis of consumers, but also vis-à-vis of B2B institutional financial players part the value chain.
-Increased valuation. Acquiring an incumbent, might help accelerate the de-risking of the start-up growth roadmap which increases its chance to deliver its full potential. This can naturally increase future investors’ valuations of the business.
There are many other reasons why disruptive start-ups should consider buying incumbents. However, there are also many good reasons why disruptive start-ups should not or just cannot buy incumbents. One of these reasons, could be the prohibitive acquisition price. And this is where LBOs come into place.
So, what is an LBO?
A Leveraged Buyout (LBO) is a financial engineering operation where a company, the “acquirer”, buys another company, the “acquisition target” or the “acquiree”, by borrowing a large amount of money to finance the acquisition. So instead of putting all the money on the table to acquire a company, you just bring a small amount. In the context LBOs between private company, usually the acquirer brings 20-30% of the money and borrows the rest.
Now the trick is that the borrowed money plus interests, are then reimbursed via the cashflow generated by the acquired company. And in case that acquiree has some tangible valuable assets, part of the debt could also be reimbursed by devesting some of these assets.
Let’s take the example in the shipping chartering industry. This industry is highly intermediated by brokerage companies for which many of them are operating through tedious, manual paper-based processes. A start-up aiming to digitalize and automate parts of shipping brokerage processes might find it hard to get adoption of its solution from these brokers especially if adoption implies disintermediation and so disruption of the brokerage value chain. Therefore, one way to enter the market could be to acquire a brokerage company which has a good reputation, making good money, yet not necessarily the dominant player. In case such target is found and negotiated let’s say for an acquisition price of €50mio, the start-up could then go through an LBO; roughly $10 to $15mio would need to come from the start-up own money (potentially thanks to some previous equity-based fundraising) and the remaining $35 to $40mio could come from the LBO lender.
Can it really work?
Broadly speaking merging two companies is challenging. As such, to make it work, one must keep in mind certain principles:
-Strategic rationale: first, the target company to acquire must fit the start-up strategic goals; consequently, effective scouting and screening process to find relevant targets remains crucial.
-Financial rationale: The merger must make sense in terms of incremental value creation; In traditional M&As, value creation is realized through incremental cash flow obtained for example through cost reduction synergies. In the start-up world, the value creation is likely to partly come from an increased valuation of the start-up. Despite that such value creation might sound theoretical, it is clearly tangible for existing investors aiming for an exit!
-Financial viability: both the acquiring start-up and the incumbent acquiree, need to have the appropriate financial risk profile to minimize cost of capital:
- The Start-up acquirer should have reached at minimum a product/market fit, demonstrated on its ability to scale the business, and raised sufficient funds from equity investors to bootstrap the LBO transaction.
- The incumbent acquiree should generate enough recurring cashflow to reimburse a big loan. Ownership of valuable assets that could be divested is also a good guarantee for lenders.
Not achieving these conditions, may infer prohibitive interest rates from lenders on top of challenging contractual conditions.
-Post-merger feasibility: The post-merger execution plan needs to be realistic, thus, feasible despite many cultural differences. As such, alignment between exec management teams from both companies is also crucial.
To conclude, M&As funded through LBO operations can be complex operations (as any M&As). Yet, it can be a very interesting tool to enable disruptive start-ups acquire incumbents. Actually, disruptive start-ups acquiring incumbents instead of the opposite, might catalyze and accelerate transformation of industries such as Travel & Transportation in a more radical way.
About the author: Landry Holi is the founder & CEO of Fairval, a consulting firm offering strategy and finance engineering services in the space of travel & transportation. Landry has nearly 30-year experience in travel & transportation. You can reach out to him by email: firstname.lastname@example.org