LBO Method and VC Method

LBO Method and VC Method

A buyout occurs when a buyer acquires a controlling stake in the equity capital from a target company’s seller in a private equity transaction. Using borrowed funds to finance a significant portion of the acquisition price is a leveraged buyout.

Characteristics of a company that is suitable as an LBO target.

  1. Undervalued or depressed stock price: Private equity firms see undervalued companies as a chance to acquire a target cheaply.
  2. Willing management and shareholders: Management and shareholders may be willing to acquire a target but lack the capital to do so. In such an instance, they will invite a PE firm to provide capital and time to expand a company.
  3. Inefficient companies: PE firms seek to increase returns by identifying inefficiently run companies and improving the management of the companies to boost their performance.
  4. Strong and sustainable cash flow: Given that it takes a significant amount of debt to finance an LBO, PE firms look for targets with strong cash flow since this will help repay debt.
  5. Low leverage: PE firms look for targets with no significant debt since this makes it easy for them to finance a large portion of the purchase price using debt.
  6. Assets: PE managers like target companies with many physical assets, which can be used as security for debts.

In the previous LOS, we talked about a typical LBO capital structure composed of 25% equity and high-yield bonds and leveraged loans to make up the rest of the purchase price. Mezzanine financing is used as an alternative to high-yield bonds. Mezzanine financing refers to debt with a relationship to common shares resulting from attached warrants or conversion options.

The LBO Model

The LBO model is used to determine the effect of the purchase price, capital structure, and other factors on the expected returns from a deal. There are three main inputs in the LBO model, i.e., the cash flow forecast, the amount of financing available for the deal, and the expected return by the investors. The target company’s management prepares the free cash flow forecasts, subject to due diligence, to ensure their reliability. The exit year is used to determine the expected IRR sensitivity of the equity capital around the expected exit date. The exit value is calculated using the expected range of exit multiples based on peer groups of comparable companies. The equity value is often determined using the income-based approach because the cash flows in buyout transactions are very predictable.

While using the income-based approach, we must factor in the initial high and declining financial leverage since this is a major issue. LBO provides the maximum price that should be paid to the seller while satisfying the returns expectations of investors. LBO, therefore, is more of a negotiation tool than a valuation methodology. Value creation occurs when factors such as earnings growth, multiple expansion, and optimization of financial leverage are combined.

Example: Leveraged Buyout

$6,000 (millions) is invested in a private equity transaction. The transaction is financed by 60% debt and 40% equity. The $2,400 of equity is further divided into $2,300 of preference shares owned by the PE fund, $95 of equity is owned by the private equity fund, and $5 of management equity. The annual return (paid at exit) of 12% is promised to the preference shares. The private equity fund’s equity is promised 95% of what is left after paying creditors and preference shares. The remainder is promised to management equity holders. Assume that the exit value five years after the investment is two times the original cost. The exit value will be \($6,000 \times2=$ 12,000\). The four claimants will be paid as follows:

  • Operational cash flows have partially retired senior debt; hence $3,600 is reduced to $2,304. Therefore, $2,304 will be paid to debtholders.
  • Preference shares will receive \($ 2,300 \times (1.12)^{5}= $4,053.38\).
  • The PE fund equity receives \(0.95 \times [12,000 – (4,053.38+2,304)] = $ 5,361\).
  • Management equity will receive\( 0.05 \times [ 12,000 – (4,053.38+2,304)] =$ 282.131\).

We see from the above example that preference shares increase in value over time because the preferred dividend is capitalized over time. A reduction in financial leverage over time is vital in increasing the return available to shareholders. As senior debt is paid off annually, more free cash flow is available in the exit year to distribute to equity holders. High levels of debt increase the risk that equity investors will bear.

The VC Method

Traditional valuation tools such as the LBO model, earnings multiples, and discounted cash flow are usually impractical in the venture capital context. VC is done in stages referred to as Series A, Series B, etc. Let us assume that a company is worth $20 million and its shareholders own 100% of the equity (pre-money valuation). The company raised $5 million more equity capital from a venture capital firm (new equity investment). The value of the company will be $20 million + $5 million = $25 million. Hence, Post-money valuation = Pre-money valuation + New equity investment. The total equity stake owned by the VC firm would be $5 million/$25 million = 20%.

The main challenge of the VC method is determining the pre-money valuation. This is because it is hard to assess the commercial viability of an idea during the early stage of the start-up. So, we use the VC method to work backward and determine the pre-money valuation. A closed-end fund with a 5-to-8-year average life horizon is commonly used to finance VC investments. At the end of the holding period, the performance metrics used to measure a firm’s progress towards success are identified. If the company is ambitious enough, it may use EPS or EBITDA to measure performance. The specific industry that the company belongs to will determine the right multiple to apply.

In the early stage, the failure rate of VC investments is higher than that of buyouts or growth equity. Hence the target return will be 10× to 30×, compared to 2.0× to 2.5× for the buyouts. The hurdle return together with the value of equity at the exit can be used to compute the post-money valuation.

$$\text{Post-money valuation}=\frac{\text{Value of equity at exit}}{ROI}$$

Example: The VC Method

A start-up is looking to raise $800,000, and the company estimates that it will make sales revenue worth $120 million over the investment horizon. A 2× multiple for a revenue-generating business is used in its industry. The company’s ROI is 20×, and the firm has no debt. The pre-money valuation is closest to:


$$\text{Pre-money valuation}=\frac{$ 120 \text{ million}\times 2}{20}- $ 0.8 \text{ million}= $ 11.2 \text{ million}$$

The required ROI is determined by the cost of capital and the competition. To incentivize and attract employees, share options are offered by start-ups, and when they are offered, they dilute the share price of the start-up. The VC firms, therefore, calculate the share price on a fully diluted basis. By doing so, the founders absorb the dilution effect while the VCs are left unaffected.

Stage Financing

Stage financing is fundamental to VC because it acts as a mitigator of risk. Since the earlier-stage investors take on more risk, the return to these investors is high. Pre-money valuations give insight into the performance of an illiquid asset class. Let us illustrate stage financing with an example.

Example: Stage Financing

Vrox Ltd, a start-up, received £500,000 from a VC firm in exchange for a 6.5% stake in Series A financing. A year later, the start-up raised £3 million in a Series B financing at 10× ROI. All investors are expected to exit simultaneously, and Series B investors project a closing valuation of £450 million. The ownership structure alongside the implied ROI in each financing round will be:

$$\text{Post-money valuation}=\frac{ £ 450\text{ Million}}{10}= £ 45 \text{ million}$$

$$\text{Pre-money valuation}=\frac{£ 450 \text{ million}}{10}- £ 3 \text{ million}= £ 42 \text{ million}$$

$$\text{VC fractional ownership}=\frac{£ 3\text{ Million}}{£ 42\text{ Million}+£ 3 \text{ Million}}= 6.67 \text{ %}$$

$$ROI=(1+IRR)^5=10=\frac{£ 450 \text{ million}}{£ 45 \text{ million}}$$

Let us now assume that the closing valuation is £153.85 million. The Series A ROI will be:

$$ROI=\frac{£ 153.846,153.8 \times6.5\text{ %}}{£ 500,000}=20$$

VC investments tend to be the minority share investments because the founders may not relinquish control. The start-up is still in its early stage of business development. It is typical to use convertible preference equity instead of common shares in later-stage financing. The capital that comes in later is less risky since most of the uncertainty of business viability has been dealt with.

If a company performs well, preference shares are irrelevant. However, at times, the performance might turn out to be lower than forecasted. In such instances, the preference dividend is treated as junior debt, reducing the value held by initial equity holders while preserving the value of Series B investors.


McDowell Group is a PE firm that specializes in leveraged and management buyouts. The firm has hired you as an analyst to look for attractive target companies. Which of the following characteristics are you most likely to consider?

  1. The efficiency of a company.
  2. The unwillingness of the management and shareholders of a company.
  3. Undervalued or depressed stock price.


The correct answer is C.

Private equity firms see undervalued companies as a chance to acquire a target cheaply.

A is incorrect. PE firms look for inefficiently run companies and bring in their management to manage the inefficiencies and make the target companies more profitable.

B is incorrect. Unwilling management can make the buyout process more expensive than the PE firm is willing to pay.

Reading 38: Private Equity Investments

LOS 38 (d) interpret LBO model and VC method output.

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