Let’s face it, no matter how well we think we’re proceeding with a deal, things come up. Some teach us valuable lessons; other times, great things come from them. Today’s blog is about one such time when a great thing was created.
Once, I took a 50% stake in a process outsourcing business with a few challenges. I fixed the fundamental issues, but after time, struggled to add more value. We got a few new clients but also lost a few, so the business was really standing still. I needed a way to exit. In the end, I was able to sell my stake back to management and exit that way—and the “Buy In, Buy Out,” or BIBO, was born.
Buy In, Buy Out
The “Buy In, Buy Out” (BIBO) strategy is where we use cash flow and financial engineering tactics to take a sweat equity stake in a business, sell it back to the founder once it is fixed, and they pay you out of the future profits.
Perhaps, you find a business that has cash flow problems, and they want you to invest $100,000 for a 30% stake. You show them how you can fix their problems without the need for $100,000 and make the business more cash-flow positive in the future. Is that worth 30% still? Of course. So, you have 30% of a profitable and cash-positive business. Your work is done; you have added real value for your share. The one person in the world who will value this share above everyone else is the founder/owner.
Going into the deal, be completely upfront, explaining that you would like an exit as soon as the business is fixed—whether that is to sell the whole business or for them to buy you out. It is important to have a well-worded contract to support this. The Harbour Club contract is just two pages.
Making It Work
To make a BIBO work, we use several financial engineering techniques that we’ve worked out over the years. Typically, these can return between 10% and 15% of the company’s gross annual revenue back to the business in cash. Obviously, that has a considerable impact on the profitability and cash flow for the business.
Essentially, a BIBO deal asks how much that result is worth to the business owner. If you can make a big increase in their profit, gross annual revenue, and cash flow, how much is that worth to them? You then put that in an equity term.
If you think about it, if a business is breaking even, or losing a little bit of money every year, and you suddenly parachute 10% or 15% of its gross annual revenue back into that business in cash or profit, you’ve basically added huge amounts of value. You might have a company that was about to close its doors or was struggling to make ends meet, and, all of a sudden, you’ve got a business that’s generating high amounts of cash on a month-on-month basis. How much is that worth to the founder? Identify the issue and pitch your solution.
Once you’ve invested your time, fixed the problems, and added value, you then create a company loan to effectively sell that stake straight back to the owner. If you think about it, the worst thing in their life is this business issue. You fix that issue, and then they fall in love with their business again. They’re the prime candidate to buy the company.
So, how can they afford to buy the company back from you? It comes back to deferral: they can pay you from the profits of the company. However, when you sell a company, you have to be careful with deferral, because you might not get the money.
How to Make Deferred Payments Work
When it comes to selling a business, or a share in a business, like in a BIBO, it is common to have a portion up front and a portion deferred. Deferral is not the same as earn-out. Earn-out is linked to a specific performance—you have to achieve something to get it, like a profit target or customer retention. Deferral is a fixed amount of money over a period of time.
You will often hear people say, “Be happy with the upfront payment because you won’t ever get the deferral,” and unfortunately, that’s often true. The deferred element becomes a resented payment each month, and eventually, people begin to talk themselves into not paying it.
However, if the buyer were to take out a loan, it would be perfectly normal to ask for a debenture (a full fixed and floating charge over the assets of the company). It’s also normal for the lender to charge interest and an arrangement fee, all things that you would not expect to get approved in a deferral agreement.
The answer is to use your own loan company, one that you create for this purpose. Now you can say, “I will sell you my 30% for $150,000, and I have a company that will give you the loan to do so.” The buyer then enters into a loan agreement and debentures with the loan company for $150,000, and you hand over your shares. As they make repayments to the loan company, the loan company sends you the money.
The loan company does not physically have to have the money; it merely processes the payments. If they stop paying, you can foreclose on the whole business (not just the 30%), and the legal case is black and white: “We lent you money, so pay us our money.” They can’t wriggle and argue and moralize on that one!
There are so many uses for this structure we have found through the Harbour Club that it is a great way to deal with large payments. If you are providing a loan for a business in most countries, it is totally unregulated. All the regulation is around consumer loans.
So, if you’re looking to do a deal with no money down, a BIBO is probably the path of least resistance transaction because it’s the easiest transaction compared with all the different structures. If you don’t already have a business and you’re not acquiring a competitor or merging with somebody else, this is probably the easiest standalone buy/sell deal that you can do.
If you’d like to learn more about how to do this and other exciting deals, I invite you to attend one of our Harbour Club events. Not only do I share the ins and outs of deals, but it’s also a place for you to network with other Club members and learn from them as well. Events are currently being conducted virtually, so your health and safety are ensured.
This article was originally published at: https://www.jeremyharbour.com/agree-on-the-buyout-when-you-buy-in