The ROI of an LBO

In the investing world, the ONE metric everyone looks at is return on investment, or ROI.

A quick example…

Let’s say you purchased Apple shares back on Feb. 28 at $267 per share and then sold them on March 4 for $303 a share.

That’s a 13.4% ROI.

Unfortunately, stocks can quickly go DOWN as well as up…

If you had purchased shares on Feb. 12 at $327 apiece and sold them on the 28th at $267, you would have LOST money.

A loss of $60 per share would be a NEGATIVE 18.3% return.

Yikes.

That’s why I don’t dabble with the stock market.

I buy profitable, small businesses instead using leveraged buyouts (LBOs).

The returns are MUCH safer — and you can even generate significant leverage for INFINITE returns.

Let me explain…

Imaging you are buying a business with revenue of $1 million and profits of $100K.

Assume you paid a premium valuation for that business — a 3X multiple.

And just to show you how good the ROI can be, let’s say you used 100% of your own cash to buy the business.

So your investment was $300K (3 X $100K).

Even if you didn’t grow the business AT ALL within a 12-month period — you would STILL generate a 33% return.

Remember, your year one profit (assuming no growth) is $100K.

$100K / $300K = 33%

Cool, right?

Certainly better than the markets.

Now look at what happens with leverage…

This time assume you put $100K of your own cash into the deal and borrowed the other $200K. Or maybe you paid the seller $100K down with $200K in seller financing ($40K per year over five years).

Then your return would look like this…

$60K (annual profit minus the seller financing) / $100K (your investment) = 60% ROI.

We jumped from 33% to 60% just by changing the deal structure.

Now let’s assume you only put $25K of your own cash into the deal and borrowed $75K from a financier for the $100K closing payment. You also keep the $200K seller financing at $40K per year for five years.

Now your profit in Year 1 (still assuming no growth) is $100K – $40K (seller financing) – $20K debt service on the $75K financed = $40K.

Your ROI is now a whopping 160% ($40K / $25K).

And what if you GROW the business from $1 million in revenue and $100K in profit to, say, $1.5 million in revenue and $200K in profit.

$200K – $40K – $25K = $135K.

$135K / $25K = 540% ROI!!

And if you were able to close that deal using with NONE of your own money…

Your returns would be INFINITE.

Let me show you…

You acquire a business worth $300K.

Your deal structure is as follows…

  • Closing payment = $100K
  • Financing of closing payment = $100K
  • Your personal investment = $0
  • Seller financing = $200K.

The business profit in the first year (after some modest growth) = $200K.

Your debt financing = $40K (assuming you retire the $100K within 2½ years).

The cash flow to you is $200K – $40K – $40K = $120K.

Your ROI is $120K / $0…

But you can’t divide by zero.

Well, you can — but the answer is INFINITY.

If you traded the S&P in 2019, your returns would have been 30.4%.

However, if you traded the S&P in 2018, your returns would have been NEGATIVE (-6.6%).

And the housing market — in 2019 the U.S. housing market appreciated by 2.3%.

In 2018, it was only 4.9%.

If you acquired a business prior to 2018, your returns in 2018 would have been INFINITE.

In 2019?

INFINITE

This year?

INFINITE.

So if you want to generate infinite returns with zero risk…

Buying small businesses is the only way.

Until next time, bye for now.

Carl Allen

Carl Allen
Editor and co-founder, Dealmaker Wealth Society

P.S. What are the five best businesses to buy right now? And which ones should you avoid? Click here to find out.