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When an outside lender such as a bank or investment firm finances the purchase of a business, the transaction is frequently called a Leveraged Buy Out or LBO. LBOs were very common in the 80s, but many of the lenders who jumped on that bandwagon lived to regret their readiness to let buyers finance 80, 90 or even 95 percent of a purchase. As you can imagine, buyers tended to default when things got tough, or had such difficulty making payments that lenders were forced to restructure the loans.

The credit crunch of the early 90s lifted a bit, but LBOs in the late 90s were quite different from those of the 1980s. Lending criteria are stricter, and buyers will be asked to put up more of their own money (or find a partner who's willing to) and it remains to be seen how this technique will evolve in the early 2000s.

In the small business context, the typical LBO buyer is one or more of your managers or key employees who wants to take over after you retire. It may also be a combination of managers and other investors. In some cases it may be your children, or a group of them. Having an outside lender finance the transition of your family business to the next generation is a good way to transfer some of the risk outside your family, if you find an institutional lender who's willing to participate. Institutional lenders are more likely to approve loans where the buyers already have experience in the particular business, so there will be a measure of management continuity.

Elements of an LBO. LBO financing is usually a package that combines several types of loans, as well as equity. The components may even come from different sources. The package itself may be put together by a bank, a commercial finance company, a venture capital firm, or a mergers and acquisitions intermediary that has access to capital markets.

Some typical components of the package might be 15 to 25 percent equity, 10 to 50 percent subordinated debt; and 40 to 70 percent senior debt. "Equity" would usually be in the form of common or preferred stock, held by the buyer or by other investors such as venture capitalists. "Senior debt" would be loans on assets such as receivables and inventory (for asset-based financing) or real estate and equipment (for more conventional financing). The senior debtholder is a secured lender who stands in first position to collect against the particular asset, if the buyer defaults. In contrast, "subordinated debt," also called mezzanine debt, is akin to a second mortgage in that if the buyer defaults, the debtholder would collect only after the senior debtors had been paid off. Consequently, the subordinate lenders frequently want a higher interest rate and an equity interest in the business as well, so there is a potentially greater reward in exchange for the greater risk they take in making the loan.

As you can guess, the complexity of the structure and the players involved make a typical LBO an unlikely prospect for the average small business, unless you're in an industry that's considered "sexy" at that moment in time. However, if you are willing to act as the subordinate debtholder, the LBO model can work for even a very small business. The determining factor would be whether the business has sufficient assets and cash flow to interest one or more institutional lenders in making the senior loan(s).

If your buyer wants to do an LBO, recognize that it will require a lot of work on your part to make it happen. These deals are neither simple nor easy, and they take time to put together. Not only will you need to cooperate with the lender, you may even need to help sell the lender on the deal. However, the result can be significantly less risk to you than if you had financed the entire purchase yourself.