Author Topic: LBO Scenario: Pay down with quarterly distributions or pay off early with cash?  (Read 3721 times)

Patches

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Hello all.  I'm hoping for some Mustachian-tinted advice on an LBO I'm involved in. 

I bought into a business as a 10% owner for $255,000.  It was leveraged (personal note with the previous owner: 6yr @ 4%, $60k down, remaining payments delayed one year, no early payoff penalty)

I've been making quarterly payments ($9,459) on the note.  These quarterly payments are made via a distribution from the company to myself.  After which I pay the personal note.  The favorable interest rate on the note coupled with the favorable tax rate on distributions makes me think I ought to just hold the course. 

However, at this current stage of the loan ($155,111 remaining) if I did one year of additional payments ($37,836) in a lump sum, it would save me $5,726 in interest.  Which is a pretty nice return.  Additionally, the company will continue to make these distributions through the pre-determined note length... so, since I will owe nothing in the final year of the note, barring a terrible turn of events in the company, this $37k will be "paid back" during the final year of the note.

I understand that paying the $37k now will be in after tax dollars... and the opportunity cost of doing so might in fact higher than the gain... however with the "return of funds" in that final year, it has me thinking... 

To pay off the remainder of the note completely would result in only another $9400 in interest savings... Clearly making the opportunity cost too high, IMO.

Personally, having this debt hinders my enjoyment of life and this job.  Having these note payments dependent on my work also adds stress.  And there is a small worry that the company would shed this distribution if/when times got hard in the business.  Which makes me think I should keep the cash around to continue to make the note payments if needed.

We don't need the cash for anything other than to use in ER... which is still 3-5 years off.

Typing this out has helped organize my thoughts on the matter.  I appreciate any input you helpful souls may have.

P

ooeei

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I certainly can't help with your question, but am just curious about this whole situation.  Isn't owning the business supposed to MAKE you money?  How did this whole arrangement get started, and what is the plus side for you?

zephyr911

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    • Pinhook Development LLC
What is the time period for that $5,726 in savings? You have to look at it as an annual rate, not just the ratio of total savings to the amount paid. I could save tens of thousands by putting a few thousand extra on my mortgage now... over decades at 3.375%. It's still a poor annual rate of return, so I invest it all instead.

Here's another way to look at it: each dollar you put in now has the exact same impact on the debt, saves you interest at the same rate, etc. If it's not worth putting all your money into it now, why is it worth paying anything extra?

If you just make scheduled payments, will this debt be amortized before ER? Is that an important milestone for you? If not, you might consider accelerating just enough to get there. Otherwise, I'd probably say let it ride.

Patches

  • 5 O'Clock Shadow
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I certainly can't help with your question, but am just curious about this whole situation.  Isn't owning the business supposed to MAKE you money?  How did this whole arrangement get started, and what is the plus side for you?

Ooeei, I can help you understand with a simple analogy.  Imagine you purchased an apartment complex with a mortgage.  You gave the bank 20% down and took ownership.  Via the profits of your venture (the rent you receive from your tenants) you pay down your note with the bank.  Would you consider that something which "makes you money?"

What is the time period for that $5,726 in savings? You have to look at it as an annual rate, not just the ratio of total savings to the amount paid. I could save tens of thousands by putting a few thousand extra on my mortgage now... over decades at 3.375%. It's still a poor annual rate of return, so I invest it all instead.


Yes, Zephyr I see your point, I viewed the $5,726 savings accrued w/in the first year (the lump sum payment early in the loan would greatly reduce the immediate interest pulled from each subsequent payment... this $5,726 is just the sum of interest saved in the following year)  However to recoup the outlay, I'd have to wait 4 years for the reimbursement from the company. Thus my outlay must be considered to be tied up for 4 years.



ooeei

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Ooeei, I can help you understand with a simple analogy.  Imagine you purchased an apartment complex with a mortgage.  You gave the bank 20% down and took ownership.  Via the profits of your venture (the rent you receive from your tenants) you pay down your note with the bank.  Would you consider that something which "makes you money?"

Ah okay, I didn't catch that your investment return is paying your loan for you, after re-reading I see that.  That makes much more sense.  So basically once the loan is paid off you'll be getting ~$9500/quarter from the company (assuming business is good), correct?

zephyr911

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Yes, Zephyr I see your point, I viewed the $5,726 savings accrued w/in the first year (the lump sum payment early in the loan would greatly reduce the immediate interest pulled from each subsequent payment... this $5,726 is just the sum of interest saved in the following year)  However to recoup the outlay, I'd have to wait 4 years for the reimbursement from the company. Thus my outlay must be considered to be tied up for 4 years.
How exactly did you calculate this? Without knowing your balance and other details, I can't validate it, but paying down $37K on a 6% loan should only be saving you a little over $2k in a year. $5700+ sounds more like a plausible figure for the whole 4 years.

I would prefer to keep things simple: if you have investments that will make you more than 6%, and if you're comfortable with your overall leverage ratio, invest elsewhere. On the other hand, if you can't count on making 8-10% elsewhere, and you really want this loan paid off ahead of time for cash flow reasons, or you want to de-leverage for a lower risk profile, then go for it.

It shouldn't matter how much free cash you have for this proposition. If it's worth paying an extra dollar, it's worth paying $1k or $10K, and vice versa.

Patches

  • 5 O'Clock Shadow
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  • Posts: 70
  • Age: 39
  • Location: Seattle
Ooeei, I can help you understand with a simple analogy.  Imagine you purchased an apartment complex with a mortgage.  You gave the bank 20% down and took ownership.  Via the profits of your venture (the rent you receive from your tenants) you pay down your note with the bank.  Would you consider that something which "makes you money?"

Ah okay, I didn't catch that your investment return is paying your loan for you, after re-reading I see that.  That makes much more sense.  So basically once the loan is paid off you'll be getting ~$9500/quarter from the company (assuming business is good), correct?

Yes, it's assumed the distributions will continue once the note is paid off.  I also happen to work for this company and receive a salary.

Yes, Zephyr I see your point, I viewed the $5,726 savings accrued w/in the first year (the lump sum payment early in the loan would greatly reduce the immediate interest pulled from each subsequent payment... this $5,726 is just the sum of interest saved in the following year)  However to recoup the outlay, I'd have to wait 4 years for the reimbursement from the company. Thus my outlay must be considered to be tied up for 4 years.
How exactly did you calculate this? Without knowing your balance and other details, I can't validate it, but paying down $37K on a 6% loan should only be saving you a little over $2k in a year. $5700+ sounds more like a plausible figure for the whole 4 years.

I would prefer to keep things simple: if you have investments that will make you more than 6%, and if you're comfortable with your overall leverage ratio, invest elsewhere. On the other hand, if you can't count on making 8-10% elsewhere, and you really want this loan paid off ahead of time for cash flow reasons, or you want to de-leverage for a lower risk profile, then go for it.

It shouldn't matter how much free cash you have for this proposition. If it's worth paying an extra dollar, it's worth paying $1k or $10K, and vice versa.

There's really no good way to copy and paste an amortization schedule, so I'll attach the one I keep for myself.  You'll note the interest portion of the payment is higher when the balance is higher.  By paying a lump sum early, it lowers the basis for the remainder of the loan.  If pay an additional year, it's like my payments skip forward a year (more actually since the additional payment is all principle) but it's a good reference for how much interest is skipped over in that year.  But again, perhaps my thinking of the instant interest savings is misguided... perhaps the gain comes later.  Thanks for taking the time to look at it.