How to finance a business acquisition: the capital stack from SBA debt to equity

The capital stack

A capital stack lists every source of money in a deal, from the first to be repaid to the last. Layers higher in the stack are cheaper because they are safer: they are repaid first and usually secured. Layers lower in the stack cost more because they absorb losses first and are paid last. In an acquisition the typical order is senior debt, subordinated or seller debt, preferred or rollover equity, and common equity.

Senior debt and SBA 7(a)

Senior debt ranks first on the company's assets and is the cheapest capital. For deals up to a few million dollars, an SBA 7(a) loan is the common structure because the guarantee lets lenders lend against cash flow and goodwill, and because a buyer can borrow most of the price. The SBA guide covers the equity, debt service, valuation and guarantee rules in full.

For larger deals, conventional bank loans or other senior lenders apply. They set their own covenants, such as minimum coverage ratios and limits on distributions. Read the covenants as carefully as the rate: a covenant breach can matter more than a half point of interest.

Seller note

A seller note is a promissory note from the buyer to the seller for part of the price. It reduces the cash needed at closing, shows the seller believes in the business, and gives the buyer a way to recover value if the seller's statements prove false (through an offset right).

How a note is treated depends on the senior lender. Under SBA SOP 50 10 8.1, a note on full standby for the life of the 7(a) loan can count as a limited source of equity, up to half of the required 10 percent. A seller note that makes payments is debt: it counts in the debt service calculation and in the cap that total acquisition debt cannot exceed the business valuation. The seller financing guide explains the terms to negotiate.

Rollover equity

In a rollover the seller keeps an ownership stake and receives less cash at closing. It aligns the seller with the company's future, reduces the cash the buyer must raise, and often comes with a role in the business. It makes most sense when the seller wants to stay involved and when the buyer values the seller's continuing help.

The SBA SOP limits this tool in 7(a) deals. In an Initial Acquisition, the seller may not remain as an officer, director, stockholder or employee, and may only consult for up to 24 months in total. Rollover is therefore a tool for non-SBA deals and for owner buyouts and partial changes of ownership, where the SOP has separate rules. In any rollover, agree on governance, information rights, who controls exit timing and how the seller's shares are valued.

Earn-outs

An earn-out is additional price paid to the seller if the business meets agreed targets after closing. It bridges disagreements about value: the seller who believes growth is coming is paid only if it arrives. It also creates conflicts, because the buyer controls the business after closing and the seller is measured on results.

In SBA-financed changes of ownership, seller earn-outs are prohibited. The SOP allows buyer rebates based on business performance, because they benefit the borrower, and requires rebate proceeds to be applied to principal on the 7(a) loan.

EARN-OUT TERMS TO DEFINE (for non-SBA deals; have counsel draft)

1. Metric: [revenue / gross profit / EBITDA], defined by reference to [accounting policies], consistently applied
2. Measurement period: [dates]
3. Target and payment: pay $[amount] if the metric is at least $[target]; [formula for partial payment, or none]
4. Cap: total earn-out not to exceed $[amount]
5. Buyer covenants: operate the business in the ordinary course; no actions taken for the purpose of reducing the earn-out; [list of consent rights]
6. Information rights: seller receives [reports] within [days]
7. Dispute process: independent accountant resolves calculation disputes within [days]
8. Offset: buyer may offset indemnity claims against earn-out payments
9. Acceleration: [events that accelerate payment, such as sale of the business]

Mezzanine and subordinated debt

Mezzanine debt sits between senior debt and equity. It costs more than senior debt, may carry warrants or equity features, and adds fixed payments. It is used when senior lenders will not fund the whole gap and the owners do not want to raise more equity. Costs and terms vary widely by lender and deal, and I could not verify a market range from a primary source, so request quotes rather than rely on a rule of thumb.

A senior lender usually must consent to mezzanine debt, and may require a subordination agreement. SBA rules also limit what lenders can allow: the SOP requires the lender to underwrite and review the terms of all other debt and equity in a deal with external capital.

Equity: the searcher, investors and sponsors

Equity absorbs losses first and takes the upside. In a traditional search fund the investor group that funded the search provides acquisition equity, and the searcher earns equity over time. A self-funded buyer supplies the equity from savings, gifts and, within SBA rules, a small group of minority investors. Independent sponsors raise equity deal by deal from capital partners.

Under the SBA SOP, outside equity from non-controlling minority investors (under 20 percent ownership, no control) can count toward the equity injection as a limited source. Those investors cannot receive distributions beyond tax distributions until the 7(a) loan is paid off, so investors who need current income should not be your source.

Worked example: a larger, non-SBA stack

The example below is illustrative and not a recommendation. A search fund buys a company with $2,000,000 of EBITDA for $12,000,000 (6.0x) with $500,000 of buyer costs. The leverage multiples are assumptions chosen to show how a stack reads.

Senior debt is 2.5x EBITDA ($5,000,000 / $2,000,000). Senior plus the seller note is 3.0x. Equity, including the rollover, is 52 percent of the total. Read a stack this way: how many turns of EBITDA are borrowed, what share is equity, and who is behind whom if results disappoint.

Stress-test the stack

Add up all fixed payments (senior debt, seller note, mezzanine) and compare them with a bad year of earnings, not the seller's best year. The steps below work for any stack.

• Step 1: write the base-case annual cash flow available for debt service (EBITDA less taxes, capital spending that cannot be deferred, and the pay you must take).
• Step 2: add all required debt payments and compute coverage. For SBA deals use the SOP's 1.25 floor as a minimum.
• Step 3: reduce earnings by 10, 20 and 30 percent and recompute. Note where coverage falls below 1.0.
• Step 4: identify what you would do in each case: cut costs, defer capital spending, ask the seller to extend a note, or inject equity.
• Step 5: if a 20 percent decline breaks the structure, lower the price, add equity, or reduce fixed payments.

The financial modeling resources on this site include templates for building this analysis. Build it before the LOI, not after.

Questions to ask every capital provider

• What do you need to see to approve, and how long will it take?
• What covenants, fees, prepayment terms and guarantees apply?
• What happens if I miss a payment or breach a covenant?
• Who has the right to approve my budget, hires or additional borrowing?
• How do you treat the seller note, and do you require a standby agreement?
• What are your rules on distributions, including tax distributions?
• Who else has seen this deal, and do you have preferred terms for the next one?

Sensitivity: how rate and loan size change coverage

Example Co's debt service depends on the loan size and interest rate. The table shows the debt service coverage ratio on $350,000 of EBITDA across three loan sizes and five illustrative interest rates, with 10-year amortization. The rates are assumptions to show sensitivity, not quotes.

Read across: at a $1,620,000 loan, coverage falls to the 1.25 floor if the rate is 12 percent. At a $1,750,000 loan, coverage fails the floor at 11 percent. The lesson is to know your lender's rate before you lock your price, and keep a cushion for rate changes if the loan is variable.

Comparing lender offers

Compare offers side by side. A lower rate with a heavy overlay can cost more than a higher rate with fewer conditions.

Fill in one column per lender as you speak to them. Blank cells are unanswered questions.

SBA loan or conventional bank loan

Buyers often ask which route is better. The table compares them on points the SBA SOP settles and on general market features. Terms on the conventional side vary by bank, so treat that column as typical questions to ask, not facts.

For deals under a few million dollars the SBA route is common because of the long amortization and high leverage. For larger deals or for buyers who do not meet SBA eligibility rules, a conventional lender or a mix of senior and subordinated debt may be the only route.

Choosing a structure in five steps

• Start from the price you are willing to pay and the earnings you can verify.
• Check eligibility: for SBA, citizenship and residency rules for owners and guarantors, and size.
• Draft the sources and uses with the minimum equity and the maximum loan.
• Compute debt service and coverage for the base case and the stress cases.
• Choose the structure that passes the stress test with the least complexity. Each added layer, such as mezzanine debt, adds fixed payments and lender consents.