How acquisitions are financed
Reading the capital stack
Every layer of the stack trades risk for return. Senior debt has the first claim on cash and assets, so it is the cheapest money. Mezzanine and vendor finance rank behind it and cost more. Buyer equity is repaid last and expects the highest return.
In this builder, buyer equity is the balancing layer. Set the debt, vendor finance and earnout, and equity fills the rest of the price, plus deal fees.
Senior debt and adjusted EBITDA
Lenders size senior debt as a multiple of earnings, using their own view of adjusted EBITDA (opens in a new tab). If a lender rejects $200,000 of add-backs and lends at 3x, the buyer loses $600,000 of debt capacity and has to fill the gap with equity or vendor finance.
The second test is cash. The year-by-year table shows free cash flow against interest and principal. A cover ratio of 1.25x or more is the usual minimum. Work out the earnings base first with the SDE vs EBITDA calculator.
Mezzanine and unitranche
Mezzanine sits behind senior lenders, so it is priced higher and often carries payment-in-kind interest or equity warrants. In many mid-market deals a single unitranche facility from a private credit fund replaces separate senior and mezzanine layers, which simplifies the intercreditor position at a blended cost.
Vendor finance and earnouts
Vendor finance is part of the price the seller agrees to receive later, as a loan to the buyer. It is usually subordinated to the bank, so sellers should ask for security, a guarantee and a clear repayment schedule.
An earnout reduces the cash needed at close, but it is contingent consideration (opens in a new tab) the buyer still has to fund later, often from the business’s own cash. Model the scenarios in the earnout modelling tool.
Fees, the working capital peg and funds flow
The headline price is not the cash required. Deal fees, arrangement fees and any shortfall against the working capital peg (opens in a new tab) all change the funds flow. Keep headroom in the equity layer so a completion adjustment does not leave the deal short on the day.
Equity returns and the exit
Equity returns come from three places: paying down debt, growing earnings and selling at a higher multiple. The builder rolls the business forward over the hold period, values it at your exit multiple and subtracts remaining debt. Compare structures side by side in the deal structure comparison, and check entry multiples in sector multiples.
Frequently asked questions
- What is a capital stack in an acquisition?
- It is every source of money used to pay the purchase price, ranked by who is repaid first. Senior debt has the first claim, then mezzanine, then vendor finance, with buyer equity repaid last. Earnouts sit outside the stack because they are only paid if targets are met.
- How much senior debt can an acquisition support?
- Lower mid-market lenders typically lend 2x to 3.5x adjusted EBITDA, provided free cash flow covers debt service at least 1.25 times. Recurring-revenue software businesses can sometimes borrow against ARR instead.
- What is a good debt service coverage ratio?
- Most lenders require a DSCR of at least 1.25x, meaning free cash flow is 25% higher than the year’s interest and principal payments. Below that, lenders cut the loan size or ask for more equity.
- What is mezzanine debt?
- Mezzanine is a loan that ranks behind senior debt. Because it carries more risk it costs more, usually 11% to 15%, and often pays interest only with the principal repaid at exit. Many mid-market deals replace senior and mezzanine with a single unitranche facility.
- How does vendor finance work?
- The seller lends part of the price to the buyer and is repaid over time with interest. It closes a funding gap and shows confidence in the business, but it is usually subordinated to the bank, so sellers should ask for security and a guarantee.
- How much equity does a buyer need to put in?
- SBA-backed deals can close with 10% to 20% equity. Private equity buyouts usually fund 40% to 60% with equity. Strategic acquirers often pay entirely from cash or shares.
- What return does private equity target on a buyout?
- Most funds target an equity IRR of 20% to 25% and two to three times their money over a five-year hold. The return depends on entry price, leverage, earnings growth and the exit multiple.
- Is an earnout part of the funding?
- Not in the same way. An earnout lowers the cash needed at completion, but the buyer still has to fund the payments later, often from the business’s cash flow. For the seller it is contingent consideration that may never be paid.