
Business Acquisition Financing Strategies
Chris Barrett
Business Acquisition Financing Strategies
Financing a business acquisition can be both thrilling and intimidating. The process involves navigating complex financial structures, understanding the cost of capital, and determining the best sources of funding to reach your objective.
Unlike the straightforward nature of something like a home mortgage, however, business acquisition financing is much more complicated, often involving a blend of debt and equity. This blend, known as the capital stack, is used to optimize both affordability and long-term growth.
Let’s explore the capital stack, its components, and how to strategically finance your next acquisition.
What Is the Capital Stack in Business Acquisition Financing?
The capital stack is a mixture of financial sources used to fund business acquisitions. Each layer corresponds to a specific type of funding, arranged in a hierarchy based on repayment priority and risk. The capital stack typically includes:
- Senior Debt: Low-cost, secured loans that form the foundation.
- Subordinated Debt: Secondary loans with slightly higher risk and interest rates.
- Mezzanine Debt: A hybrid of debt and equity financing, often used for larger deals.
- Preferred Equity: Investments with prioritized returns over common stockholders.
- Common Stock: Equity representing ownership, positioned at the top of the stack.
By understanding these layers, acquisition entrepreneurs can balance cost, risk, and control to create an optimal financing structure.
Senior Debt: The Cornerstone of Business Acquisition Financing
Definition: Senior debt refers to loans secured by collateral or personal guarantees, offering the lowest cost of capital.
Features and Benefits:
- Affordable Rates: Typically 6-11.5%, depending on market conditions.
- Priority Repayment: Lenders have first claim on repayment in case of default.
- Risks: Strict repayment schedules can strain cash flow.
Example:
In most acquisitions, SBA loans or traditional bank loans serve as the primary source of senior debt. These loans can cover up to 90% and in some cases even 95% of the purchase price, making them a very important piece of the capital stack.
Subordinated Debt: Closing the Funding Gap
Definition: Subordinated debt, or second-position debt, is the next layer of financing that ranks below senior debt in repayment priority.
Applications in Acquisitions:
- Often provided through seller financing, where the seller defers part of the payment.
- Useful for covering gaps when senior debt doesn’t meet the full purchase price.
Cost:
Rates are generally slightly higher than senior debt but since this debt is seller financed in many cases that may not always be true.
Real-World Example:
A business acquisition priced at $1 million might involve $900,000 in senior debt and $50,000 in seller financing as subordinated debt. Then the remaining $50,000 may come as equity directly from the buyer.
Mezzanine Debt: Bridging the Gap Between Debt and Equity
Definition: Mezzanine debt blends characteristics of debt and equity, offering lenders higher returns in exchange for increased risk.
Key Features:
- Cost: Interest rates typically range from 12-20% depending on market conditions.
- Structure: Often includes equity instruments like warrants or stock options.
- Use Cases: Primarily reserved for larger acquisitions or growth capital needs.
Practical Insight:
First-time buyers rarely use mezzanine debt, but understanding it prepares you for more complex transactions in the future.
Equity Financing: Preferred and Common Equity
Preferred Equity:
- Provides investors with priority returns and claims on assets in liquidation.
- Useful for aligning investor interests with business growth.
Common Stock:
- Represents ownership in the business, with returns dependent on cash flow and profitability.
Cost Comparison:
Equity financing demands higher returns (often 35% or more), making it the most expensive layer of the capital stack.
Why Cost of Capital Matters in Business Acquisition Financing
Senior Debt:
With its low cost, senior debt is the foundation of most deals. For example, SBA loans offer affordable interest rates but require monthly repayment, impacting cash flow.
Subordinated and Mezzanine Debt:
Higher costs reflect greater risks for lenders, but these layers can fill funding gaps.
Equity:
Equity financing’s high cost stems from its potential for outsized returns, making it suitable for patient investors with high risk tolerance.
Balancing these layers ensures affordability while maintaining control and financial flexibility.
Crafting an Effective Capital Stack
To optimize your business acquisition financing, consider this structure when buying a business <$5MM in enterprise value:
- Secure Senior Debt: Cover the majority of the purchase price (up to 90%).
- Leverage Subordinated Debt Through Seller Financing: Fill remaining gaps through seller financing or secondary loans (5-10%).
- Minimize Equity Financing: Retain ownership and control by limiting equity dilution (5-10%).
Example Strategy:
For a $1 million acquisition:
- $900,000 from senior debt.
- $50,000 from seller financing.
- $50,000 as a personal cash investment.
This structure maximizes leverage while preserving equity.
Conclusion
By understanding the components of the capital stack, you can craft a financing structure that balances cost, risk, and control.
Whether you’re leveraging senior debt or retaining equity, the key is to align your financial strategy with your long-term business goals. Business acquisition financing, when done right, opens the door to wealth creation and entrepreneurial freedom.
Reach out to an expert at Midwest CPA if you need help structuring the capital stack for your next acquisition.
Frequently Asked Questions About Business Acquisition Financing
Business acquisition financing refers to the various methods used to fund the purchase of an existing business, typically involving a blend of debt and equity.
The capital stack is the layered hierarchy of funding sources used in business acquisitions, including senior debt, subordinated debt, mezzanine debt, and equity.
Senior debt is secured, lower-cost financing with priority repayment. Subordinated debt is unsecured and riskier but useful for filling funding gaps.
Equity financing requires higher returns due to the increased risk for investors, often exceeding 35%.
Seller financing occurs when the seller agrees to defer a portion of the purchase price, effectively acting as a lender in the transaction.

Disclaimer
The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting, or investment advice. You should consult a qualified legal or tax professional regarding your specific situation.