When most first time buyers think about financing an acquisition, their only frame of reference is using a bank loan (mortgage) to buy a house. 

However, when it comes to buying a business, it doesn’t work the same way. You won’t find a bank that will finance 100% of the deal, which can make financing in acquisition entrepreneurship somewhat confusing at first. 

What do you do with the remainder of the purchase price? 

Do you find investors? 

Is it like venture capital? 

How do you start thinking about the different kinds of money and their associated costs? 

These are just a few of the questions that come up during the acquisition process, and this is where the capital stack comes into play. 

The capital stack will help you to understand the different forms of financing and how these impact your ability to finance a business. I’ve worked with banks and investors countless times, and I’m going to share how I think about money and how money is commonly understood in M&A. 

 

The Capital Stack

 

The capital stack is a financial structure that represents the different sources of capital used to fund a business or investment. It is typically viewed as a hierarchy, with each layer representing different types of financing. 

Senior Debt

At the bottom is the foundation: senior debt.

Senior debt is what I think of when I go to the bank – just like your mortgage, if you’ve ever purchased a house. A senior debt is secured, meaning there’s collateral or a personal guarantee attached to the loan. If I don’t make the payments in time, the lender can take my house. It’s the same with a business. If I stop paying, the lender can take my business (and potentially other assets, due to the personal guarantee I signed).

With senior secured debt, such as an SBA loan, if there aren’t enough assets in the business to satisfy the bank, they require a personal guarantee, which in turn acts as collateral for the senior secured lender.

 

Subordinated Debt

Next, we have subordinated debt, also known as second-position debt. Subordinated debt is just like it sounds – there is a secondary lender involved in the deal, but they’re behind the senior secured lender in terms of repayment priority. 

For example, seller-financing in an SBA deal would qualify as subordinated debt. In the event that you defaulted on a business with an SBA loan and a seller-financed portion that is subordinated to the SBA loan, the bank is going to get priority to any money you have for repayment before the seller is able to get repaid. 

Subordinated debt is helpful for when you can’t secure enough debt from the bank to execute the deal and you can’t pay for the remainder with cash. In these instances, you may need to bring in a second lender for additional financing.

 

Mezzanine Debt

Next is mezzanine debt, which operates as part loan and part investment, bridging debt financing (senior and subordinated) with equity financing. More than likely you won’t utilize mezzanine debt, as it tends to be used in larger deals where there’s a bigger requirement for capital. However, it’s important to know that compared to senior or subordinated debt, mezzanine debt is much more expensive because it’s unsecured.

Mezzanine debt tends to be expensive but is typically medium-term in nature. It’s useful when you need a quick capital infusion for a specific project, to bridge financing gaps, or for another strategic goal. This type of debt allows you to manage your overall cost of capital by combining different types of financing with varying interest rates.

Now we get into equity financing, versus debt financing. 

 

Preferred Equity

 

Preferred equity is represented by investors who have an ownership interest in a company. However, they have priority over common stockholders in receiving returns from the business. This normally includes first priority in dividend payments and a higher claim on assets if the company liquidates. Preferred equity holders will get their initial investment back, in addition to a percentage return, before other investors get any payments. 

 

Common Stock

At the top of the capital stack is common stock, which represents ownership shares in a business. Common stock is what I think of when I go to the stock market to buy shares of a company like Apple – their capital stack is structured similarly to this. When buying common stock, I’m purchasing a position that’s last in line for returns. Cash flow only goes to common equity partners once repayment of preferred equity is complete.

 

Understanding the Cost of Capital

 

Now, let’s talk about the factor that matters most when considering different types of capital: cost of financing. 

Senior Debt

 

For a senior secured lender, the most common interest rate over the past 20 years has been about 6% in my experience but as of writing this currently sits at 11.5%​. This is the rate I typically pay to secure capital from a bank. The rates are adjusted periodically and are benchmarked to a short-term interest rate such as the Secured Overnight Financing Rate (SOFR). 

 

Subordinated Debt

 

For a secondary, unsecured lender, the interest rate is usually slightly higher than the going rates for senior debt. However, I’ve often seen it align with senior debt rates when, for example, a seller finances part of a transaction. The seller might receive 90% of the cash at closing and hold a note at the same interest rate, knowing they have already received most of their money. However, if this capital comes from a lender or other debt investors, the rate might be slightly higher. 

 

Mezzanine Debt

 

As I alluded to, mezzanine debt is expensive. It’s often around 12-20%, which tracks with what I’ve seen over the past 17 years. Mezzanine debt involves lenders taking a big risk due to the lack of collateral. They might like the deal and want their money back quickly, but they often embed equity instruments attached, such as stock call options, rights, and warrants, if there is an exit. This helps to make the loan more attractive to lenders, as mezzanine financing behaves more like stock than debt. 

Despite being expensive, it’s cheaper than equity investing and there’s no collateral required (outside of equity). People and private equity firms choose mezzanine debt to minimize how much of their own capital they have to invest in a deal to get it done, since senior debt will only cover so much in most cases. 

Although it’s good to know what mezzanine debt is, the chances of you using it in your deal are low unless you’re acquiring a significantly larger business or operating on behalf of a private equity firm. 

 

Equity Investing

 

Now, let’s talk about equity. When I take money from an investor, they typically expect a return rate of about 35%. This is generally textbook, but some investors, especially in venture capital, might seek higher returns if they’re looking to grow a business tenfold quickly. 

Either way you can see that the cost of capital for debt financing is significantly lower than equity financing. 

 

Why Not Use the Cheapest Financing Available?

 

So, logically, people wonder: if the higher rungs of financing are more expensive, why not just use the cheapest financing option available? 

For one, there might be a limit to how much cheaper financing you’re able to get (e.g. 90% of the purchase price on an SBA loan), and two, there are stipulations that come with each type of financing. 

 

Source: LinkedIn | “Equity Financing vs. Debt Financing”

 

With senior debt, the cost is low and lenders don’t participate in any upside, but it also requires monthly payments, which can strain cash flow and is a clear liability on the balance sheet. The main benefit to lenders not having access to any upside is that if I have a big exit after five years, having tripled the business’s value, the senior lender’s loan is paid off no matter what. They don’t benefit from the growth. Payments will need to start immediately after close, but this debt is inexpensive for me and low risk for the lender. 

In contrast, equity is patient. I might sell equity to an investor, explaining that I need to service debt lenders first. We might work on a three to five-year plan where they invest $100,000 today with the expectation of receiving $500,000 to $1 million in the future. This is where the potential upside lies for the investor and where the cost of capital initially is cheaper. The risk is higher for investors but so is the potential return.

 

How to Achieve the Highest Returns in Acquisition Entrepreneurship

 

As an entrepreneur, your main focus is achieving the highest return possible. 

That said, in order to do this, we have to not just think about this from a numbers standpoint. Instead, focus on the bigger picture, which is what you dream for yourself and your business. 

What impact do you want your business to have? What’s the ideal size of the business you want to own? What value do you want to provide to your customers? What type of life do you want to live? 

The reason why focusing on these intangibles can be even more valuable than strictly focusing on numbers is: as you are doing whatever you need to do to have the greatest impact on your business, your employees, your customers, and yourself, you’ll inevitably create a business that’s sustainable and capable of generating a high financial return. 

For me personally, I love making money, creating impact, and growing businesses. That’s why I’m drawn to the higher levels of the capital stack. When I own equity in my business, I maximize the returns on my efforts and investments.

 

Advantages of Acquisition Entrepreneurship Over Startups

 

When it comes to obtaining financing, you’re in a great position as an acquisition entrepreneur. 

Startups don’t have the luxury to simply secure bank loans, because they can’t. Startups have to raise money because they lack the existing infrastructure, customer base, and cash flow, which are the same aspects of your desired acquisition that allow banks to give you the financing you’re seeking. Startups inevitably have to exchange equity for funding, and if the business succeeds, they might regret selling that equity. But that’s the price they have to pay. 

However, when buying an existing company, you can walk into a bank and leverage the existing infrastructure, track record, and profitability to secure financing (hint: this is the Buy Then Build model I’ve been using for nearly 20 years). 

 

Buy Then Build Model for Financing an Acquisition 

 

As I describe in my book Buy Then Build, with my model, I approach a bank to obtain a significant portion of the financing (~80-90%). I might add a small cash infusion, a partial seller note, or some investor funding to cover the required equity, but if I avoid taking on investors, I get to keep all of the equity. Here’s how my capital stack looks when I buy a business:

On closing day, I put 10% down, and up to 90% comes from senior secured debt. Although the debt is highly leveraged, I retain all the equity. I don’t have to worry about investors or anyone else that tells me how to run and manage my own businesses. 

This approach works so well that I’ve done it seven times now.

Then, as I pay down the debt, I’m able to preserve the existing cash flow due to the low-interest rate. Over a 10-year period (typical length of an SBA loan), my equity increases and debt decreases, resulting in equity buildup similar to real estate investing. 

Once the debt is fully paid off, I own 100% of the equity. If I grow the business by, say, 300% in four years, I can sell it, and the equity becomes much more valuable compared to the original debt amount.

Can you see why I love acquisition entrepreneurship, wrote a book about it, and run an elite accelerator teaching others how to do just this? 

Acquisition entrepreneurship combines the benefits of business ownership with the economics of real estate investing. On top of that, with SBA loans having a default rate of less than 2%, the risk on your end is highly minimized. 

This approach allows you to create significant value by leveraging debt and building equity over time. If you carefully manage your capital stack and focus on growth, you can achieve substantial returns while retaining ownership and control of your business.

Ready to acquire a business in the next 12 months? The Acquisition Lab is your first stop. Reach out to us today and get on the fast track to becoming an acquisition entrepreneur.