Evaluating The Most Common Forms of Debt Used to Finance Small Business Acquisitions

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Though it is correct to suggest that all acquisitions are funded through some combination of cash-on-hand, debt, or equity, it’s also a bit of an oversimplification. Indeed, the financing options available to prospective acquirors are numerous, and in today’s blog post, I focus specifically on debt, and evaluate the four most common sources of leverage used to finance the purchase of small and medium-sized businesses.

Many (though not all) acquisitions feature some sort of debt instrument, in part to amplify the returns to equity holders. The basic idea here is that the cash flow generated by the acquired company will eventually pay back the debt used to finance its acquisition, which lessens the amount of upfront equity that one has to raise, thus boosting eventual returns on that equity investment.

The four most common forms of leverage in SMB acquisitions include bank debt, mezzanine debt, seller financing, and SBA loans. We evaluate each of these in turn below, but begin our journey by comparing the first two:

Bank Debt vs. Mezzanine Debt

Bank debt and mezzanine debt (or “mezz debt” for short) can be broadly compared on a spectrum of pricing (i.e. the rate of interest), risk tolerance, and flexibility.

Though bank debt tends to be the least expensive option, it also tends to be the least flexible, often with well-defined covenant packages, repayment schedules, reporting requirements, and approval processes.

Mezzanine debt, on the other hand, tends to be much more flexible, with fewer covenants, more flexible repayment schedules, and less onerous reporting requirements. However, in return for all of that flexibility, the rate of interest charged by mezz funds tends to be significantly higher, often 2-3x the rate of interest charged by a commercial bank. Mezz lenders often get introduced into processes when borrowers either:

1. Can’t get bank financing at all; or
2. Can’t raise their desired quantum of debt from a traditional lender alone; or
3. Require significant flexibility from their lenders on covenants or repayment schedules. For example, consider a company that’s planning to meaningfully decrease profitability in the first few years after acquisition to make necessary investments in growth

Below I attempt to summarize some of the major differences between these two common sources of debt capital. Regardless of which option you choose for your own acquisition, be sure that you understand each of the terms listed below, as they represent some of the major considerations that prospective borrowers ought to contemplate that go well beyond the simple rate of interest being charged:

• (1) Pricing: As mentioned, the rate of interest charged by mezzanine lenders is typically much higher than the rate of interest charged by commercial banks, often by ~2-3x. This is not a trivial difference, especially in an elevated rate environment like the one that we currently find ourselves in. That said, a common mistake for first-time borrowers is to over-optimize around pricing alone at the expense of the other considerations listed below.
   
  (2) Form of Interest: Commercial banks usually charge simple cash interest, but mezzanine lenders can be more creative and charge “non-cash” or “PIK” (payment-in-kind) interest for all or a portion of the loan. For example, consider a $1M loan at a 5% rate of annual interest. If you were to borrow from a commercial bank, you would owe that bank $50K in cash interest each year. However, if you borrow from a mezz lender charging 5% PIK interest, you won’t owe them $50K in cash at the end of year 1, but will instead owe them a total of $1,050,000 at the end of year one, $1,102,500 at the end of year two, $1,157,625 at the end of year three, and so on (the amount owing compounds by 5% each year). Though this latter option gets increasingly expensive via the compounding mechanism, it limits the cash burden on the company, especially during those important (and typically difficult) first few years
   
  (3) Amortization Schedules: Equally important as (if not more important than) pricing is how the loan will amortize (or, said more simply, when principal payments will come due). Some bank loans feature “straight-line” amortization schedules, in which a 5-year loan is repaid in 5 equal installments over each of the next 5 years. Sometimes however banks can be a bit more flexible by offering one or both of the following:
   
  (a) First year interest only: This means that no principal is due in year 1, but the loan will still need to be repaid in 4 equal – but larger – installments over the final 4 years of the loan; or
   
  (b) Amortization Period Greater than the Term of the Loan: Some of the more flexible banks might offer, say, a 7-year amortization profile on a 5-year loan. In this case, the loan is still due at the end of year 5, however mandatory annual payments are calculated as if the loan had a 7-year term. This lessens the cash flow obligations on the company in the earlier years and leads to a more back-heavy repayment schedule.
   
  It’s important to remember that the market for bank debt is like any other market, in that it tightens and loosens based on the interplay of supply and demand: When credit is cheap and easy to come by, banks are effectively forced to offer more flexibility and better pricing to prospective borrowers, else they risk losing them to a competitor (remember, the “product” that banks sell is money, which by definition is a commodity). In markets where credit is tighter, more expensive, or more difficult to access, banks are less flexible as they know that their borrowers likely don’t have many other alternatives, and they themselves need to manage their own risk profiles.
   
  In contrast to banks, mezzanine lenders tend to be very flexible with amortization schedules, in some cases offering no mandatory amortization at all. Though this may be highly appealing to the cash strapped borrower, recall that any non-cash interest charged by your mezz lender will compound (at high rates) each year, and further recall that many mezz loans feature meaningful prepayment penalties: That is, they limit the amount of money that a borrower can repay on a discretionary basis at any one time, which could saddle a company with more debt than they might otherwise choose to carry.
  
  (4) Risk Tolerance: As you might expect, the risk tolerance of commercial banks is lower (which is reflected in their lower rate of interest), and their money tends to be reserved only for the most creditworthy of borrowers. Mezz lenders, on the other hand, have a higher risk tolerance (hence the higher rate of interest), and often work with companies that fall outside of the risk parameters of commercial banks.
   
  (5) Seniority in the Capital Structure: As you might expect, bank loans stand at the very top of the capital structure, and need to be repaid in full before equity holders or other lenders see a dime. The interests of mezz lenders fall below that of banks, but above those of equity holders.
   
  (6) Covenant Packages: Commercial banks usually have rather comprehensive covenant packages associated with their loans, and usually include some mix of debt service coverage, fixed charge coverage, senior debt-to-EBITDA, and total debt-to-EBITDA, among other possibilities. Mezz lenders on the other hand tend to have much more flexible covenant packages.
   
  (7) Reporting Requirements:  Bank loans often feature comprehensive reporting requirements which often include financial statements (audited for the annual statements, un-audited for the quarterly ones), covenant compliance certificates, and borrowing base calculations. Reporting requirements for mezz lenders are typically much less onerous.
   
  (8) Equity Upside: Banks are typically happy to remain as lenders, and often don’t seek any further source of upside. Mezz lenders on the other hand, often want (or need) equity-like upside in order to justify the risk that they’re taking. This will typically take the form of an equity co-investment or warrants, both of which will have dilution implications for your other equity investors.
   
  (9) Your “Pitch” and Positioning: As a prospective acquiror, you may find that you have to adjust the overall “spirit” of your pitch depending on which type of lender you’re speaking with: Commercial banks are primarily concerned with getting their money back with interest, so they are much more focused on stability and predictability than they are with growth. Mezz lenders, on the other hand, likely have reason to be interested in both stability and growth, and prospective acquirors would be wise to adjust their pitch decks and investment theses accordingly.

Asymmetry of Risk & Return in the Mezzanine Business

Given that mezz lenders are senior to equity holders in any given capital structure, you might wonder why their loans are thought of as being so risky. The reason why is due to the nature of the mezzanine business model itself: As a mezz lender, let’s say you have ten $1M loans in your portfolio, each with a 5-year term and a rate of interest of 10%. Assuming no warrants or equity co-investment rights, the most you will ever stand to gain on any one loan is 10% – the upside is capped at this rather modest amount. However, given that you’re likely lending to slightly less creditworthy borrowers, and given that your security interests fall below that of the bank’s, it’s at least conceivable that some loans won’t be repaid to you at all – representing downside potential of 100% for each outstanding loan. This asymmetry between small upside and large downside is what makes the mezz model challenging for many, but also why mezz lenders are “willing” to offer borrowers PIK interest and no mandatory amortization (hint: it is not due to their altruism).

The analysis below shows two mezz loan portfolios: In Portfolio 1, simple cash interest is charged and the loan amortizes evenly over the 5 year term. In Portfolio 2, PIK interest is charged, and the loan doesn’t amortize at all (instead, the entire amount is due at the end of year 5). Assuming that all loans are repaid in full, note how much more profit (in the form of interest income) the mezz lender stands to make in Portfolio 2 with their “more flexible” repayment profile:

To further illustrate how perilous the mezz model can be (and to further illustrate why they offer PIK interest and meaningful prepayment penalties), consider the examples below where there are some defaults in the portfolio:

In Portfolio 1, of the 10 borrowers, if only two default in full, the mezz lender’s profit on the entire portfolio is zero (note that 8 out 10 ought to be considered a good record for substantially any investor). In Portfolio 2 however, because of compounding PIK interest and no amortization, they can afford to have 3.5 loans default before the total portfolio profit falls to zero.

The lack of amortization that you may value as a borrower is thus the very same feature that makes the mezz lender willing to lend to you in the first place. In many instances this can create a mutually beneficial relationship, but in others, borrowers end up paying dearly for the flexibility that they were originally seeking.

Seller Debt

Seller Debt (also referred to as a “seller note”, a “vendor-take-back note”, or a “VTB”) is another very common instrument utilized in the majority of SMB acquisitions. Under the terms of a VTB, the seller effectively lends a portion of the purchase price to the purchaser.

Consider an example where a company is being sold for a $20M valuation, with an $11M upfront cash payment and a $9M seller note, at a 5% rate of interest maturing in 4 years. In this situation, despite a $20M valuation, the selling entrepreneur would receive only $11M in cash today, and would then “lend” the acquiror the remaining $9M (by way of not taking immediate payment of it), and charge them 5% annual interest, with principal repayment due in full at the end of 4 years (note that there could be interim principal payments).

From the perspective of sellers, VTBs are:

1. A way to retain “skin in the game” (i.e. an ongoing interest in their (now former) company), albeit with less risk and capped upside
2. Seen as a safer risk-sharing mechanism than an earn-out
3. A way to earn a potentially attractive risk-adjusted return on their exit proceeds (in our example above, the seller can earn a 5% annual return on $9M of capital, which may be superior to her other investment alternatives at the time).

From the perspective of buyers, VTBs are:

1. A way to ensure that the seller still retains some economic interest to facilitate an orderly transition, to help with introductions and knowledge transfer, or just otherwise to help the new owner after closing
2. An important optical signal to equity investors, signifying that the seller still believes in the future prospects of her business (including the company’s ability to satisfy the loan’s repayment obligations)
3. Often used as a cheap (and covenant-free) form of financing: In our example above, it’s possible that the acquiror can borrow $9M from the selling shareholder at a cheaper rate than they’d otherwise get if they asked for the same amount of money from a bank, particularly if the seller isn’t aware of prevailing rates in capital markets, which may be the case in certain instances.

Contingent Seller Debt

Buyers may also choose to utilize a contingent seller note, which provides for a payoff to the seller contingent upon certain things happening (or not happening, as the case may be). Given their contingent nature, these instruments can be thought of as a sort of hybrid between a traditional seller note and an earn-out. For instance, recall our example above where a company is being sold for a $20M enterprise value, with $11M paid in cash upfront, but now with a $9M contingent seller note.

In this case, the buyer might propose that the note will still be repaid in 4 equal installments throughout each of the next 4 years, so long as revenue stays at or above its pre-close value.

Buyers often elect to include contingent seller notes over traditional ones in situations where the company in question has a clear and material risk that they are looking to protect themselves against. For example: If a buyer’s primary concern is whether the company can hit its revenue targets because of certain industry headwinds, then they can base their contingent seller note on future revenue growth. If however our buyer’s primary concern is customer concentration, she can create a contingent seller note that will be repaid so long as the dollar amount of revenue from the company’s largest customer does not dip below its value in the most recent fiscal year. If our buyer’s primary concern is around customer churn, she can base the contingent note on gross logo retention staying above an agreed upon target. And so on.

I mention these examples because most searchers still use just revenue or EBITDA as the basis for their contingent seller notes, largely because that’s what they’ve seen others do. What these entrepreneurs may fail to realize, however, is that in structuring substantially any form of contingent consideration, they’re limited largely by their imaginations, what is measurable, and what is reasonably acceptable to both parties.

Like any form of structuring, contingent notes shift risk between buyer and seller, and when additional risk is assumed by one party, a demand for a higher return is likely to follow. In our example above the buyer has indeed mitigated her risk through the use of a contingent note, but the seller is now holding a riskier instrument than a traditional VTB, and as a result is likely to demand a higher rate of interest to compensate her for assuming that additional risk.  

Finally: In addition to contingent notes that are paid contingent on something happening, buyers can also propose notes that are issued contingent on something happening. For example, if the company in question has a stretch 3-year revenue target from a newly released product, the buyer can issue a seller note if and when the company reaches that target three years from now, to be repaid over some number of years in the future. This type of contingent note is similar to an earn-out, however allows the buyer to finance and amortize the payment over a number of years, as opposed to having to pay the full amount upfront, as is usually the case in an earn-out.

SBA 7(a) Debt

In the United States, the Small Business Administration (“SBA”) offers a unique loan program designed to help select borrowers finance their acquisition of a small business. The SBA 7(a) loan program can provide up to 90% of the business’s acquisition cost, with a 10-year term and minimal financial covenants (keep reading if this sounds too good to be true). These SBA 7(a) loans are offered to borrowers by a select group of commercial banks approved under the SBA’s 7(a) loan program, with the federal government guaranteeing 75% to 85% of the loan amount, depending on the loan size.

This guarantee reduces the risk for SBA lenders by capping their downside, incentivizing them to lend to borrowers who might otherwise be considered too risky under conventional lending criteria. Among other reasons, the SBA instituted this program to facilitate the transition of small businesses to a new generation of owners, helping them remain viable and continue contributing to the economy and tax base.

SBA 7(a) loans feature several benefits, including (but not limited to):

• A 10-year term for acquisition loans (which is longer than the terms typically offered by most commercial banks for similar purposes)
• Up to 90% financing of the total acquisition cost, which reduces the upfront equity capital required from the borrower
• No financial covenants (beyond repaying the principal according to the agreed upon schedule), which can be particularly valuable for borrowers looking to invest in growth initiatives that might temporarily reduce profitability
• Access to debt capital for borrowers who might otherwise find it challenging to secure financing

Though I wish that my home country of Canada offered a similar program, it’s worth noting that, like all financing tools, SBA 7(a) loans do not come without their limitations, risks, and possible misalignment of incentives between borrower and lender. Namely:

• Borrowers must provide a full personal guarantee against the entire amount of the loan (more specifically, anybody with a 20% or more ownership stake must provide this guarantee). This means that you must have the risk appetite to pledge your largest personal assets (homes, cars, or anything else in which you have more than a 25% equity interest) to the bank, who will hold a junior lien on them until the loan gets repaid
• Borrowers can only access the SBA program if they do not have personal liquidity that meets or exceeds the amount they are borrowing (this means you must demonstrate a need for the loan rather than having sufficient personal funds to finance the business purchase yourself)
• SBA loan amounts are typically capped at $5M, and as a result tend to be reserved for acquisitions on the smaller end of the SMB spectrum
• SBA loans don’t allow for earn-outs or equity rolls from sellers. This means that the entire amount needs to be financed upfront, which may prevent the buyer from benefiting from some of the risk-sharing mechanisms available as part of equity rolls or earn-outs

Beyond the simple mechanics of the program however, I find that I often provide two particular notes of caution to prospective SBA borrowers. Namely:

1. In almost any other context, the prospect of financing an acquisition with 90% leverage would be considered highly risky at best and downright crazy at worst. As many (former) Floridian homeowners might tell you based on their experience between 2006-2009: Just because the bank makes it available to you, doesn’t necessarily mean that you should take it all.
2. Assuming a 75% government guarantee, recall that only $0.25 of the bank’s capital is at risk for every $1 that they loan out, creating an incentive for them to make loans that they might otherwise shy away from, especially given that the $0.25 of at-risk capital is fully collateralized by the personal assets of the borrower. Further consider that most SBA7(a) loan officers receive their incentive compensation based on a percentage of the total dollars that they loan out to borrowers. Though this extra liquidity is indeed partly the intent of the program, I sometimes question just how aligned the incentives are between an SBA 7(a) lender (with capped downside and incentives that scale up as they lend more) and the entrepreneur financing their acquisition with up to 90% leverage and a full personal guarantee.

How Much Leverage Should I Use in My Acquisition?

I almost always ask prospective acquirors how they decided on the specific amount of debt that they’re proposing to use in capitalizing their transaction. I don’t ask this because I think there is necessarily a correct answer that is applicable in all instances, but instead simply to gauge the level of thoughtfulness and deliberation behind the decision.

Though no two situations are created equally, below are a few scattered thoughts that you may wish to contemplate when answering this question for yourself (though note that I tend to be more conservative than most):

• Most buyers assume that margins will stay flat or increase in the first year after closing, yet my experience suggests that they almost always go down due to required investments in people, software & other organizational infrastructure that the previous owners were unwilling to make, unable to make, or didn’t see a need to make (as a result, your 5X entry multiple on-paper is likely closer to 6X in reality). More to the point, however, buyers should make sure that they still enjoy a comfortable amount of headroom relative to covenants even in situations where margins (or the absolute dollar amount of profitability) declines in the first 1-2 years after closing
• If you under-lever, it’s a very easy problem to fix. If you over-lever, it’s a very hard problem to fix.
• In my opinion, debt should be viewed as an accelerant or magnifier of equity returns, not the source of them in and of itself
• One way to add to your “sleep at night factor” as a new CEO is to run the downside case in your model to ensure that you’d still be on-side relative to your covenants should that case actually materialize. Toggle with the total amount of debt until you are, with enough headroom to act as an additional margin of safety. Again, if you find that your company is under-levered 12 months from now, there is likely little stopping you from simply adding additional debt at that point in time.

In Sum

I began this blog post by stating that the choice of financing tools for any prospective acquiror is much more nuanced than a simple decision between cash, equity and debt. Hopefully our discussion above provided you with a better understanding of just how nuanced those decisions can be, even when we don’t explicitly contemplate equity.

Though leverage can act as an attractive amplifier of returns, first-time CEOs in particular would be wise to be prudent and conservative in their use of it.

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