7 Capital Stack Tools You Need to Know

1. Senior Debt: The Foundation of Most Acquisitions

Senior debt is typically provided by banks or other traditional lenders and forms the base of most acquisition capital stacks.

Why use it:

• Lowest cost of capital (typically 7-11% in today's market)

• Non-dilutive to your ownership

• Interest payments are tax-deductible

• Establishes banking relationships for future needs

When it works best:

• When acquiring stable businesses with predictable cash flows

• When the target has significant hard assets that can serve as collateral

• When you have a strong personal credit profile and industry experience

Example: Tyler acquired a manufacturing company generating $5m in annual revenue with $1m in EBITDA. The business had $1.5m in equipment and real property. He secured senior debt for 60% of the $4m purchase price ($2.4m) at 9% interest with a 10-year term, using the company's assets as collateral.

2. Subordinated/Mezzanine Debt: Bridging the Gap

Subordinated debt (often called mezzanine financing) sits between senior debt and equity in the capital stack. This debt is "junior" to senior debt but "senior" to equity positions.

Why use it:

• Fills financing gaps when senior debt isn't sufficient

• Still less expensive than equity (typically 10-15%)

• Limited or no dilution of control

• Can include flexible repayment terms

When it works best:

• When you need additional capital beyond what senior lenders will provide

• When the business has strong cash flow but fewer hard assets

• When you want to minimize equity dilution

Example: Michael wanted to purchase a software company valued at $8m with $1.6m in EBITDA. The bank would only lend $4m as senior debt. Rather than bringing in more equity partners, he secured $1.5m in mezzanine financing at 12% interest with interest-only payments for the first two years, allowing time for growth initiatives to take effect.

3. Buyer Equity: Skin in the Game

This represents the cash contribution from the acquiring deal sponsor.

Why use it:

• Demonstrates your commitment to lenders and other capital providers

• Gives you maximum control over the business

• Allows you to retain more upside potential

• Improves terms from other financing sources

When it works best:

• Always a component in acquisitions (lenders typically require 10-20% minimum)

• When you want to maintain decision-making control

• When you have personal capital available without overextending yourself

Example: Alex was purchasing a distribution business for $3m. Though he could have raised more investor equity, he chose to contribute $600k (20%) of his own capital to maintain majority control and secure better terms on his senior debt.

4. Investor Equity: Expanding Your Capabilities

Capital contributed by outside investors in exchange for ownership shares.

Why use it:

• Allows you to pursue larger deals than you could finance alone

• Can bring in strategic partners with valuable expertise

• Reduces your personal financial risk

• No fixed repayment obligations

When it works best:

• When acquiring larger businesses beyond your personal financial capacity

• When you need specific industry expertise or connections

• When the target business has significant growth potential that can generate returns for investors

Example: Jessica identified a healthcare services company valued at $12m. She contributed $1m herself and raised $3m from investors with healthcare backgrounds, giving them a 30% stake. Their industry expertise proved invaluable in accelerating growth post-acquisition.

5. Seller Rollover Equity: Alignment of Interests

This occurs when the seller retains a minority ownership stake in the business after the sale.

Why use it:

• Reduces the cash needed at closing

• Demonstrates the seller's confidence in the business's future

• Creates alignment between buyer and seller

• Facilitates knowledge transfer and transition

When it works best:

• When the seller has built unique systems or customer relationships

• When you want the seller to remain engaged during transition

• When you want the seller to continue running the company

• When the business has strong growth potential that can benefit both parties

Example: David purchased a marketing agency where the founder had deep client relationships. Instead of a complete buyout, the founder rolled over 20% of the equity value ($800k of a $4m valuation), staying on as a client relationship manager for three years and participating in the upside as David expanded the business.

6. Seller Note: Flexible Financing

A seller note is a loan provided by the seller, representing a portion of the purchase price to be paid over time instead of up front.

Why use it:

• Bridges valuation gaps when buyer and seller disagree on price

• Reduces the need for external financing

• Often features more flexible terms than institutional financing

• Can include performance-based adjustments

When it works best:

• When bank financing is insufficient

• When negotiating with motivated sellers ready for transition

• When the business has some uncertainty that makes valuation challenging

Example: Robert acquired a specialty retail business for $2.5m. The bank provided $1.2m in senior debt, Robert contributed $500k in equity, and the seller agreed to a $800k note paid over five years at 8% interest, with payments structured to align with the business's seasonal cash flow.

7. Seller Earnout: Performance-Based Consideration

An earnout ties a portion of the purchase price to the business achieving specific performance targets after the acquisition.

Why use it:

• Bridges valuation gaps by making part of purchase price contingent on performance

• Reduces upfront capital requirements

• Aligns seller's final payout with successful transition

• Validates seller's claims about business upside potential

When it works best:

• When acquiring businesses with unproven growth initiatives

• When the seller is making aggressive projections

• When there's uncertainty about customer retention post-transition

• When the seller will remain involved in some capacity

Example: Lisa purchased a service business where the owner claimed several recent initiatives would drive significant growth. They agreed on a $3m base purchase price plus an earnout that could deliver up to $1.2m more if revenue and profitability targets were met over the next two years. This protected Lisa from overpaying while giving the seller opportunity to realize value from his growth initiatives.

Putting It All Together: Crafting Your Optimal Capital Stack

The most successful acquisitions typically use multiple layers of the capital stack in combination. Each business acquisition presents unique challenges and opportunities that call for different financing approaches.

When evaluating which elements to include in your capital stack, consider:

• Your personal financial capacity and risk tolerance

• The target business's asset base and cash flow stability

• The seller's goals and timeline

• Available financing options in the current market

• Your post-acquisition growth strategy

Remember that your capital structure doesn't just help you close the deal—it significantly impacts your returns, flexibility, and stress level for years to come. A thoughtfully constructed capital stack can be the difference between a burdensome acquisition and a transformative opportunity.

With these seven powerful financial tools in your arsenal, you're well-equipped to structure acquisitions that meet both your financial capabilities and your entrepreneurial ambitions.

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