What it means
Very few acquisitions are paid for from spare cash alone, so buyers assemble a funding package from several sources. Each layer has a different cost, a different level of security and a different claim on the business if things go wrong.
Senior bank debt is the cheapest layer because it is secured on the assets and repaid first, but lenders cap it against the target's earnings. Above it sit more expensive layers such as mezzanine debt or a seller note, and at the bottom is the buyer's equity, which carries the most risk and the highest expected return.
Lenders size their support against the target's earnings before interest, tax, depreciation and amortisation, usually expressed as a multiple. A senior facility of three times that earnings figure is a common starting point, and the total debt multiple is one of the first numbers any credit committee looks at.
Financial leverage cuts both ways, which is the central point for anyone assessing a deal. Debt magnifies the equity return when trading holds up and magnifies the damage when it does not, so the sensible question is how far earnings could fall before interest cover becomes uncomfortable.
Seller funding deserves particular attention because it is often the cheapest and most flexible piece. A deferred payment or an earn-out tied to future performance reduces the cash needed on day one and keeps the seller invested in a smooth handover, which is why buyers push for it in owner-managed deals.
In practice
Real-world examples
Example 1
A private equity house funds a $60,000,000 healthcare acquisition with 3.0 times senior debt, a seller note and its own equity, and models the returns under a downside case where earnings fall 20%.
Example 2
A family manufacturing group buys a supplier using an asset-based facility secured on the target's stock and receivables, because its bank was unwilling to lend against earnings alone.
Example 3
A listed retailer funds a bolt-on acquisition by placing new shares with institutional investors, accepting some dilution in exchange for keeping its balance sheet unstretched ahead of a refit programme.
Think of it
Buying a company using acquisition financing is like buying a rental house with a mortgage and a small deposit. You use a little of your own savings, borrow the rest against the value of the property, and use the rent collected from tenants to pay off the monthly mortgage.
Formula
Calculation
Total funding required = purchase price + transaction fees + any working capital injection, and this must equal the sum of cash, debt and equity raised.
A buyer agrees to acquire a business for $60,000,000 and expects $2,000,000 of adviser, legal and financing fees, so the total funding required is $60,000,000 + $2,000,000 = $62,000,000.
The funding package is built as $10,000,000 of cash from the buyer's own balance sheet, $30,000,000 of senior bank debt, a $7,000,000 seller note payable over three years, and $15,000,000 of new equity from the buyer's shareholders. Those sources total $10,000,000 + $30,000,000 + $7,000,000 + $15,000,000 = $62,000,000, which matches the requirement exactly.
The target's annual earnings before interest, tax, depreciation and amortisation are $10,000,000, so the purchase multiple is $60,000,000 / $10,000,000 = 6.0 times. Senior leverage is $30,000,000 / $10,000,000 = 3.0 times, and total debt including the seller note is $37,000,000 / $10,000,000 = 3.7 times, a level most lenders would consider acceptable for a stable business.Case study
Seen in the real world
Brackenhill Industrial Services is a fictional business services group, and this case study is illustrative rather than a real transaction. It agreed to buy an invented plant hire company for $60,000,000 against annual earnings before interest, tax, depreciation and amortisation of $10,000,000.
Its first funding plan used $45,000,000 of senior debt, which put leverage at 4.5 times and left interest cover uncomfortably thin. The bank offered $30,000,000, so the fictional management team closed the gap with a $7,000,000 seller note repayable over three years and $15,000,000 of fresh equity, alongside $10,000,000 of its own cash and $2,000,000 set aside for fees.
The lower leverage cost the shareholders some upside, but it proved decisive eighteen months later when a major customer moved to a rival and earnings dipped by 15%. At 3.7 times total debt the business stayed comfortably inside its covenants, whereas the original plan would have breached them within a quarter.
Watch out
Common mistakes
- Budgeting only for the headline price and forgetting adviser fees, financing fees and the working capital the acquired business will need after completion.
- Pushing debt to the maximum a lender will offer without testing what happens to interest cover if earnings fall by 15% or 20%.
- Assuming the seller will accept full payment in cash on completion, when a deferred element or earn-out is often available and cheaper than bank debt.
Questions
People also ask
What is a typical level of debt in an acquisition?
Senior debt around three times earnings before interest, tax, depreciation and amortisation is a common benchmark, though stable, cash-generative businesses can support more.
What is a seller note?
It is a deferred payment owed to the seller, effectively a loan from the person selling the business, usually repaid over two to four years.
Why do lenders focus on earnings before interest, tax, depreciation and amortisation?
Because it is a rough proxy for the cash the business generates to service debt, which is what determines whether the loan can be repaid.