What it means
Banks treat these loans differently from ordinary business lending because the borrower often has no track record of running the thing being bought. Underwriting therefore concentrates on the target's historic earnings and on how much cash the buyer is contributing personally.
A typical structure is a term loan of five to seven years repaid in monthly or quarterly instalments, sometimes with a short interest only period at the start. Rates are usually floating, quoted as a margin over a reference rate, and the margin often steps down as borrowings fall relative to earnings.
Covenants are the heart of the agreement. The two most common are a debt service coverage ratio, testing whether cash flow comfortably exceeds the year's total payments, and a leverage covenant capping total debt as a multiple of earnings.
Security and personal guarantees are usually part of the package on smaller deals. Government backed small business lending schemes exist in many countries precisely to support acquisitions where the buyer cannot provide enough collateral alone.
Timing is the practical difficulty buyers underestimate. Credit approval, valuation and legal work commonly take eight to twelve weeks, so anyone who agrees a completion date before speaking to a lender usually ends up renegotiating it.
In practice
Real-world examples.
Example
A regional accountancy practice borrows $850,000 over six years to buy a retiring competitor's client list. The lender requires the seller to stay on for twelve months, because client retention is the only real security behind the loan.
Example
A management team borrows $4,200,000 to buy the division they run from its parent group. The facility is split into a five year amortising tranche and a seven year bullet tranche, so early cash flow is not consumed entirely by repayments.
Example
A restaurant operator agrees a purchase in March but does not approach a lender until May. Credit approval and valuation take eleven weeks, the seller refuses a further extension, and the buyer forfeits a $50,000 deposit.
Formula
Calculation
Monthly payment = P x r / (1 - (1 + r)^-n), where P is the loan amount, r the monthly interest rate and n the number of monthly payments.
Debt service coverage ratio = cash available for debt service / annual debt service
A buyer borrows $3,000,000 over seven years at 8% a year to fund an acquisition. The monthly rate is 8% / 12 = 0.6667% and there are 7 x 12 = 84 payments.
Monthly payment = $46,758.64
Annual debt service = $46,758.64 x 12 = $561,103.68
If the target generates $900,000 of EBITDA after paying the new owner a market salary, the coverage ratio is $900,000 / $561,103.68 = 1.60 times, comfortably above the 1.25 times minimum most lenders require.
Over the full term the buyer repays $46,758.64 x 84 = $3,927,725.76, so the total interest cost is $3,927,725.76 - $3,000,000 = $927,725.76.Case study
Seen in the real world.
This is an illustrative, fictional example. Nadia Kerrow, an invented operations manager, agreed to buy Ferngate Laundry Services for $2,400,000, contributing $600,000 of her own cash and seeking an acquisition loan of $1,800,000. The business generated $520,000 of EBITDA after allowing for a market rate salary for her.
Her first application asked for a five year term at 7.5%, which produced a monthly payment of $36,068.31 and annual debt service of $432,819.69. That gave a coverage ratio of $520,000 / $432,819.69 = 1.20 times, below the bank's 1.25 times minimum, and the application was declined despite the business being profitable and the deal being sensible.
Restructuring the same loan over seven years at the same rate cut the payment to $27,608.90 a month, or $331,306.76 a year, lifting coverage to $520,000 / $331,306.76 = 1.57 times and clearing the covenant easily. The fictional lesson is that a decline is frequently a structuring problem rather than a verdict on the business.
Watch out
Common mistakes.
- Applying for the shortest possible term to save interest, then failing the coverage test because the annual payments are too large.
- Leaving no working capital headroom, so the acquired business runs short of cash in its first quarter under new ownership.
- Forgetting that the buyer's own salary must be deducted before calculating cash available for debt service, which flatters the coverage ratio.
Questions
People also ask.
How much deposit does an acquisition loan need?
Buyers commonly contribute 20% to 40% of the price, with the lower end usually requiring vendor finance or a government backed guarantee to bridge the gap.
Can the seller help fund the purchase?
Yes, a vendor loan note deferring part of the price is common and lenders view it favourably because it keeps the seller committed to a smooth handover.
What is tested by the covenants?
Most facilities test debt service coverage and leverage quarterly, and a breach usually triggers renegotiation, a higher margin or a waiver fee rather than immediate repayment of the whole balance.
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