Acquisition financing structures: SBA 7(a), seller notes, earnouts, mezzanine debt, and who carries risk

What to take away

SBA 7(a) acquisition loan mechanics

The SBA 7(a) program guarantees a portion of a loan from a participating lender. The maximum loan amount is $5 million. For a business acquisition, the SBA generally requires a 10 percent equity injection. That equity can come from the buyer or from a seller note on full standby for two years.

Collateral and cash flow set the limit. The SBA wants a debt service coverage ratio of at least 1.15. That ratio compares net cash flow to annual loan payments. If your target's cash flow after owner compensation is thin, the structure collapses.

Normalize the owner's salary first. The SBA's guidance on calculating startup costs supports normalizing owner compensation before you size the loan.

The SBA's 1.15 coverage ratio is a floor, not a target. Lenders often require more cushion.

Real-world SBA example: In fiscal year 2023, the SBA approved 57,362 7(a) loans totaling $27.5 billion, an average of about $479,000. Live Oak Bank is a major SBA 7(a) lender. A $2.5 million acquisition with a $2.25 million SBA 7(a) loan and $250,000 buyer equity fits the 10 percent rule.

Seller-financed promissory note terms

A seller note, also called vendor take-back financing, is a loan from the seller to the buyer. The note must state principal, interest, repayment schedule, and default terms. Cornell's Legal Information Institute explains the essential elements of a promissory note.

The IRS requires adequate stated interest, often based on the applicable federal rate. If the seller finances the sale, the seller reports the gain under the installment method. That means tax is paid as principal payments arrive. For Canadian sellers, a vendor take-back can defer capital gains realization. The lifetime capital gains exemption under section 110.6 may also apply.

Rebuild this for your deal. A seller note is more flexible on collateral than a bank loan. But the seller will demand a personal guarantee and often a security interest. If your cash flow is seasonal, negotiate a payment schedule that matches receipts. In an SBA deal, the seller note must be on full standby for two years.

Real-world seller note example: In a typical SBA 7(a) acquisition, a $2.5 million purchase might use a $250,000 seller note on full standby for two years to meet the 10 percent equity injection. The IRS publishes the applicable federal rate monthly. Typical seller note interest rates range from 3 to 6 percent.

Earnout structures and customer concentration

An earnout pays the seller extra if the business hits future revenue or earnings targets. The buyer funds it from future cash flow, not a bank. This helps when buyer and seller disagree on value. But the earnout requires clear accounting definitions. Which expenses count? Does the target include the new owner's salary?

Customer concentration changes the earnout math. If one customer is 40 percent of revenue, tie the earnout to retaining that customer. SEC business combination rules require disclosure of risk factors, including customer concentration. Your deal size affects the cap. A small deal may use a revenue earnout. A large deal may use an adjusted EBITDA earnout.

Real-world earnout example: Facebook's 2014 acquisition of Oculus was valued at $2 billion, including a $300 million earnout tied to milestones. The base price was $400 million cash and 23.1 million shares. That earnout equals 15 percent of the total price, so milestone definition drove the number.

Mezzanine debt and management buyouts

Mezzanine debt is subordinated debt between senior bank debt and equity. It costs more because the lender takes more risk. Mezzanine lenders often receive warrants, which give them the right to buy equity. That dilutes the buyer's ownership if the company performs well.

A management buyout uses a similar stack. Managers put in cash, a bank provides senior debt, and a mezzanine lender or the seller provides the rest.

The SEC investor alert on solicitation discusses conflicts and disclosures relevant to management buyout transactions. Rebuild mezzanine for your deal by calculating coverage with the mezzanine payment included. If the ratio falls below 1.0, the structure fails.

Real-world mezzanine example: Mars acquired Wm. Wrigley Jr. Company in 2008 for about $23 billion. Berkshire Hathaway provided $4.4 billion in subordinated debt, which is mezzanine-style financing. That subordinated piece was about 19 percent of the purchase price. Mezzanine lenders often charge 10 to 15 percent interest plus warrants.

A numbered checklist to rebuild any structure

Where the mechanics transfer

The four structures differ in who takes risk. SBA 7(a) puts risk on the government and lender. A seller note puts risk on the seller. An earnout puts risk on the seller for future performance. Mezzanine debt puts risk on a specialized lender.

Do not copy the outcome. Copy the test. If a structure worked for a $2 million purchase, it may fail for a $500,000 purchase because fixed costs and collateral rules do not scale down.

For six invented purchases shaped by what could be funded, from thin collateral to a coverage test and an approval that lapsed, read acquisition financing examples, taken apart. That is the line-by-line breakdown that connects the mechanics to the numbers.

Common questions