Financing an Acquisition: Cash, Debt, Stock, and Earnouts

The financing structure matters for both buyer and seller. Buyers want to minimize cash at close, preserve flexibility, and share risk. Sellers want certainty, more cash upfront, and favorable tax treatment. Finding the right structure requires understanding each party's priorities.

Funding Sources

Cash on Hand

Using existing cash is the simplest approach—no negotiations with lenders, no interest expense, no restrictions.

• Pros: Simple, fast, no ongoing obligations
• Cons: Depletes liquidity, opportunity cost, may not be sufficient
• Best for: Smaller deals, buyers with strong cash positions

Bank Debt

Traditional bank financing for acquisitions, either as a term loan or acquisition line of credit.

• Typical terms: 3-7 year term, interest at SOFR + 2-5%, covenants
• Leverage: Banks typically lend 2-3x EBITDA for acquisition financing
• Security: Usually requires liens on assets and personal guarantees
• Timeline: 4-8 weeks for approval and closing

Start conversations with banks early—before you have a specific deal if possible. Understanding your borrowing capacity helps you target appropriately sized deals.

SBA Loans

SBA 7(a) loans can finance acquisitions with government guarantee, enabling more favorable terms.

• Maximum: $5 million
• Terms: Up to 10 years, competitive rates
• Equity injection: Typically 10-20% required
• Restrictions: Seller can't stay on to run the business in most cases

Seller Financing

The seller provides a loan to the buyer, to be repaid over time.

• Typical terms: 10-30% of purchase price, 3-7 years, subordinated to bank debt
• Interest rates: Often 5-8%
• Alignment: Seller has incentive for smooth transition
• Flexibility: Terms are negotiable between parties

Seller financing benefits both parties: buyer gets more financing, seller defers taxes on the gain, and both are aligned during the transition period.

Earnouts

An earnout is contingent consideration—additional payments if the acquired business achieves specified performance targets after closing.

When to Use Earnouts

• Valuation gap: Bridge difference between buyer's and seller's view of value
• Growth uncertainty: When future performance is genuinely uncertain
• Key person dependency: Tie payments to seller's continued involvement
• Financing constraints: Reduce upfront cash requirements

Structuring Earnouts

• Metrics: Revenue, EBITDA, gross margin, specific milestones
• Timeline: Typically 1-3 years post-close
• Caps: Maximum earnout payments
• Thresholds: Minimum performance required to trigger payment

Earnout Pitfalls

• Manipulation: Buyer can manage results to minimize earnout
• Disputes: Disagreements over accounting and measurement
• Integration conflicts: Earnout may conflict with integration plans
• Seller distraction: Seller focuses on earnout metrics vs. overall business

Define earnout terms precisely in the purchase agreement. Specify accounting methods, what expenses can be allocated, and how disputes will be resolved.

Equity Considerations

Seller Equity Rollover

The seller retains a minority stake in the combined company:

• Alignment: Seller shares in future upside
• Transition: Seller stays engaged during transition
• Tax deferral: Seller may defer tax on rolled equity
• Typical range: 10-30% of seller's proceeds

Outside Equity

Bringing in outside investors to help fund the acquisition:

• Private equity: For larger deals, PE firms provide equity and expertise
• Family offices: May provide patient capital with less involvement
• Strategic investors: Partners with strategic interest in the deal

Dilution Trade-offs

Using equity reduces debt and risk but dilutes ownership:

• More equity = less risk, less upside per share
• More debt = more risk, more upside if successful
• Balance based on your risk tolerance and confidence in the deal

Negotiating Financing Terms

With Banks

• Shop multiple banks for competitive terms
• Negotiate covenants (especially EBITDA definitions)
• Push for flexibility on prepayment, additional borrowing
• Understand reporting requirements and compliance burden

With Sellers

• Seller financing shows seller confidence in the business
• Negotiate subordination to bank debt
• Consider interest-only periods
• Link seller note forgiveness to indemnification claims

Financing Contingencies

Your Letter of Intent (LOI) should address financing:

• Include financing contingency if debt financing is required
• Specify timeline to secure financing commitments
• Provide evidence of financing capability (bank prequalification)