How to Finance a Middle Market Business Acquisition

Summary: Smaller middle-market business acquisitions are typically financed using a combination of senior debt, seller financing, and the buyer's equity injection. Some transactions may include seller rollover equity and a 2nd lien receivables financing line to improve cash flow.

Transaction size plays an important role when determining the available financing options.  The number of financing options and their flexibility usually increase as deals get bigger. This is because larger transactions attract competition from more lenders.

In this article, we discuss how small middle-market transactions are financed and provide an overview of how to qualify for financing. We cover the following subjects:

  1. What is the middle market?
  2. Lower market financing
  3. Middle market financing
  4. General requirements
  5. Equity injection
  6. Financing options
  7. Typical structure

1. What is the middle market?

The middle market is loosely defined as companies with revenues between five million and one billion dollars. However, these numbers vary depending on which source you use.

From a business acquisition perspective, we prefer to view the market differently. The number of available options to finance an acquisition is not solely based on the company's revenues. Instead, it is based on the transaction's size.

The transaction size is the amount of funds the buyer needs to execute the transaction successfully. Typically, this includes:

  • Company valuation (EBITDA multiple)
  • Funds for Capital Expenses (CapEx)
  • Funds for working capital
  • Transaction costs

Transaction size is a helpful figure that allows us to explain this in a way that relates to what buyers ultimately need. After all, this is the number buyers are ultimately dealing with. Consequently, the rest of the article uses transaction size rather than revenues.

2. Lower market financing ($5M to $10M)

We define lower market acquisitions as transactions with a value that goes from $5 million to $10 million. These transactions are in a financial grey zone that straddles the small business market and the middle market. The larger ones could be defined as being very small middle market transactions. However, the smaller ones are typically seen as small business transactions.

Lower market transactions face a financing dilemma. They are usually too large to qualify for SBA-backed financing. However, they are usually too small for most private credit and private equity companies. This unfortunate situation limits their options.

Some private credit lenders specialize in lower-market acquisitions. These lenders are usually very selective and only finance transactions that meet their specific criteria.

3. Middle market transactions (above $10M)

We define middle market acquisitions as transactions with a value that exceeds $10 million. This market is competitive, and several lenders and private credit companies specialize in it. Furthermore, the number of potential lenders and financing products increases as transactions grow larger.

4. General qualification requirements

The following is a general list of requirements to finance an acquisition valued between $5 million and $25 million. This list only covers the requirements that apply to most lenders. Ultimately, each lender will have qualification criteria that match their capabilities and risk tolerance.

a) Transaction size

Each lender has a preferred transaction size range. In general, the transaction needs to be bigger than $5 million. Otherwise, it will be considered a small business acquisition. Note that acquisitions under $10 million can be challenging to finance due to the limited number of lenders.

b) Buyers industry experience

Lenders prefer to work with seasoned buyers and management teams with extensive industry experience. At a minimum, they must have experience in the target company's industry. Business ownership experience is a benefit.

c) Buyers equity injection

Every acquisition requires an equity injection from the buyer. The equity injection typically covers 5% - 25% of the transaction value. Lower-market transactions typically require a higher equity injection than a middle-market acquisition.

The actual equity injection is transaction-specific and could be higher or lower than this estimate. The next section covers the equity injection requirements in more detail.

d) Suitable Fixed Charge Coverage Ratio (FCCR)

Some lenders require that the acquisition target have a minimum FCCR of around 1.2. This measure shows the lender that the target company has enough earnings to cover fixed charges (e.g., rent, debt, etc.).

e) Suitable Debt-to-EBITDA ratio

Most lenders require the acquisition target to have a debt-to-EBITDA ratio greater than 4. This ratio also ensures the company has sufficient earnings to cover its debt.

f) Reliable financial statements

Lenders require reliable financial statements for the target, acquirer, and related entities. Ideally, these statements should cover the Trailing Twelve Months (TTM). Without these, lenders won't be able to evaluate the transaction.

h) Letter of Intent / Indication of Interest

Lenders usually engage with the buying team once they have a Letter of Intent (LOI) or Indication of Interest (IOI) in place. This is because the LOI/IOI contains the basic information the lender needs to begin meaningful discussions with the buyers and structure a financing package.

i) Acceptable valuation

The company must be in a valuation range that the lender considers acceptable. Most middle and lower-market lenders focus on acquisitions valued at 2.5 - 9 x EBITDA.

j) Quality company

The target company must be a 'quality company.' The term is in quotation marks because it is highly subjective and varies by lender. At a minimum, the company must have reasonable financial statements, a good team, and good prospects.

Ideally, the company should work in an industry your lender is comfortable with. Note that small lenders tend to prefer or dislike specific industries. This preference can affect their perception of a quality company and the terms you ultimately get.

5. Buyer's equity injection

Every business acquisition requires an equity injection from the buyer. The equity injection usually comes from the buyer and their associates. Buyers can also use the equity of a business they own as part of the equity injection if the company will be combined with the acquisition target.

The equity injection cannot be financed by the seller. Consequently, seller financing and rollover equity do not count as part of the buyer's equity injection.

a) Lower market transactions

Lower market transactions typically require a 20% - 25% equity injection from the buyer. This figure can vary substantially and be higher or lower based on transaction details.

High-quality acquisition targets in attractive industries may qualify for a lower equity injection requirement. However, this is the exception rather than the norm.

The high equity injection requirement for lower market acquisitions is a significant limitation for buyers. It's the main reason financing a transaction valued between $5 million and $10 million is difficult.

Few buyers have the liquid assets to cover this amount. For those with the assets, the equity injection represents a substantial part of their net worth.

b) Middle market transactions

Middle-market companies typically require an equity injection of 10% or less. The actual size depends on the quality of the business and the transaction structure.

These transactions are more attractive to lenders and private credit companies. Consequently, they have more flexible equity injection requirements than their lower market counterparts.

Additionally, your lender's industry preferences play an important role as well. A leader who is comfortable with your acquisition target's industry will likely require a lower equity injection.

6. How are middle market acquisitions financed?

Acquisitions under $25 million are primarily financed using a senior term loan. The loan is secured by business assets and amortized over a defined number of years. The payment terms can be flexible, which can be helpful during the first years of the acquisition.

a) Revolver component

Acquisitions in the B2B space may get a revolving line of financing by leveraging their accounts receivable. This facility improves cash flow and provides funds for operations. Larger acquisitions may qualify for cash-flow based revolving lines of credit.

b) Mezzanine financing

Mezzanine financing is not typically used in acquisitions under $25 million. However, it may be offered in select transactions. In this case, the transaction will have a senior debt tranche and a subordinated mezzanine debt tranche. The mezzanine tranche is typically more expensive due to its higher risk.

7. Typical structure

Business acquisitions under $25 million are typically financed with the buyer's equity injection and a senior debt component. The structure may also include seller rollover equity and a working capital line.

a) Buyer's equity injection

The typical equity injection is 10% - 20% of the transaction value, net of seller rollover equity and seller financing. It can also include the equity of a company that the buyer is bringing into the transaction.

b) Seller financing

Many transactions have a seller financing component. Seller financing typically covers 5% - 20% of the transaction. Some lenders require the seller to finance a portion of the sale since it reduces transaction risk (e.g., seller compliance with post-sale commitments).

c) Seller rollover equity

Some sellers chose to sell only a portion of their company and keep a minority interest in their business. This minority interest is typically rolled over into the acquisition entity, enabling the seller to participate in any potential future growth.

d) Senior debt

The remaining part of the transaction, not covered by the equity injection and any rollover equity, is financed using senior debt. Loans are amortized over a time period and paid in regular installments.

e) Working capital financing

Transactions for companies in the B2B space may also include a working capital line. These lines can improve cash flow by financing the company's accounts receivable. The most common solution is to use asset-based financing secured by a 2nd lien on the company's accounts receivable.

Want to finance a business acquisition?

We offer small business, lower marker, and middle market acquisition financing. The first step to work with us is to submit this form. Once we review it, one of our associates will contact you to discuss the specific details of your acquisition.



Editor's note:

This information should not be considered legal or financial advice. Given the complexity of business acquisitions, this document is not guaranteed to be 100% accurate or cover every potential option. However, we make every effort to provide you with the best information. If you have comments, suggestions, or improvements, contact us via LinkedIn.

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