Key considerations for your capital stack

If you’re planning to acquire a private company, you may be asking yourself, “How will I pay for the business?”

This seemingly simple question is one of the most important decisions you’ll make as an acquirer. The structure of your financing - called your capital stack - directly impacts the financial stability, flexibility, and long-term value-creation potential of your target business. Poor structuring can lead to excessive leverage, covenant breaches, or misaligned incentives among stakeholders, which can ultimately erode returns and create additional challenges when growing your business.

In this article, we’ll explore what a capital stack is, discuss the balance of risk and return between different financing sources, and break down each component to highlight what acquirers should watch out for when crafting their capital structure.

Balancing the risk and reward of your capital stack

Building the right capital stack for your transaction is essential for optimizing investment returns while managing risk and safeguarding against potential pitfalls. 

This delicate balance requires a thorough analysis of the target’s cash flows, asset quality, and market conditions to ensure that the investment opportunity has enough leverage for attractive upside potential, yet does not overburden the company during adverse periods. 

Ultimately, achieving this equilibrium aligns the interests of all stakeholders, minimizes default risk, and lays the foundation for robust financial performance across varying economic cycles.

Breaking down each component of your capital stack

The right capital stack goes beyond managing risk and choosing the right cost of capital. Each component of your capital stack has distinct characteristics that can influence your day-to-day business decisions, your strategic planning, and the company’s performance.

Below, we’ll explain the key components of a capital stack and highlight the distinct characteristics of each that you should consider when planning your acquisition.

Senior debt

Senior debt reserves the highest priority to be paid back in the event of a liquidation. This debt is secured by company assets and typically carries the lowest interest rate due to its low-risk nature and strict repayment obligations.

Here’s what you should look out for:

Rates and fees:

Interest rates: Assess whether the rates are fixed or floating, and understand how market conditions might affect them.

Fees and expenses: Be aware of arrangement fees, commitment fees, and other associated costs.

Amortization and maturity:

Repayment schedules: Determine if the debt is fully amortizing or has a bullet maturity, and ensure that repayment terms align with projected cash flows.

Refinancing risk: Evaluate the likelihood of needing to refinance at maturity and the potential impact of changing market conditions.

Covenants and restrictions:

Financial covenants: Monitor metrics such as Debt Service Coverage Ratio (DSCR), leverage ratios, and EBITDA thresholds.

Operational restrictions: Understand any limitations on additional borrowing, dividend distributions, or asset sales.

Security and recourse:

Collateral requirements: Identify which assets are pledged and understand the implications in the event of an economic downturn or bankruptcy.

Recourse vs. nonrecourse: Know whether lenders have access to the parent company’s other assets in a default scenario.

Subordinated debt and mezzanine financing

Subordinated debt is considered junior debt, sitting just below senior debt in repayment priority in the event of a liquidation. Suborindated debt is accompanied by higher interest rates, whlie mezzanine financing acts as a “hybrid” debt security with equity-like features, such as warrants or convertible options, to compensate for its increased risk.

Consider these aspects when building your capital stack:

Cost of capital:

Higher interest rates: Recognize that subordinated debt and mezzanine financing typically carry a higher cost relative to senior debt.

Payment-in-kind (PIK) options: Consider if interest accrues rather than being paid in cash, which could impact cash flow.

Equity-like features:

Warrants or conversion rights: Be mindful of features that offer lenders upside potential but might dilute equity if exercised.

Subordination terms: Clearly understand the lender’s position in the repayment hierarchy.

Flexibility vs. control:

Covenant structure: Although mezzanine debt is often less restrictive than senior debt, it may still come with covenants that affect strategic decisions.

Exit provisions: Be aware of any conversion or early redemption features that could influence the timing or structure of your exit.

Equity (LP capital and sponsor equity)

Equity can either come from investor capital or from the sponsor (acquirer) themselves. This component of an acquisition is typically small relative to the amount of debt used in a transaction (ie, a leveraged buyout).  

Here’s what to consider:

Capital deployment:

Proportion of the stack: Recognize that equity typically represents only a fraction of the total purchase price, impacting the overall risk/return profile.

Management incentives: Consider setting up management equity or incentive pools to align interests post-acquisition.

Rights and protections:

Governance: Look for provisions that grant board representation, veto rights on major decisions, or protective provisions in adverse scenarios.

Waterfall distribution: Understand the distribution structure on exit, including any preferred returns, clawback provisions, or dilution protections.

Exit flexibility:

Liquidation preferences: Evaluate how these preferences might affect the return distribution upon exit, especially in downside scenarios.

Tax considerations: Factor in the tax implications of different equity structures and their impact on net returns to LPs and sponsors.

Seller financing and earnouts

Seller financing and earnouts are characterized as “seller contribution.” This type of financing can help bridge the gap between the debt and equity a buyer uses and the total purchase price of the business. Seller financing is provided by the seller as debt that is typically repaid after all senior lenders are paid back. Earnouts, on the other hand, are a deferred compensation agreement paid to the seller based on certain milestones after the deal has closed. 

Keep an eye out for these unique factors:

Alignment of interests:

Performance metrics: Clearly define the milestones or performance targets that trigger additional payments in your earnout agreement.

Timing and payout structure: Make sure the earnout period aligns with the company’s growth trajectory and your exit strategy.

Risk allocation:

Contingencies: Determine what happens if performance targets aren’t met and how this affects the overall deal economics.

Legal protections: Ensure the seller’s financing terms are well-documented to avoid disputes down the line.

Why addressing your capital stack early in your acquisition journey can speed up your closing process

Once you’re under contract with a target acquisition, your to-do list may seem never-ending. You’ll be spending time facilitating a quality of earnings review of the target business, getting any licenses or permits transferred to you, and perhaps the most time-consuming, collecting your funding. 

Talking with lenders, submitting documentation, and raising investor capital all take time while you’re under contract. To reduce the risk that your closing period gets delayed, you should consider how you might structure your capital stack early on; for example, discuss potential opportunities with investors or learn the loan requirements for different lenders. 

The better you prepare before having a transaction under contract, the better chance you’ll have of an efficient closing process, ensuring a successful transfer of business. 

How Zest can help

Zest is digitizing private market transactions, building tools to streamline how entrepreneurs, funds, and investors transact. Our platform is designed to save you time, reduce administrative costs, and bring transparency to your deal process. Whether you’re exploring your first LBO or looking to expand your portfolio with another, our technology can simplify documentation, execution, and post-acquisition reporting.

Get started with Zest today.