Debt capacity: how much to borrow to buy an SME or startup
A target’s debt capacity starts from the cash flow available for debt service: normalized EBITDA minus maintenance capex, working capital growth, tax and your own salary. Divide that figure by a target DSCR of at least 1.5 to get the maximum annual installment, then convert it into principal over a five to seven year term at the offered rate. In the worked example, 380,000 euros of available cash flow supports about 253,000 euros of annual debt service, roughly 1.45 million euros of debt over seven years at 5 percent.
Most buyers reason backwards. They find a target, agree on a multiple, then go looking for ways to finance the price. That is the surest route to overpaying and being strangled by debt service the first time trading turns hard. I have watched buyers discover, deep into bank negotiations, that the structure they had in mind needed nearly twice the cash the target actually generated. Seasoned acquirers start from the other end: the company’s cash flows, the debt those flows can safely repay, and only then the price. Everything else follows from that number. The structure, the equity check, your room to negotiate.
Start from cash, never from profit
A bank gets repaid in cash. Not in EBITDA, not in net income. So your starting point has to be the free cash flow available for debt service, not accounting profit. Build it up from normalized EBITDA, the figure you have adjusted for private spending, a market rate owner salary and one off items. Then strip out everything that genuinely consumes cash each year. The list is longer than most buyers expect.
- Maintenance investment (replacement capex): what you have to spend each year just to keep the asset base in working order, as opposed to growth projects. In manufacturing it is often 3 to 5 percent of revenue.
- Change in working capital: a growing business ties up more inventory and receivables, and that cash is not available to repay the bank.
- Income tax: it is paid in cash and reduces, euro for euro, what is left for debt.
- Your own pay as owner: if you are buying the business to make a living from it, your salary is an unavoidable cash outflow, not a number you flex to make the deal work.
Take a concrete case. A services SME shows normalized EBITDA of 800,000 euros. Maintenance capex runs at 80,000, growth ties up 40,000 of working capital a year, tax takes 120,000 and you pay yourself 180,000. That leaves 380,000 euros of cash flow genuinely available for debt service. It is this figure, not the 800,000 of EBITDA, that sets your borrowing capacity.
The coverage ratio: how much the bank will really accept
A lender will never let you put all of your available cash flow towards repayment. It wants a cushion, measured by the debt service coverage ratio (DSCR): available cash flow divided by total annual installments, principal plus interest. A DSCR of 1.0 means every euro you earn goes straight to the bank, with no margin for error. No serious lender finances at that level.
The DSCR is not an arbitrary bank rule, it is your margin of survival. At 1.5 you can lose a third of your cash flow and still make every installment. At 1.1 the first lost client tips you into default.
Aim for a target DSCR of at least 1.5, and higher still if the cash flows are volatile or concentrated on a handful of clients. With 380,000 euros of available cash flow and a target of 1.5, the maximum annual debt service the business can carry is 380,000 / 1.5, around 253,000 euros a year, principal and interest included. Any structure that asks for more leaves you exposed to default at the first setback.
From debt service to the amount you can borrow
Once you know the maximum annual debt service the business can bear, you convert it into a borrowable principal, which depends on the term and the rate. An SME acquisition loan is typically repaid over five to seven years. With an installment of 253,000 euros, a rate of 5 percent and a seven year term, you can carry roughly 1.45 million euros of debt. Over five years, the same annual service supports only about 1.1 million, because each instalment carries more principal.
The effect of the term is decisive and often misunderstood. A longer loan lets you raise more debt, but it also raises the risk: the further repayment stretches out, the longer you stay exposed to a downturn. Do not push the debt to its limit just to inflate the price you offer. Debt is not free and it does not forgive. It is the one line in your income statement that does not fall when revenue falls.
Assembling the financing and closing the price
Senior bank debt covers only part of the price. The rest comes from your equity and, very often, a vendor loan. Back to the example: if the target carries 1.45 million of bank debt and the seller agrees to a 400,000 euro vendor loan repaid after the bank, you can structure a price of about 2.5 million by putting in 650,000 euros of equity. The vendor loan earns its keep twice over. It reduces the equity you have to find, and it ties the seller to the genuine continuity of the business, because it only gets repaid if the company holds up.
- Senior bank debt: the cheapest money, the most demanding on collateral and covenants, repaid first.
- Vendor loan: ranked behind the bank, it bridges the gap between senior debt and price, and signals the seller’s confidence.
- Equity: your stake, which absorbs the risk first and must hold something back after closing, never zero.
- Post acquisition cash reserve: keep six to twelve months of debt service in available cash on the day you take over.
Never build a deal where every last euro of your cash goes into the equity. The first year after a takeover is the riskiest: nervous clients walking away, staff testing the new owner, working capital to refinance. A structure that just about works on paper but holds nothing in reserve is a fragile one. Always stress test it. What happens to the DSCR if cash flow falls by 20 percent? If it slips below 1.1, your price is too high or your debt too large.
Estimating debt capacity comes down to translating the operating reality of an SME or startup into a price you can pay and still sleep at night. EBITDA adjustments, real cash flows, financing structure, stress test: all of it belongs before the letter of intent, not after. In my experience it is the single piece of acquisition analysis that saves buyers the most money. If you are looking at a target right now, model its repayment capacity before you commit to a price. That is what keeps you from signing up to debt the business cannot carry.
Key points
- Banks get repaid in cash, not EBITDA: start from the cash flow available for debt service, never from accounting profit.
- Deduct maintenance capex, working capital growth, tax and your own salary from normalized EBITDA.
- Target a DSCR of at least 1.5; at 1.1, losing a single client can push you into default.
- The same annual debt service carries about 1.45 million euros over seven years at 5 percent, but only about 1.1 million over five years.
- Keep six to twelve months of debt service in cash on day one; never put your last euro into the equity.
Frequently asked questions
What DSCR do lenders expect on an SME acquisition loan?
Treat 1.5 as a sensible floor for a leveraged purchase of an SME or a startup, and go higher when cash flows are seasonal, volatile or concentrated on a few clients. Bank covenants sometimes sit closer to 1.2, but a covenant you barely clear protects the bank, not you. Set your own target above whatever the term sheet requires.
Why push for a vendor loan?
A vendor loan cuts the equity you have to bring and keeps the seller invested in a clean handover, since it only gets paid if the business performs. It is also a signal: a seller who refuses any deferred payment on a shaky file is telling you something about their own confidence. In practice it often covers 10 to 30 percent of the price.
What if the asking price exceeds the debt capacity?
You have three levers, in this order: negotiate the price down using the cash flow math as your argument, raise the share of vendor loan or deferred payment, or walk away. Piling on debt the cash flows cannot support is not a lever, it is a deferred default. A serious seller will engage with an argument built on repayment capacity.
How should I treat my own salary in the calculation?
As a fixed cash outflow, at the level you genuinely need to live on, before you compute the cash available for debt. Many acquisition plans only look bankable because the buyer pencils in a token salary for year one. That rarely survives twelve months, and it degrades your judgment exactly when you need it most.
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