Demystifying Equity Step Ups in Business Acquisitions

Equity step ups are a unique financing arrangement used in self funded search funds and small business acquisitions to align the interests of entrepreneurs and investors. Instead of investors taking a fixed ownership percentage based solely on how much equity they provide, a step up applies a multiple to their capital contribution. Typical step up multiples fall between 1.5× and 2.5×, and a 2.0× multiple is considered standard. For example, if investors contribute 16 percent of the enterprise value and the agreement specifies a 2.0× step up, the investors receive 32 percent of distributions. This structure compensates them for the risk of backing a searcher and incentivizes the entrepreneur to achieve strong returns before equity ownership is diluted. Investors often negotiate a 1.0× liquidation preference and an 8 to 14 percent preferred return, ensuring they receive their original capital back before common shareholders and enjoy a modest baseline return.

Background on Equity Step Ups and SBA Loans

‍This model grew out of the search fund ecosystem, a niche segment of private equity where entrepreneurs raise a small pool of capital to find and purchase a private business. When exploring how to get an SBA loan or how to qualify for an SBA 7(a) loan, prospective buyers sometimes encounter the concept of equity step ups. The SBA does not prohibit equity step-ups as long as the ownership structure is clearly documented and the borrower satisfies the core 7(a) loan requirements. These include being a U.S. citizen or lawful permanent resident, owning 20% or more of the business, demonstrating good character, providing an adequate personal equity injection, and showing sufficient cash flow to service the loan. At Pioneer Capital Advisory, we guide borrowers through every step of the SBA process, from understanding qualifications and timelines to navigating lender requirements and final approval. While timelines can vary depending on deal complexity and underwriting speed, our average closing time is approximately 75 days from term sheet to final funding.

What Lenders Look for in Self Funded Searchers

For self funded searchers, knowing how to get an SBA loan and how to qualify for an SBA 7(a) loan begins with building a strong financial package. Lenders will look at the borrower’s credit history, industry experience, and their ability to cover debt with operating income. Debt service coverage ratio (DSCR) is critical. Lenders often require net operating income to be at least1.25 times the annual debt service. The SBA requires that financial projections for a change of ownership demonstrate a Debt Service Coverage Ratio (DSCR) of at least 1.15 by the end of the second full year following funding. While equity step-ups may affect how profits are ultimately distributed among investors, these distributions must remain subordinate to debt obligations. SBA loans must be repaid first, and no profit can be distributed until the borrower has satisfied the required annual debt service. As a result, borrower eligibility still hinges primarily on DSCR and the overall financial health of the target business.

Best Practices When Structuring Step Ups

When structuring a step up, searchers should avoid excessive salary or perks that could erode investor returns. Aligning incentives builds trust and reduces friction later. Engaging a knowledgeable SBA loan broker or business acquisition SBA consultant can also help navigate the nuances of these structures. Brokers, consultants, intermediaries, and advisors can review the deal, explain how to apply for an SBA loan, and help match you with SBA loan lenders and the right SBA lender match. Because search funds are typically raising relatively small capital amounts, they rely on a network of SBA loan brokers and SBA loan advisors who understand both traditional equity structures and creative instruments like step ups.

SBA Guidelines Still Apply‍

While step-up structures can offer flexibility, buyers still need to follow SBA rules on seller standby notes, personal guarantees, and business eligibility. Always consult qualified professionals before finalizing any structure. If you’d like to understand the SBA loan process — from application timelines and approval requirements to comparing lenders — our SBA 7(a) loan guide is a great place to start. And if you’d like personalized assistance, reach out to Pioneer Capital Advisory — your trusted SBA consultant and best SBA loan broker.

Explore More SBA Loan Resources

To deepen your understanding of SBA financing, explore our related resources:

• Learn the SBA 7(a) loan process and how to get approved in our article on navigating the SBA 7(a) loan process for your business acquisition
  
• Understand how to qualify for an SBA 7(a) loan and what lenders require in our comprehensive guide to SBA loans for buying a business
  
• Discover what an SBA loan broker does and how to choose the right one in our post on finding the right SBA loan broker
  
• Review the differences between various business loans in our piece on discovering the best loan to buy a business
  
• Learn why partnering with an M&A attorney is essential during due diligence and financing
  

Final Thoughts

Equity step-ups can be a powerful tool for aligning investors and entrepreneurs, but they must be structured carefully. It's critical to ensure the deal meets SBA guidelines and that you can confidently meet DSCR expectations. If you're considering a search fund or self-funded acquisition, contact us today to discuss how we can help you navigate the SBA financing process.