Earnouts and Seller Financing: Bridging a Valuation Gap
| John M. McCormick | business, Mergers & Acquisitions
Quick Answer
Seller financing and earnouts both help close a gap between what a seller wants and what a buyer can pay or is willing to risk. With seller financing, the buyer pays part of the price over time under a promissory note. With an earnout, part of the price depends on how the business performs after closing. Both shift risk to the seller, so the protections in the documents matter as much as the headline price.
This article is part of our Legal Guide to Buying or Selling a Business.
What Is Seller Financing?
In seller financing, the seller accepts a promissory note from the buyer for part of the purchase price and is paid over time with interest. It is common in small and mid-sized acquisitions, often alongside bank or SBA financing. For the buyer, it reduces the cash needed at closing. For the seller, it can support a higher price and signals confidence in the business.
How Can a Seller Protect a Seller Note?
- A personal guarantee from the buyer's owners
- A security interest in business assets, perfected by a UCC filing
- Clear default, cure, and acceleration provisions
- Cross-default to the buyer's senior loan and key obligations
- Financial reporting covenants so the seller can see problems early
- Limits on the buyer's right to set off indemnity claims against note payments until a claim is finally resolved
When a bank or SBA lender is involved, the seller note will usually be subordinated to the senior loan, and the lender may restrict or delay payments on it. Those terms can change the seller's economics significantly, so they should be reviewed before the seller agrees to finance any part of the price.
What Is an Earnout?
An earnout makes part of the purchase price contingent on the business reaching defined targets after closing, such as revenue, gross profit, EBITDA, customer retention, or a specific milestone. Earnouts are useful when buyer and seller disagree about future performance. They are also a frequent source of post-closing disputes.
| Earnout Metric | Advantages | Risks |
|---|---|---|
| Revenue | Easy to measure; harder for the buyer to manipulate | Ignores profitability; buyer may resist paying for unprofitable growth |
| Gross profit | Balances growth and margin | Requires clear cost accounting rules |
| EBITDA or net income | Aligns with buyer's value | Most vulnerable to buyer decisions on expenses, allocations, and integration |
| Milestones | Simple yes-or-no outcome | Disputes over whether the milestone was actually met |
Why Do Earnouts Lead to Disputes?
After closing, the buyer controls the business. Decisions about pricing, staffing, overhead allocation, and integration with the buyer's other operations can affect whether a target is met. Sellers should negotiate defined accounting principles, operating covenants, access to records, a clear dispute process (often an independent accountant), and acceleration if the buyer sells the business or materially changes how it operates. Buyers will want enough flexibility to run the company they bought.
How Do These Terms Interact With Indemnification?
Buyers often want the right to reduce seller note or earnout payments to cover indemnity claims. Sellers should limit that right to claims that have been finally determined or agreed. For more on how these risk-allocation terms work, see our guide to reps, warranties, and indemnification.
Attorney Insight
Seller financing and earnouts are tools, not giveaways. The question I ask sellers is simple: if the buyer stops paying, what do you actually have? A guarantee, collateral, and clear default rights turn a promise into something enforceable. Without them, the deferred part of the price is only as strong as the buyer's goodwill.
Frequently Asked Questions
Is seller financing common?
Yes, particularly in small business acquisitions and in transactions financed by banks or the SBA.
How long do earnouts last?
It varies by deal. Longer periods give the seller more time to hit targets but also extend the period of dependence on the buyer's management.
Can an earnout be guaranteed?
Earnouts are contingent by design, but sellers can negotiate minimum payments, acceleration triggers, and operating covenants to reduce risk.
Continue Reading
- The Legal Guide to Buying or Selling a Business (start here)
- Asset Purchase vs. Stock Purchase: Choosing the Right Deal Structure
- Letters of Intent in Business Acquisitions: What Is Binding and What Is Not
- Legal Due Diligence Checklist for Buying a Business
- Reps, Warranties, and Indemnification in a Purchase Agreement
- Buying a Business With an SBA Loan: The Legal Steps
- How to Prepare Your Business for Sale: A Legal Checklist
- Non-Competes, Employees, and Key Contracts in a Business Sale
- Buying or Selling a Business in Virginia
- Buying or Selling a Business in North Carolina
Talk With an M&A Attorney Before You Sign
McCormick Law & Consulting represents buyers and sellers in business acquisitions, primarily in Virginia and North Carolina and in transactions that cross state lines. The transactions in which we have represented a party total hundreds of millions of dollars in combined deal value, a measure of the size of those deals, not of amounts recovered or earned for clients. We have formed roughly a thousand new business entities and currently represent hundreds of businesses, so we approach every deal from the operating side as well as the legal side. Every transaction is different, and the size or outcome of past deals does not predict the result in yours.
With offices in Norfolk, Virginia and Raleigh, North Carolina, we handle most of our transactions in those two states and also assist clients with multistate transactions. If you are buying or selling a business, a short call early in the process can save time, money, and leverage later. Learn more about our mergers and acquisitions practice.
This article provides general information only. It is not legal, tax, or financial advice and does not create an attorney-client relationship. Laws differ by state and change over time. Our attorneys are licensed in Virginia and North Carolina. We assist clients with business transactions involving multiple states. For matters involving the law of a state where we are not licensed, we associate with appropriately licensed counsel or otherwise proceed only as permitted by applicable law.