When you get a letter of intent from a buyer, two terms tend to show up that can make or break how much money you actually walk away with: earnout and seller financing.
They sound like legalese, but both have direct, concrete effects on when you get paid, how much you get paid, and how much risk you carry after the deal closes.
Understanding the difference before you sign anything is the kind of thing your attorney will thank you for later.
Key Takeaways
- Earnouts tie a portion of the sale price to future business performance, which puts post-sale risk on the seller.
- Earnouts tie a portion of the sale price to future business performance, which puts post-sale risk on the seller.
- Earnouts tie a portion of the sale price to future business performance, which puts post-sale risk on the seller.
What is an Earnout?
An earnout is a contractual arrangement where part of the purchase price is paid to the seller only if the business hits certain targets after the sale closes.
Those targets are usually tied to revenue, EBITDA, customer retention, or gross profit. If the business clears the threshold, the seller gets the additional payment. If it falls short, they don't.
Buyers like earnouts because they reduce their upfront risk. If a seller is projecting strong growth and the buyer is skeptical, an earnout lets them say:
Prove it, and we'll pay for it. Sellers sometimes accept earnouts to close a deal they couldn't close otherwise, or because they genuinely believe in the projections and want to capture that upside.
The problem is that once the deal closes, the seller often has limited control over the very metrics the earnout depends on.
A new management team, a change in sales strategy, or a restructured cost base can all affect whether the business hits its targets, none of which the seller is directing anymore.
How earnouts are typically structured
| Element | Common approach | What to watch |
|---|---|---|
| Metric used | Revenue, EBITDA, or gross profit | EBITDA is easier to manipulate through expense allocation |
| Time period | 12–36 months post-close | Longer periods carry more buyer-side risk to the seller |
| Payment triggers | Tiered thresholds or a single annual target | Tiered structures reward partial performance; binary ones don't |
| Payment timing | Annually at period end | Confirm whether interest accrues on deferred amounts |
| Seller role post-close | Transition period of 6–24 months | More control = more ability to influence outcomes |
Watch out
Buyers sometimes push EBITDA-based earnouts because they can load expenses onto the acquired business after close, reducing the reported EBITDA and shrinking or eliminating the earnout payment.
Revenue-based earnouts are harder to game but require careful definition of what counts as revenue.
What is Seller Financing?
Seller financing (also called a seller note or vendor financing) is different from an earnout in one fundamental way: it's a loan, not a contingent payment.
The seller agrees to accept a portion of the purchase price over time, typically with interest, and the buyer makes scheduled payments until the note is paid off.
If the business underperforms, the buyer still owes the money.
It's common in small and mid-market deals where buyers can't (or won't) finance 100% of the purchase price through a bank or private equity.
Seller notes typically cover 5–30% of the total deal value and carry interest rates between 5–10%, though rates vary by deal size, industry, and credit risk.
Be Sure to Try Our: Seller Financing Calculator
Seller Note Basics
- The note is a legal debt instrument, usually subordinated to senior bank debt
- Repayment periods are typically 3–7 years
- The seller earns interest on the outstanding balance
- If the buyer defaults, the seller has recourse, though collecting is not always straightforward
- SBA lenders often require a seller note as part of deal structure to show seller confidence in the business
Earnout vs. Seller Note: Core Differences
Earnout
- Payment is contingent on performance
- No guarantee of receiving the full amount
- Typically no interest on deferred portion
- Seller bears post-close business risk
- Disputes are common and expensive
Seller note
- Payment is contractually owed regardless of performance
- Earns interest over the repayment period
- Seller has legal recourse on default
- Still carries buyer credit risk
- Treated as a capital gain at time of receipt
How Each Structure Affects Your Total Payout
Both structures reduce your day-one cash. That's the starting point.
Whether they're worth it depends on deal context, business trajectory, and how much trust you have in the buyer's ability to operate and grow what you built.
With an earnout, you're betting on two things: the business will perform to its projections, and the buyer won't do anything after close that sabotages those results.
Neither is entirely in your control. The average earnout dispute ends up in arbitration or litigation, which costs money and takes years. Even sellers who eventually win often collect less than they expected.
With a seller note, you're extending credit to the buyer. Your risk is buyer default, not business performance. That's a different kind of risk.
If the buyer has strong financials, a solid track record, and bank financing in place, the seller note risk is relatively low. If the buyer is thin on capital and the seller note is a big chunk of deal consideration, that risk is much higher.
Tax treatment: a meaningful difference
| Structure | Tax treatment | Timing |
|---|---|---|
| Earnout | Taxed as capital gain when received (installment sale treatment possible) | Each year the payment is received |
| Seller note (principal) | Capital gain reported as payments received under installment sale rules | Spread across repayment period |
| Seller note (interest) | Taxed as ordinary income | Each year interest is received |
Tax treatment can work in the seller's favor if structured correctly. Spreading capital gains over several years through installment sale elections keeps you out of higher brackets in the year of close.
Talk to a CPA who specializes in business sales before agreeing to any structure, because the tax implications can meaningfully shift your net outcome.
When Buyers Push These Structures and What it Signals
A buyer who demands a large earnout when valuations are clear and financials are clean is often signaling valuation disagreement.
They don't believe the business will perform as projected, so they want you to take on that risk. That's not inherently bad, but you should go in clear-eyed.
A buyer who requests a seller note is often signaling something different: they want you to have skin in the game and confidence in the transition.
SBA loans routinely require seller notes for exactly this reason. It's less about distrust and more about deal mechanics.
If a buyer is asking for both a large earnout and a large seller note while offering minimal upfront cash, look hard at that deal.
You're essentially financing the acquisition and getting paid based on performance you no longer control. That's a lot of risk to carry into your post-sale life.
Negotiating These Terms: What Sellers Can Ask For
Both earnouts and seller notes are negotiable. Here's where experienced sellers focus their energy:
- Push for revenue over EBITDA as the earnout metric, it's harder to manipulate through expense allocation
- Negotiate operating covenants that restrict the buyer from making changes that would hurt earnout performance without seller consent
- Get the seller note secured against business assets, not just a promise to pay
- Require an acceleration clause: if the buyer sells or refinances the business before the note is repaid, the remaining balance comes due immediately
- Cap the earnout period at 12–24 months; longer timeframes increase uncertainty and dispute probability
- Ask for tiered earnout payments instead of a single binary threshold, so partial outperformance still gets compensated
Red Flags to Watch for Before Signing
- The earnout metric is EBITDA with no expense allocation restrictions
- The seller note is subordinated so far down that it's practically uncollectable in a default scenario
- The buyer refuses operating covenants that protect the earnout period
- No acceleration clause on the seller note
- The earnout period exceeds 36 months
- Combined earnout and seller note represent more than 40% of total deal value
Example: How These Numbers Actually Look
| Deal element | Amount | Notes |
|---|---|---|
| Total deal value | $4,000,000 | Agreed enterprise value |
| Cash at close | $2,400,000 | 60% of deal value |
| Seller note | $800,000 | 20% at 6.5% over 5 years |
| Earnout (max) | $800,000 | 20% contingent on hitting Year 2 revenue |
| Interest earned on note | ~$140,000 | Approximate total over 5 years |
| Total if earnout is fully achieved | ~$4,140,000 | Includes interest income |
In this example, the seller is getting 60 cents on the dollar upfront. The rest depends on buyer creditworthiness and business performance.
Whether that trade is worth it depends on how clean the earnout metrics are and how much confidence the seller has in the buyer's ability to run and grow the business.
Conclusion
Earnouts and seller notes are common deal tools, and used with the right protections in place, they can help both sides get a transaction done that wouldn't close on cash alone.
The risk is in the details: how the metrics are defined, how the note is secured, and how much control a seller retains over the outcomes they're being measured against.