Earnouts vs. Seller Notes: Which One Best Bridges Valuation Gaps

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When you face a valuation gap, you do not need to walk away. You can use deal structures such as earnouts versus seller notes to bridge the gap between what you want and what a buyer offers when selling your California business. Earnouts are widely used in industries like life sciences, where over 80% of deals include them, while their use in other sectors like technology, manufacturing, or business services has also grown in recent years, especially in the lower-middle-market or larger M&A transactions.

Seller notes give you a way to receive part of your price in future payments when buyers cannot pay the full amount upfront. The right structure depends on your situation, so let experienced advisors like Dream Business Brokers help you create a win-win outcome.

Expert M&A Advisor’s Opinion: Vinil Ramchandran

In all my years of M&A Advisory work, I have never met a Seller that loves deferred payments, either in the form of Earnouts or Seller Financing. Sellers typically prefer to get all their money upfront upon Closing the transaction.  This is totally understandable since anytime someone owes you money, it comes with some level of risk. 

At Dream Business Brokers, we generally push back on deferred payments and negotiate for all or most of the payment to be made at Closing. However, there are times when a deferred payment simply makes sense for both sides, and without it, the Seller may walk away with a significantly lower valuation.  

Read on to learn about the various situations where Earnouts or Seller Notes can be helpful.

Key Takeaways

• Earnouts tie part of the sale price to your business’s future performance, making them ideal when you expect strong growth.
• Seller notes allow you to receive payments over time, providing a predictable cash flow when buyers lack upfront funds.
• Both earnouts and seller notes help bridge valuation gaps, but they come with different risks and benefits that you should understand.
• Consider using a hybrid approach that combines earnouts and seller notes to balance risk and secure guaranteed payments.
• Work with experienced advisors to set clear terms and protect your interests during negotiations for a successful deal.

What Are Earnouts and Seller Notes?

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Before getting to a more detailed explanation of both forms of deferred payments, Sellers need to realize that a deferred payment may come with a corresponding tax deferral benefit in California, as they may not be taxed until they receive the payment. Of course, Vinil Ramchandran doesn’t give tax advice here as he is not a CPA, but you should consult your tax professional to thoroughly understand the tax consequences or benefits of structuring a deal with a deferred payment. The language that goes into a Seller Note can change whether you are taxed upfront or upon receipt of the payment. So, it is very important to also engage a good M&A Attorney to draft these documents.

Earnouts Explained

You may encounter earnouts in many M&A deals. Earnouts let you tie part of the purchase price to your business’s future performance. In these agreements, you and the buyer agree that you will receive extra payments if your company hits certain targets after the sale. These targets often relate to cash flow, revenue, gross profit, or earnings. Earnouts help you and the buyer address uncertainty about the business’s future. They also reduce conflicts that can come from information gaps between you and the buyer.  

In transactions where I have had to do an earnout, I usually prefer to stick to earnouts based on revenue. Earnouts tied to EBITDA can be more easily manipulated by the Buyer who can artificially lower the EBITDA during the earnout period by reinvesting in the company only to enjoy greater growth and EBITDA after the earnout period when they won’t owe the Seller any additional payments. This would require additional contractual language in the Purchase Agreement to give the Seller some control against the Buyer manipulating financials. While it is feasible to do so, it creates an additional level of complexity in the transaction and creates more opportunities for a future lawsuit if the Seller and Buyer disagree on the EBITDA figure.

Examples

Here are a few examples where Vinil Ramchandran, M&A Advisor, has had to use earnouts as a tool to maximize the value of the business for the Seller.

1. Seller had recently launched a new product line. He spent money on R&D, marketing, inventory, etc, but had just done a soft launch and had very little revenue to show for it. However, the customer feedback from the soft launch was great and he expected the revenue to grow drastically in the next few years. We at Dream Business Brokers, wanted to ensure the Seller got paid for the value he helped create even if it wasn’t fully realized yet. The Seller wasn’t going to let the Buyer enjoy all the fruits of his hard work in launching this product without getting paid for it.  If he wasn’t getting some fair compensation for it, he would have preferred to keep the business for a couple more years to show the revenue growth before selling it. The Buyer understandably couldn’t pay much upfront based on the trust that revenues would balloon in the near future. So, the only fair compromise was to negotiate an earnout deal where the Seller would receive a percentage of the new product sales for the next 3 years. This satisfied both parties’ concerns, and the deal moved forward.
2. The Seller’s business had a service offering that wasn’t structured as Annual Recurring Revenue in a manner that would be more highly valued by Buyers. However, there was potential to convert these customers to a Recurring Revenue model after the sale of the business.  So, we negotiated an Earnout based on the growth of Annual Recurring Revenue contracts over 3 years post-Closing. Both parties met their needs, and the deal was Closed.

Tip: Earnouts work well when you believe your business will perform better than the buyer expects.

Seller Notes Explained

Seller notes offer a different way to bridge the gap between what you want and what the buyer can pay upfront. In this structure, you act as the lender. The buyer gives you a promissory note for a portion of the purchase price. You receive payments over time, usually with interest. Seller notes give you predictable payments, but you must trust the buyer to make those payments.

• Seller notes often appear in deals where buyers need help financing the transaction.
• You can use seller notes to show confidence in your business and support the buyer’s success.
• Many primary lenders also like to see the Seller carry a small Note as it shows that the Seller has some ongoing “skin in the game” to ensure a smooth transition.

Why Use Them to Bridge Valuation Gaps

You face valuation gaps when you and the buyer see your business’s worth differently. Earnouts vs. seller notes both help you close this gap. Earnouts align your interests with the buyer’s by linking extra payments to future results. Seller notes provide a clear payment schedule, which can make the deal more attractive to both sides.

Method	How It Bridges the Gap	Best For
Earnouts	Ties extra payments to performance	Uncertain or high-growth deals, high customer concentration, new product or service offering
Seller Notes	Offers fixed payments over time	Buyers with limited cash

You can use these tools to keep negotiations moving forward and reach a fair agreement.  

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Earnouts for Bridging Valuation Gaps

How Earnouts Work

You can use earnouts to bridge the gap between what you want and what a buyer offers. Earnouts tie part of the purchase price to your company’s future results. You and the buyer agree on performance targets, such as revenue or profit goals. If your business meets these targets, you receive extra payments. This approach lets you benefit from sharing future success and gives the buyer confidence that they are paying for future success, not just past results.

Earnouts appear in many M&A deals. For example, in a study of mid-market transactions about 28% of private acquisitions in some areas included earnout provisions. In industries like mining and metals, this number rises to 46%. Services and pharmaceuticals also see high usage, with 38% and 35% of deals including earnouts.  Data for smaller Lower Middle Market companies (under $50 mil in revenue) tend to be more opaque and harder to track since they are generally handled confidentially.  However, we can use the data from reports about larger companies as an indication of trends in the M&A space.

Pros and Cons of Earnouts

Earnouts vs. seller notes offer different ways to close valuation gaps. Earnouts give you a chance to receive more money if your business does well after the sale. You can stay involved and help drive success. Buyers like earnouts because they only pay extra if the business performs.

However, earnouts introduce uncertainty. You may not receive the full amount if the company misses its targets. Disputes can arise over how to measure results. The table below shows some typical outcomes:

Statistic	Value
Percentage of purchase agreements with earnout provisions	54%
Percentage of earnout deals that resulted in disputes	26%

Common Earnout Pitfalls

You should watch for common pitfalls when using earnouts for bridging valuation gaps. Buyers may change how they recognize revenue or increase reserves for bad debt, which can lower reported earnings. They might also allocate more shared expenses to your old business or classify ongoing costs as “one-time” expenses. These actions can affect whether you hit your performance targets.

Tip: Work with experienced advisors to set clear rules for measuring success and avoiding disputes.

Earnouts vs. seller notes both help you reach a deal, but you must understand the risks and rewards of sharing future success.

Seller Notes for Bridging Valuation Gaps

How Seller Notes Work

Seller notes act as a loan from you to the buyer. When you use seller notes in M&A deals, you agree to accept part of the purchase price over time instead of all at closing. The buyer signs a promissory note that outlines the payment schedule, interest rate, and terms. You receive regular payments, often monthly or quarterly, until the note is paid off. This structure gives you a predictable cash flow and helps buyers who may not have enough funds upfront.

Note: Seller notes can make your deal more attractive to buyers who need flexible financing.

Pros and Cons of Seller Notes

Seller notes offer several advantages. You can close the gap between your asking price and the buyer’s offer. You also show confidence in your business’s future by accepting payments over time. The fixed payment schedule gives you clarity on when you will receive your money.

However, seller notes come with risks. You rely on the buyer’s ability to run the business and make payments. If the buyer struggles, you may not receive the full amount. Unlike earnouts, seller notes do not depend on business performance, so you do not benefit from future growth beyond the agreed payments.

Pros	Cons
Predictable payments	Buyer credit risk
Flexible deal structure	No upside from future growth
Can speed up closing	Possible collection issues

Seller Note Risks

You face credit risk when you use seller notes for bridging valuation gaps. If the buyer cannot make payments, you may need to take legal action or renegotiate.

For example, imagine you sell your company for $10 million, with $8 million paid at closing and a $2 million seller note over five years. If the buyer’s business falters, you risk missing out on those payments. We often mitigate this risk by placing a lien on the assets of the business and requiring Personal Guaranty from the Buyer. Personal Guarantees can sometimes work if the Buyer is an individual or a founder-led small business. It’s unlikely to get a Personal Guaranty from a PE firm or a large Strategic Buyer.

Primary lender to fund the transaction

Another point to note is that if the Buyer is using a primary lender to fund the transaction (as opposed to just cash and a Seller Note), then the Seller Note is typically subordinated to the primary lender’s loan. In other words, your Note will be in second position behind the primary lender, and you cannot initiate any collection actions that would jeopardize their payments and may require the lender’s permission.

For smaller SBA loans, where Buyers put a down payment of less than 10%, the lender may require a portion of the Seller Note (to make up their 10% minimum down payment requirement) to be on full Standby for the entire term of the SBA lender’s loan, which is usually 10 years.  As you can see, there are risks associated with the Seller Note, but it can still make sense if you are getting an overall valuation that justifies the risk.

Tip: Protect yourself by checking the buyer’s financial strength and including clear terms in the note.

When you compare earnouts vs. seller notes, consider your risk tolerance and need for predictable payments. Seller notes can help you reach your target purchase price, but you must weigh the risks before making a decision.

Earnouts vs. Seller Notes: Key Differences

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Payment Structure and Timing

You need to understand how payment structures differ when you compare earnouts vs. seller notes. Earnouts tie your future payments to the business’s performance after the sale. If your company meets certain targets, you receive additional money. Seller notes, on the other hand, work like a loan. You receive fixed payments over a set period, usually with interest, regardless of how the business performs.

The table below highlights the main differences in payment structure and timing:

Feature	Earnouts	Seller Notes
Payment Structure	Variable payments based on future performance	Fixed payments based on agreed interest rate
Timing of Payments	Payments may be delayed based on performance. Often 1 -5 years.	Payments usually start after a set period. Often soon after Closing and sometimes after a Standby period if subordinated to a primary lender.
Typical Composition	Can range from <10% to >75% of purchase price based on perceived risk	Secondary to other financing, often requires abeyance for 2 years

In most M&A transactions, earnouts pay out over one to three years, sometimes up to five years in certain industries. Seller notes provide a predictable schedule, so you know when to expect your payments.

Risk and Predictability

You face different risks with each structure. Earnouts expose you to the risk that the business may not hit its targets. The new owners control key decisions, which can affect performance metrics. This misalignment means you might not achieve the results needed for full payment, even if you believe in your company’s potential.

Seller notes offer more predictability. You receive fixed payments, and your risk depends on the buyer’s ability to pay. You do not need to worry about how the business performs after the sale. The table below compares the risk and predictability of both options:

Feature	Earnouts	Seller Notes
Payment Structure	Performance-based, contingent on targets	Fixed payments, not tied to performance
Predictability	Lower predictability due to performance risk	Higher predictability with fixed payments
Risk of Non-Payment	Yes, if targets are not met	No, payments are scheduled
Seller Involvement	Often requires seller’s ongoing involvement	No ongoing involvement required
Potential for Disputes	Yes, over performance metrics	No disputes over performance

Note: With earnouts, you may feel frustrated if you lose control over decisions that impact your payment. Seller notes reduce this risk, but you still need to check the buyer’s financial strength.

Impact on Negotiations

When you negotiate M&A deals, both you and the buyer want to reach your financial goals. Earnouts and seller notes each shape negotiations in unique ways.

• Earnouts require you and the buyer to agree on clear performance targets. You must define milestones and set rules for measuring success. If you do not, you risk disputes and delays.
• Seller notes let you show confidence in your business. Buyers may use seller notes to negotiate better terms with banks. You should set clear payment terms and consider protections like personal guarantees.

The table below summarizes how each structure affects negotiations:

Key Points	Description
Common Goals	Both parties aim to meet financial objectives
Risk Minimization	Each side tries to shift risk to the other
Alignment of Objectives	Earnouts require aligning incentives to avoid conflicts

You may face challenges such as defining fair milestones or dealing with operational changes that affect performance. Seller notes can simplify negotiations, but you must assess your risk tolerance and structure the note to avoid financial strain.

Tip: Work with experienced advisors to set clear terms and protect your interests during negotiations.

By understanding these key differences, you can choose the structure that best fits your needs and increases your chances of success in your next M&A transaction.

Choosing the Right Bridge for Your Deal

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When to Use Earnouts

You should consider earnouts when you and the buyer cannot agree on the value of future growth. Earnouts work best in M&A transactions where you expect your business to outperform the buyer’s projections. You can use this structure if you want to keep sharing future success and believe in your company’s potential. Earnouts often fit deals in industries with high uncertainty or rapid change. You may see only 50-70% of earnouts reach full or partial payout, so you need to weigh the risk. If you want to show confidence and align your interests with the buyer, earnouts let you benefit from paying for future success.

• Earnouts suit deals with uncertain forecasts.
• You can use them to bridge gaps when buyers hesitate to pay for unproven results.
• Earnouts require clear targets and definitions to avoid disputes.

When to Use Seller Notes

Seller notes help you close deals when buyers have limited cash or face challenges with traditional financing. You should use seller notes if you want predictable payments and trust the buyer’s ability to run the business. This structure works well for small to mid-sized companies, especially those with $1 million to $50 million in revenue. Seller notes give you clarity with specific terms like principal, interest rate, and payment schedule. You can use seller notes to make your deal more attractive and flexible for buyers.

• Seller notes fit businesses with limited hard assets or higher risk.
• You can use them to support a smooth transition and maintain your legacy.
• Seller notes help address valuation gaps when buyers question your asking price.

Hybrid Approaches

You do not have to choose only one method. Many deals combine earnouts and seller notes to balance risk and reward. You can use a hybrid approach to secure some guaranteed payments while still benefiting from future performance. This strategy lets you customize the deal to fit your needs and the buyer’s situation. You can reduce uncertainty and increase the chance of success by blending both structures.

Tip: Work with advisors to design a hybrid structure that matches your goals and risk tolerance.

Role of Dream Business Brokers

Dream Business Broker guides you through every step of selling your business. You gain access to experts in business sales, acquisitions, exit planning, and valuation. Their team supports you with real estate transactions and specializes in manufacturing, distribution, and service-oriented businesses.

Dream Business Brokers focuses on companies with $1 million to $50 million in revenue. You receive help with pricing strategy, confidential marketing, and connecting with pre-screened buyers.

Their advisors manage negotiations, due diligence, escrow, and closing, ensuring a smooth process from start to finish. You can trust their experience to help you achieve your goals and maximize value.

Bridging Valuation Gaps: Action Steps

Key Considerations for Buyers and Sellers

You need to approach valuation gaps with a clear plan. Start by defining exact metrics for performance measurement. Set a realistic timeline for any earnout period. Always clarify accounting standards in your agreement to avoid confusion later. You should specify what counts toward the earnout and what does not. Include audit rights so you can review financial statements and request audits if needed.

Buyers and sellers often make mistakes by misapplying the standard of value or assuming all valuations are the same. Clear communication about the chosen standard helps you avoid costly errors. Sellers sometimes feel uncertain with earnouts, especially if projections seem unrealistic. Disputes can arise when you and the buyer interpret performance standards differently. To reduce tension, negotiate a consulting role or a structured transition period. This keeps both sides aligned and helps the buyer grow the business.

Tip: Protect your interests by including legal protections and dispute resolution methods in your agreement.

You should also consider setting caps on payments and describing how unexpected events may impact the earnout. Establish a payment schedule and outline any required approvals. If you want more control, negotiate operational restrictions and maintain some involvement after the sale.

Getting Professional Help

You do not have to navigate these complex decisions alone. Work with experienced advisors who understand deal structures and industry standards. They can help you define clear terms, set achievable goals, and avoid common pitfalls. Advisors guide you through negotiations, due diligence, and closing. They also help you build trust with the other party, which is essential for a successful transaction.

Professional help ensures you address all key issues, from performance metrics to legal protections. With expert support, you can bridge valuation gaps and create a deal that works for both sides.

You can bridge valuation gaps with either earnouts or seller notes, depending on your goals and deal specifics. Use the table below to guide your choice:

Earnouts Work Best When…	Seller Notes Work Best When…
You want a higher price and plan to stay involved	You want to exit completely and value predictability

You should understand each structure’s risks and benefits. Business brokers like Dream Business Broker bring objectivity and expert negotiation skills. If you face a valuation gap, reach out for professional guidance to secure the best outcome

FAQs About Earnouts vs. Seller Notes