Earnout vs. Seller Note:
Two Very Different Ways to Defer Purchase Price

A seller note (also called a seller promissory note or seller financing) is unconditional debt - the buyer borrows a portion of the purchase price from the seller and repays it with interest over a defined period, regardless of how the business performs. An earnout is contingent deferred consideration - the seller receives additional payment only if the acquired business meets specific financial targets after closing. The key distinction is certainty: a seller note gives the seller a contractual right to a defined payment schedule. An earnout gives the seller a right to additional consideration that depends on future results the seller no longer controls. For sellers, a seller note is almost always preferable to an earnout of the same amount.

Sellers accept earnouts when: (1) the buyer will not agree to a seller note of the necessary size - often because the buyer's total debt capacity is constrained; (2) the deal has a genuine valuation gap that neither party can bridge with a fixed price - the earnout is the compromise; (3) the seller believes strongly in the business's future performance and is willing to bet on it; or (4) the buyer specifically requires the seller to have 'skin in the game' to ensure continued post-closing engagement. Sellers should be aware that earnouts are consistently the most disputed element of purchase price - a seller note is almost always more reliable and should be negotiated for whenever possible.

A seller note is typically a 3-7 year promissory note with an interest rate of 5-8% (interest rates have risen in recent years - prevailing AFR-based rates apply for tax purposes). Principal can be paid in equal installments, bullet (all at maturity), or based on a specific amortization schedule. The note is typically unsecured but subordinated to any senior bank debt. Buyers often seek 'subordination agreements' from the seller, acknowledging that the bank lender's claims are senior. Key terms to negotiate: interest rate, amortization schedule, prepayment rights (can the buyer pay early?), events of default, and security (if any - some seller notes are secured by the business's assets or by a personal guarantee from the buyer).

Yes, and this combination is common in smaller middle-market deals. The deal structure might be: 60% cash at closing, 20% seller note (unconditional, pays over 5 years), 20% earnout (contingent on 2-year performance). The seller note gives the seller a reliable payment stream; the earnout gives the buyer a mechanism to defer the highest-risk portion of the price until the business's trajectory is clearer. Sellers in this structure should ensure that the seller note and earnout payments do not interfere with each other - specifically, that the buyer cannot withhold seller note payments as an offset against claimed earnout shortfalls.

If the business fails, the seller note is at serious risk. Seller notes are typically unsecured (or at best subordinated to senior bank debt), so in an insolvency scenario, senior lenders and trade creditors are paid before the seller note holder. If the business is wound down with insufficient assets to cover all obligations, the seller may receive little or nothing on the note. This risk is why savvy sellers negotiate for: security interest in business assets (if the buyer will agree), personal guarantees from the buyer or principals, regular reporting requirements so the seller can monitor the business's financial health, and acceleration clauses that allow the seller to call the note if certain financial covenants are breached.