Earnout VS. A Seller Note: Which One Is Best For You | Sell My Biz

When selling a business, the seller has two main options during the deal structure and its terms: an earn-out or a seller note.

An earn-out is a payment made by the buyer to the seller based on the future performance of the business. A seller note, also known as seller financing, is a loan that the seller provides to the buyer in exchange for payments over time.

Both have their advantages and disadvantages. It is essential to understand what each option entails before making a decision.

Let’s take a look at what an earn-out and a seller’s note are. What are the advantages of each option? Which one may be best for your situation when selling a business?

This guide provides you with a framework for a deep understanding of:

• What benefits and drawbacks does each option have?
• What considerations should you make when deciding between the two?
• What resources are available to help make an informed decision?
• And what key points have been learned?

With this information, a seller can determine the best options for them when considering the sale of their business.

Let’s dive in…

Pros and Cons of Selling a Business Note in Comparison to an earn-out.

The primary advantage of an earn-out is that it provides the seller with a potential upside if the business performs well after the sale is closed.

Additionally, an earn-out can also help to reduce the risk for the buyer. The buyer’s risk decreases as it allows the buyer to purchase the business at a lower upfront price. The buyer can then invest in improvements over time.

The main disadvantage of an earn-out is that it may introduce a certain amount of uncertainty into the deal. The business, under the buyer’s ownership, may not perform as the buyer expects. For example, market conditions may change. As a result, the seller may receive less than they were expecting.

On the other hand, a seller note or financing can provide the seller with a more certain return on their investment.

In terms of what option is best, it depends on what the seller is looking for.

An earn-out can provide potential upside and less risk to the buyer. It also introduces a certain amount of uncertainty into the deal.

Seller financing provides a more certain return for the seller but also limits their upside potential.

What is best for the seller will depend on what they value more – potential upside or security.

Before deciding between an earn-out and a seller note when selling a business, it is essential to consider the associated risks and rewards of each option.

Furthermore, it is crucial to understand the resources available to you, enabling you to make informed decisions with all the necessary information. With this data, a seller will be able to select which option suits them best.

Next, we’re going to reveal some of the benefits and drawbacks of both an earn-out and a seller note. What to consider when choosing between the two options?

Benefits of a Seller Note over an Earn Out

When selling a business, one of the most significant advantages of seller financing or a note is that it’s senior to the equity position. This senior position means that in the event of default, the buyer will make payments to the seller first before any other investors or creditors.

Additionally, by taking on a seller note instead of an earn-out, the seller can also receive both interest and principal payments from the buyer. This provides the seller with more certainty of receiving what they expect, as opposed to an earn-out, which relies on the future performance of the business.

Senior to the Equity position: 3 Key Points

1. Senior to the Equity Position: A seller note is senior to the equity position, meaning that payments must be made to the seller first before any other investors or creditors in the event of default.
2. Interest and Principal Payments: By taking on a seller note instead of an earn-out, the seller can receive both interest and principal payments from the buyer.
3. Certainty of Return for the seller: This provides the seller with more certainty of receiving what they expect, as opposed to an earn-out, which relies on the future performance of the business.

Seller Note or Financing Example

A seller’s note works as follows. We are using an example to explain things clearly.

1. The buyer agrees to buy the business for $1 million, and the seller also agrees to sell the business.
2. The buyer and seller agree that the buyer will provide a down payment of 50% or $500,000 to the seller at the close of escrow. They further agree that the buyer will repay the seller the remaining $500,000 over five years, in installments of $100,000 per year, plus interest.
3. The buyer agrees to pay the seller regardless of how the business performs under Buyer’s ownership and management, and the seller agrees.

Disadvantages of a Seller Note Compared to an Earn Out

The primary disadvantage of a seller note compared to an earn-out is that it limits the seller’s upside potential. That is, the payments the buyer makes do not relate to the business’s performance. If the business performs well under the buyer’s ownership, it will reduce the total return the seller receives.

For the buyer, this can be seen as a risk, as they may not recoup their full investment if the business does not perform as they expect.

Additionally, seller notes typically have more stringent terms. This may include higher interest rates and more extended repayment periods than an earn-out.

Let’s take a closer look at the limited upside potential for the seller and what it means to you as a business seller in California.

Limited upside potential for the seller

The limited upside potential for the seller when using a seller note or financing, compared to an earn-out, means that you may not receive what could have been earned had the business performed well.

In this case, the buyer would be more at risk and would probably need the seller to agree to stricter terms, such as increasing interest rates and lengthening repayment periods, to safeguard their investment.

In other words, a seller note can provide a seller with more certainty when selling a business, but it does limit the potential upside for the seller.

For example, if the buyer agrees to pay $1 million for a business and the seller agrees to a seller note or financing option, then at bes,t they will earn what is specified in the agreement.

The seller will likely agree to an interest rate that compensates them for the risk and time involved in receiving the full payment.

The seller will also be limited to what is specified in their agreement and may not be able to benefit from increased revenues or profits that the business generates.

Benefits of an Earn-Out Compared to a Seller Note

When selling a business in California, an earn-out may be more desirable for the seller than a seller note because it offers more upside potential and greater flexibility in what they expect to receive from the sale.

A seller note may be attractive due to its simplicity, but it does limit the return the seller can receive if the business performs well. It also poses a greater risk to the buyer since they may not be able to recoup their full investment.

Therefore, it is essential to carefully consider the various options when selling a business and determine which one is best suited for your particular situation.

In a nutshell, compared to a seller note, an earn-out provides more upside potential for the seller. This is because it rewards them with additional compensation based on the future performance of the business.

The advantage of an earn-out is that it gives the seller more flexibility in what they are expecting to receive from the sale.

Because of this, an earn-out is usually more desirable for the seller than seller financing.

Overall, an earn-out can provide a seller with greater upside potential and better terms than a seller note could offer.

Let’s dive more into market-based rewards.

Market-based rewards tied to future performance

When selling your business in California, it is essential to consider what will be explicitly rewarded for which performances.

For example, certain market-based rewards can be tied to the future performance of the business, such as increased sales or profits.

These types of rewards offer a greater incentive for the seller, as they are based on what the business can achieve in the future.

Overall, market-based rewards are often more attractive to sellers than what they can obtain with a seller note or financing option, as they provide greater upside potential and better terms.

Potentially Higher Returns for the Seller if the business performs well.

An earn-out is typically based on future business performance, allowing the seller to earn greater profits if the company performs well.

For example, if an earn-out is tied to increased sales or profits, then the seller can benefit from any additional revenues or profits generated by the business.

These types of rewards provide an excellent incentive for sellers.

Earn-out Deal/Term Structure Explained

An earn-out works as follows. We are using an example to be clearer.

1. The buyer agrees to buy the business for $600,000, and the seller also agrees.
2. The buyer and seller agree that the buyer will also pay the seller an agreed-upon amount if the business achieves its annual gross revenue sales targets.
3. For example, the buyer agrees to pay the seller $125,000 per year from the date escrow closes as long as the gross revenue for that year is $250,000 or more.
4. The buyer also agrees to do this for a period of 5 years. From the buyer’s perspective, if the seller is confident that the buyer will achieve a gross revenue of $250,000 or more per year for five years, that is a good deal for the buyer.
5. The seller is comfortable with the buyer and their ability to achieve a gross revenue of $250,000 or more per year, thereby earning $125,000 per year for 5 years, or an additional $650,000, in addition to the $600,000 purchase price.

Key Takeaway

Depending on what stage your business is in, you’ll want to consider different types of arrangements when selling it.

Although a seller note or financing option may sound appealing because it’s straightforward, it could diminish the return on investment if the business performs well and also puts the buyer at greater risk, as they likely won’t be able to recover all their money.

On the other hand, an earn-out can provide more upside potential for the seller since it rewards them with additional compensation based on the future performance of the business.

Therefore, it is essential to carefully weigh all available options when selling a business in California and determine what will be most beneficial in terms of return, flexibility, and risk.

Market-based rewards may also be an attractive option for sellers, as they offer greater upside potential and more favorable terms.

Whatever the decision, it is essential to consider what will be most beneficial when selling a business in California. With the right choice, a seller can reap the benefits of a successful sale.

While there are several advantages to an earn-out, it’s essential to be aware of the potential disadvantages as well. Here are some key points about the disadvantages of an earn-out compared to seller financing.

Disadvantages of an Earn Out Compared to a Seller Note

If you’re a business owner in California and considering an earn-out as a method to sell your company, there are five key points you should be aware of first.

1. The buyer may not be able to pay the additional compensation, which can hurt the seller’s return on investment.

If, for instance, the company doesn’t generate enough income or profits to meet the earn-out conditions, then the seller won’t receive what they originally agreed upon.

2. The terms of an earn-out are often more complicated and more challenging to understand than those of a seller note.

For example, there may be more legal documents involved and a lengthy negotiation process to review each term.

• If the buyer and seller disagree on how to achieve the predetermined performance goals, an earn-out can create tension between them.
• If both parties cannot agree on what success looks like, the conflict will undoubtedly follow.
• An earn-out generally puts more risk on the seller, which may then translate to less favorable terms being negotiable or a lower level of return than what could have been achieved with a seller note.
• Many earnouts are based on future performance, which can create significant uncertainty for the seller. It’s tough to predict what will happen with the business in the future, so there’s no guarantee that the earn-out will be met.

3. Earnouts are typically time-sensitive and may have short deadlines that can be difficult to meet.

For instance, if the seller needs to wait three years before receiving payment, it can be challenging to manage finances during that period.

• An earn-out is often structured in a way that requires the seller to remain involved with the business for a specified period after the sale has been completed.
• This means that the seller may need to continue to provide services or support until the goals of the earn-out are achieved.
• Lastly, an earn-out may not be tax-efficient, as income taxes may be due on it, depending on the type of structure used. This could further reduce the seller’s return on investment. See tax planning for more insights.

4. The seller does not have control over what the buyer does with the business, which can be a risk for both parties.

Take this example:

• The seller may have agreed to an earn-out based on what they thought were achievable goals. However, if the buyer chooses not to make the necessary investments or changes necessary to reach those goals, it can hurt everyone involved.
• Lastly, an earn-out is usually more expensive than a seller’s note. This means that additional fees and legal costs may need to be considered as part of the decision-making process.

5. An earn-out is subordinate to other debt and equity, so it will be paid after these obligations are met, if any money remains from the sale proceeds.

Now, this risk example is just what it sounds like: a risk.

• If the buyer is unable to pay what they owe, then the seller’s return may be significantly reduced or nonexistent.
• In contrast, a seller note typically offers more advantages than an earn-out.

 

When selling a business in California with a seller note, buyers pay the seller, interest and principal payments on what they owe. Additionally, the seller’s note is senior to the equity, and most earnouts are contingent upon future performance.

If you’re the seller, then it’s crucial to weigh all your options before making a decision. In general, seller notes have more advantages than other methods of selling. With that in mind, carefully consider your financial goals before proceeding with any sale.

Remember that everything is a trade-off, and what makes sense depends on your personal and business goals–especially if you are selling your most valuable asset and retiring. With that in mind, please note the following “no guarantee” disclaimer.

No Guarantee For Future Returns

Imagine you own a business in California with no debt, and the buyer only offers an earn-out.

You agree to this offer, but it turns out that the buyer does not make the necessary investments in the business or make any changes needed to reach the predetermined performance goals. As a result, after three years, you may get nothing from the earn-out and have no way to recoup what you sold for.

This is a worst-case scenario, but it’s essential to consider what could happen if things don’t go as planned. In this case, a seller note may have been more desirable because it provides greater security, and the seller receives interest and principal payments.

Ultimately, it’s your decision what type of sale you want to pursue. Knowing what risks are associated with each option can help you make an informed decision and plan accordingly.

When selling a business, always weigh all your options before making a final decision.

Next, consider what goals you are trying to achieve and what financial rewards you want to receive. Good luck!

Key Considerations When Deciding Between an Earn-Out and a Seller Note.

As a business owner looking to exit business ownership in California, one of the most critical decisions to make is what type of sale to pursue.

An option that has gained popularity is the earn-out. This entails agreeing on performance goals beforehand and subsequently paying the seller based on how well they achieved those goals.

Additionally, with a seller’s note, the buyer receives interest and principal payments on what they owe.

While both options have their merits, it’s crucial to weigh all your options before making a final decision.

Before choosing between an earn-out and a seller note, let’s consider some key factors. After that, we will explore your third option of securing an SBA loan for potential buyers who are serious about purchasing your business as part of your exit plan.

If you have read till here, you deserve a free 30-minute consultation. Your choice!

Three key components to consider when deciding on your options.

One: Risk tolerance

When considering your risk tolerance, it’s essential to think through what could happen if the buyer does not perform as expected.

Under an earn-out, the seller will receive a portion of their original sale price depending on how well the buyer achieves specific goals.

If the buyer falls short of the predetermined goals, then the seller may not receive the earn-out.

When thinking about which option to choose, it is essential to take into account the predicted cash flow. If choosing a seller’s note, the seller will receive periodic interest and principal payments from the buyer.

The third option to consider is securing an SBA loan for potential buyers who are serious about purchasing your business as part of your exit plan. Under this scenario, the seller is not subject to a performance-based payment and can receive a lump sum at closing.

Ultimately, the type of sale that best fits your goals depends on the risks you are willing to accept and the cash flow you want to receive. Consider all your options before making a final decision.

Two: Expected return on investment

An earn-out can be an excellent option for sellers seeking a higher return on investment. However, it does come with the risk that the buyer may not reach their predetermined performance goals.

A seller note offers more security as it provides the seller with interest and principal payments, and is senior to the equity. Most earnouts are based on future performance, so there’s no guarantee of what will happen once you’ve sold the business.

Additionally, an SBA loan may be a good option to consider if you want to receive a lump sum payment at closing with less risk of not recouping what you sold for.

When you know your long-term goals, you can make more informed decisions about the sale and structure of the deal when it comes time to exit your business.

Let’s demonstrate a scenario for you below.

Three: Long-term goals

Let’s say you sold your business for $1 million and received a seller note of $800,000. After five years, the entire amount of what you are owed has been paid back with interest. Additionally, the buyer achieved their performance goals within the first two years, and you also received an earn-out of $200,000.

In this example, you received your full asking price of $1 million and achieved what you were hoping for in the sale. By exploring all options and weighing the risks associated with each one, you were able to make informed decisions that resulted in a successful sale.

Another option is to determine if the buyer can qualify for a loan and pay the seller a specified amount for the business at the time of escrow closing.

For example, the buyer agrees to purchase the business for $500,000, and the buyer will secure an SBA loan to facilitate the transaction.

An SBA lender will require the buyer to have a good credit score, a down payment of at least 10%, and the business to have a positive cash flow for the last 3 years.

If the buyer can qualify for an SBA loan, they pay a down payment of $50,000 and get a loan for $450,000.

Therefore, consider your risk tolerance and the desired cash flow before deciding on the type of sale that best suits your goals. Weigh all options, from an earn-out to a seller note or even an SBA loan, to make the most informed decision possible when selling your business.

Conclusion: What is best for you?

The decision to sell a business is not one to be taken lightly.

Several key factors must be considered when determining the strategy that best aligns with your goals.

1. A seller note may offer more stability and security,
2. while an earn-out can result in higher returns on investment.
3. Additionally, an SBA loan could also provide a lump sum payment with less risk.
4. Ultimately, the type of sale that best fits your goals depends on the risks you are willing to accept and the cash flow you want to receive. Consider all your options before making a final decision.

 

With careful consideration and exploration of all available options, you can make the most informed decision possible when selling your business. Good luck!

Resources: What is available to help you make a decision?

If you are still uncertain about what type of sale is best for you, there are many resources available to help guide your decision.

• Consulting a financial adviser or a business attorney can be an invaluable resource, providing insight into what will work best for you.
• Additionally, the U.S. Small Business Administration and other government organizations have numerous programs that assist small businesses, including resources on what to consider when selling a business.
• Lastly, researching other people’s experiences with different types of sales may be beneficial in getting a better understanding of what type of sale is right for you.

 

Whatever option you choose, it is crucial to make an informed decision when selling your business in California. With the right resources and an understanding of your options, you can make the best decision for you and what will ensure a successful sale.

The above information provides general guidance when selling a business. Please do not consider it as legal advice or financial advice.

Summary of Key Points: What have we learned?

1. Earn-out and seller notes are both viable options when selling a business, each with its own set of benefits and drawbacks.
2. The choice of which option to choose will depend on the seller’s goals and risk tolerance.
3. Resources are available to help you make an informed decision regarding what option is best for you.

Final Thoughts: valuing a business in California

Small business valuation multiples are used to guide an accurate valuation of your company.

While they’re not an exact science, they can give you a ballpark estimate of what your business might be worth.

Keep in mind that other factors can affect the value of your business. This includes its location, growth potential, what’s happening in the local economy, changes to tax laws, and, of course, profitability.

If you need help with determining your company’s worth, schedule a free consultation with Andrew Rogerson. He can help you determine the best way to value your company and maximize its value.

Additional resources for business valuations

• How To Increase Company Valuation? 4 Value Drivers You Need To Know
• What is Quality of Earnings Analysis: Sell a Business Due Diligence in California
• Adjusted Financial Statements When Selling a Business in California
• SDE Adjustments To Make Before Selling a Business in California
• How Do I Calculate The Value Of My Business To Sell In California
• What is My Business Worth? | Valuing and Selling Your Business
• How Much is a Business Worth to Sell? | Determine Business Worth
• Income Approach Valuation | Finding Business Worth Easily
• How To Value A Business Quickly: Best Business Valuation Formula
• Seller’s Discretionary Earnings (SDE) Valuation | Selling a Business in California
• Financial Due Diligence When Selling a Business
• MSP Valuation Multiples 
• EBITDA Multiples for Trucking Companies

Do you have any questions about valuing a company? Leave a comment below and we’ll be happy to help!

Conclusion

Using the best valuation formula to determine your biggest asset’s worth, as well as the decision to exit business ownership, is a significant life event.

When you collaborate with a business brokerage firm in California, it will provide all the solutions and insights necessary to get the most out of the business sale.

There are only a few ways to sell and value a business quickly in California. Use the services of a business broker like Andrew Rogerson, who can guide you through the best strategy not only due to his experience, but also his training and certifications.

It is currently the perfect storm to value and sell your business in California.

With a certified business intermediary by your side, we are confident that you will sell your business in California quickly and at the highest possible price.

Andrew Rogerson is a certified business broker based in Sacramento, California. Call Toll-Free at (844) 414-9700. If you prefer, email him at support@rogersonbusinessservices.com. Andrew serves the whole state of California.

Go to the following article: Part of the answer:  What’s my business worth series ->