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 earnout or a seller note.
An earnout is when the buyer makes a payment to the seller based on the future performance of the business while 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, and it is important to understand what each option entails before making a decision.
Let’s take a look at what an earnout and seller note is, what the advantages are of each option, and which one may be best for your situation when selling a business.
This guide provides you with a framework with a deep understanding of:
- What benefits and drawbacks do each option have,
- what considerations should be taken 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 decide what options are best for them when considering selling their business.
Let’s dive in…
Overview of the Pros and Cons of Selling a Business Note in Comparison to an Earnout
The main advantage of an earnout is that it provides the seller with a potential upside if the business does well after being sold.
This could result in additional income for the seller, as they will receive payments based on the performance of the company.
Additionally, an earnout can also help to reduce the risk for the buyer by allowing a buyer to purchase the business for less money upfront and then invest in improvements over time.
The main disadvantage of an earnout is that it introduces a certain amount of uncertainty into the deal. The buyer may not perform as expected or the market conditions may change, which could lead to the seller receiving less than what they were expecting.
On the other hand, a seller note or financing can provide the seller with a more certain return on their investment.
The buyer will be required to make regular payments to the seller in exchange for taking ownership of the business.
This provides the seller with security that they will receive what they were expecting from the sale and it is also senior to any equity stake the seller may have in the business.
In terms of what option is best, it depends on what the seller is looking for.
An earnout can provide potential upside and less risk to the buyer, but 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.
At the end of the day, what is best for the seller will depend on what they value more – potential upside or security.
Before deciding between an earnout and a seller note when selling a business, it is important to consider what risks and rewards are associated with each option.
Furthermore, it is crucial to comprehend what resources are at your disposal to enable you to decide 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 earnout and seller note, and what considerations should be taken when choosing between the two to guide making an informed decision.
Benefits of a Seller Note over an Earn Out
When selling a business, one of the biggest advantages of a seller financing or note is that it’s senior to the equity position. This means that in the event of default, the buyer will be required to make payments to the seller first before any other investors or creditors.
Additionally, by taking on a seller note instead of an earnout, the seller can also receive both interest and principal payments from the buyer.
This provides the seller with more certainty to receive what they are expecting, as opposed to an earnout which is reliant 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 earnout, the seller can receive both interest and principal payments from the buyer.
3. Certain Return: This provides the seller with more certainty to receive what they are expecting, as opposed to an earnout which is reliant on the future performance of the business.
Seller Note or Financing Example
A sellers note works as follows with an example we’re making up:
- The buyer agrees to buy the business for $1 million and the seller also agrees to sell the business.
- Buyer and seller agree that the buyer will provide a downpayment of 50% or $500,000 to the seller at the close of escrow and then repay the seller the remaining $500,000 over 5 years at $100,000 per year plus interest.
- 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 main disadvantage of a seller note compared to an earnout is that it limits the upside potential for the seller.
Since payments are made regardless of how the business performs, this reduces the overall return that could be earned if the business performs well.
This can also be seen as a risk to the buyer, since they may not be able to recoup their full investment if the business does not perform as expected.
Additionally, seller notes typically have more stringent terms which may include higher interest rates and longer repayment periods than what would typically be associated with an earnout.
Let’s have a closer look at the limited upside potential for the seller and what it means to you as a seller of a business 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 earnout means that you may not be able to 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 rules- for example, 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 best 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 earnout may be more desirable for the seller than a seller note because it provides more upside potential and more flexibility in what they are expecting to receive from the sale.
A seller note may be attractive due to its simplicity, but it does limit the return that could be earned if the business performs well and also poses a greater risk to the buyer since they may not be able to recoup their full investment.
Therefore, it is important 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 earnout provides more upside potential for the seller since it rewards them with additional compensation based on the future performance of the business.
The advantage of an earnout is that it gives the seller more flexibility in what they are expecting to receive from the sale.
Because of this, an earnout is usually more desirable for the seller than seller financing.
Overall, an earnout can provide a seller with greater upside potential and better terms than what could be achieved with a seller note.
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 think about what will be 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 provide a greater incentive for the seller considering that they are based on what the business can achieve in the future.
Overall, market-based rewards are often more attractive for sellers than what can be obtained through a seller note or financing option since they provide greater upside potential and better terms.
Potentially Higher Returns for Sellers if a Company Performs well
An earnout is usually based on future business performance, so the seller could get greater profits if the company does well.
For example, if an earnout 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 a great incentive for sellers and give them greater flexibility in what they are expected to receive from the sale are explained below.
Earnout Deal/Term Structure Explained
An earnout works as follows with an example we’re making up:
- The buyer agrees to buy the business for $600,000 and the seller also agrees.
- Buyer and seller agree that the buyer will also pay the seller an agreed amount if the business achieves annual gross revenue sales targets.
- 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.
- The buyer also agrees to do this for 5 years so the seller is confident the buyer will achieve a gross revenue of $250,000 or more per year for five years.
- The seller is comfortable with the buyer and their ability to achieve a gross revenue of $250,000 or more per year and therefore earn $125,000 per year for 5 years or an additional $650,000 in addition to the $600,000 purchase price.
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 does well and also puts the buyer at greater risk since they likely won’t be able to get all their money back.
On the other hand, an earnout 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 important to carefully weigh all options available when selling a business in California and what will be most beneficial in terms of return, flexibility, and risk.
Market-based rewards may also be an attractive option for sellers since they provide greater upside potential and better terms.
Whatever the decision, it is important to consider what will be most beneficial when selling a business in California. With the right choice, a seller can benefit from a successful sale.
While there are several advantages to an earnout, it’s important to be aware of the potential disadvantages as well. Here are some key points about the disadvantages of an earnout 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 earnout 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 make enough income or profits to match the earnout conditions, then the seller won’t end up getting what they originally agreed upon.
2. The terms of an earnout are often more complicated and harder to understand than those of a seller note.
For example, there may be more legal documents involved and a long negotiation process to go over each of the terms.
- If the buyer and seller disagree about how to reach the pre-determined performance goals, an earnout can create tension between them.
- If both parties cannot agree on what success looks like, conflict will undoubtedly follow.
- An earnout 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 a lot of 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 earnout will be met.
3. Earnouts are typically time-sensitive and may have short deadlines that can be difficult to meet.
If, for instance, the seller needs to wait for three years before receiving payment, it can be difficult to manage finances during that period.
- An earnout is often structured in a way that requires the seller to stay involved with the business for some time after selling it.
- This means that the seller may need to continue to provide services or support until the goals of the earnout are achieved.
- Lastly, an earnout may not be tax-efficient since income taxes may have to be paid on it depending on what kind of structure is used. This could reduce the seller’s return even further. 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 earnout based on what they thought were achievable goals,
- but if the buyer chooses not to make the necessary investments or changes needed to reach those goals, it can hurt everyone involved.
- Lastly, an earnout is usually more expensive than a seller note. This means that additional fees and legal costs may need to be taken into account when making a decision.
5. An earnout is subordinate to other debt and equity, so it will be paid after those obligations are met if there is any money left 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 non-existent.
- In contrast, a seller note typically offers more advantages than an earnout.
When selling a business in California with a seller note, buyers receive interest and principal payments on what they owe, the seller note is senior to the equity, and most earnouts are tied to future performance.
If you’re the seller, then it’s important 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 what financial goals you want to achieve 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 keep the following “no guarantee” disclaimer in mind.
No Guarantee For Future Returns
Imagine you own a business in California with no debt and the buyer only offers an earnout.
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 pre-determined performance goals. As a result, after three years, you may get nothing from the earnout and have no way to recoup what you sold for.
This is a worst-case scenario, but it’s important 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 important decisions that must be made is what type of sale to pursue.
An option that has become popular is an earnout. 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 important to weigh all your options before making a final decision.
Before choosing between an earnout 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 minutes consultation. Your choice!
Here are three key components to consider when deciding on your options:
One: Risk tolerance
When considering what risk tolerance you are willing to accept, it’s important to think through what could happen if the buyer does not perform as expected.
Under an earnout, 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 pre-determined goals, then the seller may not receive the earnout and be unable to recoup what they sold for.
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, what type of sale best fits your goals depends on what risks you are willing to accept and what cash flow you want to receive. Consider all your options before making a final decision.
Two: Expected return on investment
An earnout can be a great option for sellers looking to get a higher return on investment, but 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. In addition to that, the buyer achieved their performance goals within the first two years and you also received an earnout 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 see if the buyer can qualify for a loan and pay the seller an agreed amount for the business at the close of escrow.
For example, the buyer agrees to buy the business for $500,000 and the buyer will get an SBA loan to buy the business.
An SBA lender will require the buyer to have a good credit score, a downpayment of at least 10% – maybe more – 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 so the seller is paid the $500,000 at the close of escrow and that completes the transaction.
Therefore, consider what risk tolerance you are willing to accept and what cash flow you want to receive before deciding what type of sale best fits your goals. Weigh all options, from an earnout 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.
Many important factors must be considered when deciding what strategy best fits your goals.
- A seller note may offer more stability and security,
- while an earnout can result in higher returns on investment.
- Additionally, an SBA loan could also provide a lump sum payment with less risk.
- Ultimately, what type of sale best fits your goals depends on what risks you are willing to accept and what 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 decide?
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 and provide 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 important 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 information provided here is intended to be used as general guidance when selling a business. It should not be seen as legal advice or financial advice.
Summary of Key Points: what have we learned?
- Earnout and seller notes are both viable options when selling a business, each with its own set of benefits and drawbacks.
- Which option to choose will depend on the seller’s goals and risk tolerance.
- 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 appraisal 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.
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Do you have any questions about how to value a company? Leave a comment below and we’ll be happy to help!
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. There could be plenty of emotions involved.
When you collaborate with a business brokerage firm in California, it will provide all the solutions and insights toward getting the most out of the business sale.
There are only a few ways to sell and value a business quickly in California, and an experienced business broker like Andrew Rogerson can guide you through the best strategy.
It is currently the perfect storm to value and sell your business in California. With the great resignation, quiet quitting, and layoffs that started during the pandemic and the trend to continue till 2023, there are no shortages of experienced and well-financed buyers looking for the next opportunity to grab.
Andrew Rogerson is a certified business broker based in Sacramento, California. Call Toll-Free at (844) 414-9700. If you prefer, email him at email@example.com. Andrew services the whole state of California.