How Should Earnouts and Seller Financing Be Documented?

When a business is sold, the headline purchase price doesn’t always tell you how much the seller will receive at closing. Assume a buyer and seller agree on $10 million. The buyer pays $7 million in cash at closing, the seller takes back a $1 million promissory note, and the other $2 million can be earned over two years if the business reaches certain financial targets. Seven million dollars is in the seller’s account at closing, $1 million is owed later, and $2 million may never become payable at all.

My short answer to the earnout vs. seller financing question is that they should be documented as two different parts of the deal, because they create different risks. A seller note is money the buyer already owes. An earnout is money the seller may earn later. I don’t treat either as a detail to work out after the parties agree on price. It is part of the price.

How is an earnout different from seller financing?

Both involve payments after closing, so they’re often discussed together, but they aren’t the same thing. With seller financing, the buyer generally owes the money. The note may carry interest, monthly payments, a maturity date and perhaps a balloon, but the seller’s main concern is simple: can the buyer actually pay? With an earnout, the buyer may owe additional purchase price only if something happens after closing. Maybe the business reaches a revenue or EBITDA target, a major customer stays, or a project is completed. If the condition isn’t met, the buyer may owe nothing.

So with a seller note, we’re mainly dealing with credit risk: can the buyer pay, what happens if it doesn’t, and what collateral or guarantee supports the obligation? With an earnout, we’re dealing with performance risk: what has to happen before the seller gets paid, how is it measured, and who controls the decisions that affect the result? Different questions need different protections.

The two tools also solve different problems. Seller financing often fills a funding gap: the buyer has cash and bank financing for most of the price but not all of it. From the seller’s side, I think it’s important to call that what it is. The seller is extending credit, and the promise to be paid later is only as good as the person or company making it.

Earnouts usually bridge a valuation gap. Assume a company has historically generated $1 million of EBITDA. The seller recently added several large customers and believes EBITDA will soon reach $1.5 million. The buyer may believe the growth is possible but not want to pay for it today, so it pays a lower fixed amount at closing and more if the growth actually happens. That can be a reasonable compromise, but it doesn’t make the disagreement about value disappear. It changes the question from what the business is worth to whether the seller actually earned the additional price. If the documents are vague, the parties may simply be moving the fight from before closing to after closing.

What has to happen for an earnout to be paid?

When I look at an earnout, my first question is: what exactly has to happen for the seller to get paid? The answer may be revenue, gross profit, EBITDA, customer retention, a major contract, a new location, regulatory approval or another measurable milestone. The metric should match the issue the parties are trying to solve.

Revenue is usually easier to understand, and it’s less affected by many expense decisions the buyer makes after closing. Even so, it raises questions. What if the buyer moves a customer to an affiliate, or combines the acquired company with another business? How are refunds, credits and discounts handled? Revenue may be simpler, but it isn’t always simple.

EBITDA can give a better picture of profitability, but it creates more room for disagreement. After closing, the buyer may hire, change compensation, add management, increase advertising, change corporate overhead or accounting systems, or spend money on integration. Those may all be reasonable decisions, and they can all reduce EBITDA. That’s why I generally don’t like an earnout provision that says EBITDA will be calculated under GAAP and stops there. If another million dollars of purchase price depends on EBITDA, the agreement needs to say how that number will be built.

The parties also need to decide whether the earnout is all or nothing. Assume the seller receives $1 million if EBITDA reaches $2 million. If EBITDA reaches $1.99 million, does the seller get zero? Maybe. Or a graduated formula can increase the payment as performance improves. Neither structure is automatically right, but both sides should understand the answer before closing. Where the formula is complicated, I like putting an example directly into the agreement. If everyone can see how the earnout works at three or four performance levels, there’s less room for surprise later.

Who controls the business during the earnout, and how is the result checked?

After closing, the buyer owns the business, but the seller may still have a large amount of money tied to how it performs. Suppose the seller can earn another $2 million if the business hits an EBITDA target. The buyer adds management, increases marketing, hires more employees and starts charging the acquired company for corporate-office services. Those decisions may be completely reasonable, even good for long-term value, but they can lower EBITDA during the earnout period. The seller says the buyer’s decisions caused the miss; the buyer says it has to be able to run the company it bought. Both sides have a point.

I don’t think the answer is usually to make the buyer run the business exactly as the seller did. The buyer needs room for legitimate business decisions. But I also don’t like an agreement that lets the buyer do whatever it wants while the seller lives with the result. I prefer to address the decisions that can materially distort the earnout: how corporate overhead is treated, whether customers can move to an affiliate, what happens if the company is combined with another business or its accounting method changes, and what happens if the buyer sells the company before the period ends. Telling everyone to act reasonably isn’t enough, because two reasonable people can disagree about what is reasonable.

The seller also needs a way to check the result. If the buyer reports after 12 months that it missed the target, the seller may no longer have access to the accounting system or payroll records, or know which expenses were added. At a minimum, I want the agreement to say when the buyer prepares the calculation, what financial information comes with it, how long the seller has to review it, whether the seller can request supporting records, how the seller objects, and what happens if the parties can’t agree.

For a true accounting dispute, such as whether an expense belongs in adjusted EBITDA, an independent accountant may be well suited to decide. But if the seller says the buyer moved a major customer to an affiliate to avoid the earnout, that isn’t just math; it may turn on the buyer’s operating covenants and whether it complied with them. The agreement should distinguish a calculation dispute from a legal dispute.

How should a seller note be structured and protected?

A seller note may sound simple, but the details matter. First, the principal amount. Then the interest rate: when does interest start, is it paid monthly, or does it accrue? Then the repayment schedule: principal and interest every month, interest only, quarterly payments, or a balloon at maturity?

The balloon question is especially important. Suppose the buyer gives the seller a $1 million note with a three-year maturity and still owes most of the principal at the end. Where is that money coming from? Maybe a refinancing, cash from the business, or the sale of another asset. Those may all be possible, but they aren’t guaranteed. The note also needs default provisions. What happens if a payment is missed? Is there a cure period? What if the buyer becomes insolvent, the business is sold, or control changes? Those aren’t boilerplate questions; they determine when the seller can actually enforce the obligation.

Next is who actually owes the money. A buyer may form a new LLC just to acquire the business, and on closing day it may have very little history and few assets beyond the company it just bought. The seller should look beyond the signature on the note. A guarantee from an individual owner or a parent company can help, but it’s only as valuable as whoever stands behind it. The seller may also seek collateral: equipment, inventory, accounts receivable, other business assets or, in some deals, an equity pledge.

Saying a note is secured isn’t enough. We need to know whether the security interest was properly documented and perfected, and who has priority. Under Article 9 of the Uniform Commercial Code, perfection generally requires filing a financing statement, and in Texas the Secretary of State is the central filing office for those filings. Among competing perfected security interests in the same collateral, priority generally follows the order of filing or perfection.

Set-off deserves the same attention. The buyer may want to reduce note payments if it has an indemnification claim against the seller. From the buyer’s side, that’s practical: why pay the seller while claiming the seller owes money back? From the seller’s side, a fixed payment obligation can suddenly become tied to a separate dispute. Set-off isn’t always wrong, but the parties should know exactly which claims can be set off, when, how, and within what limits.

What changes when a bank or SBA lender is involved?

A senior lender putting money into the acquisition will usually want priority. The seller’s debt may be subordinated and its collateral junior to the bank’s. Payments on the seller note may be restricted, and a default under the senior loan may prevent the buyer from paying the seller. The bank may also require the note to remain outstanding longer than the buyer and seller expected.

That last issue isn’t a small drafting change. If the seller expected repayment in two years and the lender requires the debt to stay in place much longer, the seller is being asked to extend credit for a much longer period, and the economics change. I’ve seen deals where the commercial terms assumed the seller would be refinanced out at a certain point, but the senior lender wanted the seller debt in place much longer. The buyer may need that financing, and the seller may not want to become a long-term lender. Balloons raise the same issue: if the senior lender won’t permit a year-two or year-three balloon, the deal doesn’t work the way the parties negotiated it.

SBA-backed acquisitions add another layer. The SBA’s SOP 50 10 sets its own requirements for seller debt in change-of-ownership loans and can restrict how seller notes and earnouts are structured. That’s why I prefer getting the lender involved early. Seller financing shouldn’t be negotiated in a vacuum and sent to the bank at the end; the purchase agreement, seller note, guarantee, security documents and senior loan all need to fit together.

Three questions to ask before agreeing to an earnout or seller note

Seller financing can bridge a financing gap and an earnout can bridge a valuation gap, so I don’t think buyers and sellers should avoid either. But a seller note creates repayment risk, an earnout creates performance risk, and those risks can last for years. Whichever side of the earnout vs. seller financing decision you land on, ask three questions.

1. 01

   What has to happen before I get paid?

   If that answer isn’t clear, the documents aren’t ready.

2. 02

   What could prevent the payment?

   Financial trouble, a lender block, a failed refinancing, a missed target, or post-closing changes to the calculation.

3. 03

   What protection do I have if something changes?

   A guarantee, collateral, acceleration on a sale, defined overhead treatment, financial reports or a clear dispute process.

Settle the payment structure early, ideally in the LOI (see What Should an LOI Resolve Before Diligence Begins?), along with the deal structure itself (see Asset or Equity Purchase: What Changes?). The goal isn’t to eliminate every risk. It’s to make sure the parties understand the risk they’re taking, decide who should bear it, and put that into the documents before a problem arises, because if part of the price is still outstanding, the financial relationship isn’t over at closing.

If you’re weighing an earnout or seller note in a Texas business sale, Escamilla Law Office’s mergers and acquisitions practice can work through these terms with you and your advisors. The Transaction Readiness Check is a useful place to start.

Frequently Asked Questions

More answers are on our M&A FAQs page.

Sources

1. Cornell Law School, Legal Information Institute. U.C.C. Sec. 9-310, When filing required to perfect security interest or agricultural lien.
2. Cornell Law School, Legal Information Institute. U.C.C. Sec. 9-322, Priorities among conflicting security interests in and agricultural liens on same collateral.
3. Texas Secretary of State. About the Uniform Commercial Code.
4. U.S. Small Business Administration. SOP 50 10: Lender and Development Company Loan Programs (Version 8.1 with Technical Policy Updates, effective October 1, 2026).
5. Internal Revenue Service. Publication 537 (2025), Installment Sales.

Attorney advertising. This article is for general informational purposes only and is not legal advice. Reading it does not create an attorney-client relationship. Escamilla Law Office, 7550 I-10, Ste 800-863, San Antonio, TX 78229. (210) 997-0025.