Use a seller note when the gap is about cash at closing, and an earnout when it is about what the business will earn next. A seller note is fixed debt: the buyer owes it whatever happens, and senior lenders count its payments in coverage and its balance in leverage. An earnout is paid only if agreed targets are hit after closing, so it comes out of results that have already arrived and protects coverage better. Senior lenders subordinate both, block payments when covenants are tight, and often cap the amounts.
- Seller note
- Fixed debt; owed whether or not the business performs
- Earnout
- Contingent price; paid only if agreed targets are met
- How the lender counts it
- Note: in coverage and leverage from day one. Earnout: usually once earned
- Senior lender's terms
- Both subordinated; payments allowed only while covenants hold
- Best fit
- Note for a cash gap; earnout for a dispute about the future
Two different promises to the seller
A seller note is the seller lending the buyer part of the purchase price. It has a principal amount, an interest rate, a term and a payment schedule, and the buyer owes it on the same terms in a good year or a bad one. See seller financing vs bank financing for how a note compares with borrowing the whole price.
An earnout is additional purchase price that depends on what the business does after closing: revenue, gross profit or EBITDA over one or more periods, measured against targets written into the purchase agreement. If the targets are hit, the seller is paid. If they are missed, the seller may receive part or nothing.
The real difference is who carries the risk that the future disappoints. With a seller note, the buyer does, and so does the buyer's lender, because note payments compete with the senior loan for the same cash. With an earnout, the seller does: the extra price exists only if the extra earnings do.
Side by side
| Seller note | Earnout | |
|---|---|---|
| What the seller is owed | A fixed amount with interest | A variable amount, possibly zero |
| If the business underperforms | Still owed in full | Reduced or not paid |
| In the lender's coverage test at closing | Yes, its scheduled payments count | Usually not, because nothing is owed yet |
| Once earned | Not applicable | Often counted as debt until paid |
| In the leverage covenant | Counted as debt, unless the credit agreement excludes subordinated seller paper | Usually excluded until earned, then counted until paid |
| Senior lender's usual terms | Subordinated; payments blocked on default or covenant breach | Subordinated; payments permitted only if covenants hold after paying |
| Main source of disputes | Default and payment blockage | How the targets are measured |
How a senior lender reads each one
The seller note. The senior lender will require a subordination agreement that puts the note behind its loan in payment and in any claim on collateral. It will decide whether note payments can be made at all and on what conditions, commonly only while there is no default and the covenants are met. And it will count the scheduled note payments in its debt service coverage test, because the buyer is obliged to make them. A note with large payments in the early years takes cash flow the senior lender wanted for itself, and the senior loan gets smaller to compensate. The terms senior lenders commonly accept are set out in seller-note subordination terms and seller note terms in conventional deals.
The earnout. At closing, nothing is owed, so a lender generally sizes its loan on the base price and the historical earnings, and the earnout does not appear in the coverage test. Credit agreements commonly treat earnout payments like restricted payments: allowed only if there is no default and the covenants still hold after the payment is made. Many count an earned but unpaid earnout as debt in the leverage covenant. Some lenders cap the total earnout or ask that part of it be funded with new equity rather than from the business's cash. More on the mechanics in how earnouts interact with acquisition debt.
Lenders cap and subordinate both. The difference is that a seller note is a claim on the cash flow the loan was sized on, and an earnout is a claim on cash flow that did not exist when the loan was made.
The same gap, bridged two ways
Take a business whose cash flow available for debt service is 1,250 a year. The seller wants a price the buyer thinks is 1,500 too high; the seller's case rests on a large new customer contract that has been signed but has not yet produced a full year of revenue. The senior loan the buyer can raise on the historical earnings carries payments of 1,000 a year: coverage of exactly 1.25x, the level conventional bank lenders commonly look for.
Bridge it with a seller note. The buyer adds a 1,500 note paid over several years at about 250 a year. Total debt service is now 1,250 against cash flow of 1,250: coverage of 1.0, well short of what conventional bank lenders look for, and total leverage rises by the full 1,500 on the day of closing. The senior lender will shrink its loan, ask for the note to pay interest only or accrue until the senior loan is further paid down, or decline.
Bridge it with an earnout. The buyer agrees to pay up to 1,500 more over three years, as a share of earnings above 1,250. If the contract delivers and earnings rise to 1,650, the earnout payment comes out of the extra 400, and coverage on the senior loan never falls below where it started. If the contract disappoints, nothing is paid and coverage stays at 1.25x.
That is why an earnout generally protects the buyer's coverage ratios better when the argument is about future performance. The buyer still pays it out of the business, but the payments track the ability to make them.
What the senior lender will ask for
Whichever tool bridges the gap, the senior lender writes the rules for it into the credit agreement and a subordination or intercreditor agreement, and the seller signs up to them. For companies with $10M to $100M+ in revenue the terms commonly look like this:
- Seller note: payment conditions. Interest, and sometimes scheduled principal, may be paid only while there is no default and the covenants are met, often tested pro forma for the payment. Some lenders allow cash interest only, with principal due after the senior loan matures.
- Seller note: maturity. Commonly set after the senior loan's maturity, so the note cannot demand repayment while the senior loan is outstanding.
- Seller note: standstill. If the buyer defaults, the seller may not sue or enforce for a period, and any payment received in breach is turned over to the senior lender.
- Earnout: payment tests. Payments treated like restricted payments: allowed only if there is no default and leverage or coverage holds after the payment. Some lenders require part of a large earnout to be funded with new equity.
- Earnout: in the leverage covenant. Often excluded until earned, then counted as debt until paid. Check whether an earned but blocked payment counts, because it can push leverage over a limit in the same quarter it is blocked.
- Both: caps. Many lenders cap the total seller paper and contingent consideration against the purchase price or against EBITDA.
Where the buyer uses a unitranche or a senior loan with a mezzanine layer behind it, the seller note sits behind both, and the seller should expect its payments to be the first blocked when results slip. That is the price of being paid over time rather than at closing.
Which one fits your gap
A seller note fits when the gap is about cash at closing. The buyer and seller agree on value; the buyer simply cannot fund all of it with equity and senior debt. The earnings already support the payments, or the note can pay interest only or accrue while the senior loan pays down. The seller wants a fixed claim and is willing to be subordinated for it. See how much seller financing is typical.
An earnout fits when the gap is about the future. A contract that has been signed but not yet billed, a recovery from a bad year, a new location still ramping, a product line the seller believes in and the buyer cannot yet underwrite. The measure should be something both sides can read from the books without argument, over a period short enough that the business is still recognizably the one that was bought.
Many deals use both. A modest seller note, sized to what the historical earnings carry, plus an earnout for the part of the price that depends on what comes next. Where the seller wants to share in the upside indefinitely, rollover equity is the third option, and when the gap is too large for the seller to carry, mezzanine debt is the fourth.
Where earnouts go wrong, and how to write one a lender will accept
Earnouts fail on definitions far more often than on performance. The seller measures EBITDA the way the business always did; the buyer adds management fees, integration costs or a new accounting policy; the target is missed by the width of the argument. Write the measure precisely, tie it to the same accounting as the historical statements, and state what the buyer may and may not change. Revenue and gross profit are harder to dispute than EBITDA.
The second failure is funding. The purchase agreement says the earnout is due; the credit agreement says it may not be paid because a covenant is tight. The buyer is now in breach with one party or the other. Settle this before closing: the subordination terms should say what happens to a blocked earnout payment, usually that it is deferred with interest and paid once the conditions are met, and the seller should see those terms before signing.
Midas Partners's financing model runs the deal with and without each earnout payment and each note payment, so a lender can see coverage and leverage in the year a payment falls due, not only at closing. Once a borrower's documents are in, the full package, with that model, a lender presentation, a blind teaser and an underwriting memo, is built in a day, and a senior banker checks every page. Of the 1,800+ lenders in the book, 1,148 write term and private credit, and they differ widely on earnouts: some will not finance a deal with one, and others will if the payments are capped and conditioned. See how we underwrite.
Common questions
- How much seller financing will a senior lender accept?
- It depends on the lender and the deal. What decides it is whether the combined debt service still clears the lender's coverage test and whether total leverage stays within its limit. A note that pays interest only, or accrues, is easier to fit than one with scheduled principal. See how much seller financing is typical.
- Does the lender count an earnout as debt?
- Usually not at closing, because nothing is owed yet, so it does not enter the coverage test the loan is sized on. Once it is earned and the amount is fixed, many credit agreements count it as debt until it is paid, and the payment itself is typically allowed only if the covenants still hold afterward.
- What happens if the senior lender blocks an earnout payment?
- That depends on what was negotiated. Well-drafted deals say the blocked payment is deferred, usually with interest, and paid once the lender's conditions are met again. Deals that leave it unsaid put the buyer between two contracts that conflict, which is why the subordination terms should be settled before closing.
- Can a seller note be reduced if the business underperforms?
- The purchase agreement can let the buyer offset indemnity claims against a note, and lenders are used to that. A note whose amount rises or falls with future earnings is really an earnout, and lenders will treat it as one in their covenants.