Earnouts and Seller Financing: Structuring Deferred Payments in a Business Sale

Buyers and sellers of small businesses often disagree about value, or the buyer cannot pay the full price in cash at closing. Two tools address these gaps: earnouts and seller financing. They are common in small business deals, and they are also a leading source of post-closing disputes when drafted loosely.

Seller financing

In seller financing, the seller accepts a promissory note from the buyer for part of the purchase price. The buyer pays the note over time with interest.

Typical terms:

Principal amount as a portion of the price, often a modest to significant share in small deals.
Interest rate, usually above the rate on safe investments to reflect credit risk, and above the applicable federal rate to avoid imputed interest issues.
Amortization schedule and maturity, commonly several years.
Security: a lien on the assets or a pledge of the ownership interests.
Personal guarantees from the buyer's owners.
Subordination to senior bank financing, which lenders often require.
Covenants: maintain insurance, deliver financial statements, and restrict distributions or debt.
Default and acceleration provisions.
Offset rights allowing the buyer to reduce payments for indemnity claims (often negotiated).

Why sellers agree: it can support a higher price, help close a deal when the buyer cannot secure enough financing, and spread taxable gain over years under the installment method.

Risks for sellers: the buyer may fail to pay. The seller remains exposed to the business's performance after leaving. Subordination to bank debt places the seller behind the bank in a default.

Risks for buyers: the payment burden strains cash flow, and personal guarantees create exposure.

Earnouts

An earnout is a contingent payment based on the business's performance after closing, such as revenue, gross profit, EBITDA, customer retention, or a specific milestone. The purchase price includes a fixed component paid at closing and an additional amount payable if targets are met.

Typical terms:

Metric: revenue is easier to measure and harder for buyers to manipulate but ignores profit. Profit measures are more relevant but subject to accounting choices and cost allocation.
Measurement period: commonly one to three years.
Thresholds and caps: minimum performance needed and a maximum payout.
Definitions: how revenue and expenses are calculated, and which accounting principles apply.
Operating covenants: buyer's obligations to operate the business in good faith and not take actions designed to reduce the earnout.
Information rights: the seller's right to receive financials and audit calculations.
Acceleration: payment triggers if the buyer sells the business or breaches covenants.
Dispute resolution: an independent accountant to resolve calculation disputes.

Why they are used: they bridge valuation gaps when the seller believes in future growth and the buyer wants to pay for results actually achieved.

Risks: disagreements about how the buyer runs the business, cost allocations, and integration effects. Sellers who leave the business lose control over the outcome. Buyers may face claims of bad-faith operation.

Tax treatment: seller side

Installment method: a seller who receives at least one payment after the year of sale may report gain as payments are received, unless they elect out. This applies to notes and contingent payments, though depreciation recapture is recognized in the year of sale. See selling a business: tax basics.
Interest: a stated interest portion is ordinary income to the seller. If the note does not provide adequate stated interest, part of the payments may be recharacterized as interest under imputed interest rules.
Contingent payments: the seller reports gain as payments are received, and for earnouts, portions may be treated as interest if paid more than a year after closing.
Compensation risk: if earnout payments depend on the seller's continued employment, they may be treated as compensation, which is ordinary income and subject to payroll tax. Structure and documentation matter.
Loss on default: if the buyer defaults, the seller may have bad debt treatment, which can be limited.
Interest on deferred tax: large installment obligations can trigger an interest charge on the deferred tax in some cases.

Tax treatment: buyer side

Basis: in an asset purchase, the buyer's basis includes the note and, when the amount becomes fixed, the earnout payments. Contingent purchase price adds to basis when determined. See purchase price allocation.
Interest deduction: stated interest on the note is generally deductible, subject to limitations.
Compensation: if the earnout is compensation, the buyer deducts it as wages, subject to reasonableness and withholding.

Drafting checklist

Define the metric precisely, including accounting policies and permitted adjustments.
Set operating covenants and clarify buyer's discretion.
Address integration: what happens when the buyer merges the business with another operation.
Provide information and audit rights.
Specify payment timing and interest on late payments.
Handle setoff rights for indemnity claims.
Consider security: liens, guarantees, or escrow accounts.
Address change of control and sale of the business.
Include dispute resolution with an independent accountant.
Coordinate with employment and consulting agreements to avoid mixing compensation and purchase price without intention.
Confirm tax treatment with advisers before signing.

Alternatives

Escrow or holdback: a portion of the price held back for indemnity claims rather than performance.
Rollover equity: the seller retains a stake in the business, participating in future value.
Consulting agreements: to compensate the seller for transition help.
Price adjustment for working capital, rather than earnout.

Common mistakes

Vague earnout definitions.
Assuming the buyer will run the business the same way.
Underestimating credit risk of a seller note.
Subordinating without protections.
Ignoring imputed interest rules.
Not addressing what happens if the buyer sells.
Mixing compensation and purchase price by accident.
Not planning for the seller's tax on payments received in the year of sale, such as recapture.
Using verbal agreements for critical terms.
Not considering security and guarantees.

For help modeling the tax effect of deferred payments in a sale, AE Tax Advisors can assist, and a discovery call is a good first step. Legal drafting belongs with an attorney.