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; with an SBA loan only the note is available, because SBA prohibits earnouts to the seller. A seller note is fixed debt: the buyer owes it whatever happens, and a lender counts its payments in debt service. 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 cap and subordinate both.
- 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 payments in debt service from day one; earnout usually once earned
- With an SBA loan
- Seller note allowed; earnout to the seller prohibited
- 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 |
| Toward SBA equity injection | Up to half of it, only on full standby for the life of the loan | Not allowed at all with SBA financing |
| 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, for non-SBA deals, 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 historical earnings available for debt service, after a market salary for the buyer, are 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 earnings of 1,250: coverage of 1.0x, well short of what conventional bank lenders look for and below the 1.15x SBA minimum. The senior lender will either shrink its loan, push the note onto standby, 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.
With an SBA loan, the question is already answered
SBA prohibits an earnout to the seller in a change of ownership it finances. A buyer using a 7(a) acquisition loan bridges a price gap with more equity, a seller note, or a lower price. A note whose amount rises or falls with future results works like an earnout, and a buyer should expect an SBA lender to look at it that way.
- Equity injection. SBA requires at least 10% of total project costs for a complete change of ownership. A seller note can supply up to half of that only if it is on full standby, with no principal or interest paid, for the life of the SBA loan. Interest may accrue and be paid after the SBA loan is repaid. See seller notes and SBA's full-standby rule.
- A note that pays is debt. A seller note that is not on standby is allowed, but it counts in debt service, not toward the injection. SBA requires coverage of at least 1.15x, and from 1 October 2026 (SOP 50 10 8.1) a change of ownership must show 1.25x on historical results, so a paying note has to fit inside that.
- The valuation caps the loan. Where the amount financed, less appraised real estate and equipment, exceeds $250,000, or buyer and seller are related, SBA requires an independent business valuation, and the loan for the purchase cannot exceed it. A price above the valuation is a gap the buyer or seller has to fill. See the SBA valuation requirement.
- The seller steps away. In a complete change of ownership the seller may not stay on as an owner, officer or employee, and may consult for up to 12 months (up to 24 months under SOP 50 10 8.1 from 1 October 2026). Sellers who want an earnout usually want a hand in running the business that has to hit it, which an SBA deal does not allow. See whether the seller can stay on.
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 sit on standby. 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.
Transparent's financing model runs the deal with and without each earnout payment, so a lender can see coverage in the year the 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. The book's 1,148 term and private credit lenders 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
- Can I use an earnout if I am buying with an SBA loan?
- No. SBA prohibits an earnout to the seller in a change of ownership it finances. The gap has to be closed with more buyer equity, a seller note or a lower price. A seller note counts toward up to half of the required equity injection only if it is on full standby for the life of the SBA loan.
- 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 conventional lenders are used to that. A note whose amount rises or falls with future earnings is really an earnout, and on an SBA deal a buyer should expect the lender to treat it as one.