Bridging the Valuation Gap in SBA and LMM Deals: The Case for Contingent Promissory Notes

One of the toughest parts of ETA is the gap between seller expectations and buyer reality. * Sellers often want a premium for “potential.” * Buyers want protection against downside risk. * SBA lenders only want to underwrite predictable cash flows. When those three forces collide, deals stall at LOI. One tool that doesn’t get enough airtime in our community: the contingent promissory note. Instead of paying every dollar up front, the buyer issues a note that gets forgiven (not paid) if the business doesn’t meet clear, objective performance metrics. It looks like debt on Day 1, but acts like an earnout. Done right, it aligns incentives and bridges the valuation gap without blowing up lender underwriting. How to structure it well: * Metric: Tie forgiveness to verifiable numbers (GAAP revenue, EBITDA, customer retention, supplier retention). * Mechanism: Define *exactly* how the metric will be measured (audited financials, contracts, retention reports). * Timeframe: 3–5 years, with annual checkpoints. * Payment Dates: Fixed and predictable (e.g. April 1 each year). Example: * $500K contingent note, payable in $100K annual tranches. * If revenue <80% of target → 100% forgiven for that tranche. * If revenue is 80–89% → 50% forgiven. * If revenue ≥90% → no forgiveness, payment required. This structure creates true risk-sharing: * Seller keeps skin in the game. * Buyer isn’t overpaying for promises that don’t materialize. * Lender gains comfort knowing payments are performance-based. Why it matters: Contingent notes are one of the cleanest ways to overcome: * Valuation gaps. * Sellers with unrealistic expectations. * Customer concentration. Get the drafting wrong and you’ll be litigating definitions for years. Get it right and you can save a deal that otherwise dies at LOI. Question for the group: Have you seen contingent notes used effectively in your own searches? What worked (or didn’t)? Disclaimer: Informational only — not legal, tax, or financial advice. Consult your own advisors before relying on this structure.