Is the Seller Note/Earn out an absolute requirement?

September 01, 2021

by a searcher from Texas Christian University - Neeley School of Business in Fort Worth, TX, USA

I am looking at a deal that I am very interested in. Seems pretty standard, with that said, the Seller is not interested in a seller note or earn out. To his credit, he has a legitimate reason, wanting all the cash in hand to make other investments. He is even interested in staying on for an extended period, and even full time at a reduced salary (which suggests he believes in the long term prospects of the company).

My question to the community - Do you believe a Seller Note or Earn Out is an absolute requirement?

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Reply by a professional
from William Mitchell College of Law in Minneapolis, MN, USA

It's definitely not a requirement. Keep in mind these are 2 different things, that serve different purposes. The earn out is meant to bridge a gap in valuation between a buyer and seller. The seller thinks the business is worth more than the buyer is willing to pay because of how well the business will perform; they bridge the gap by agreeing on a fixed price at closing, with an earn out payable in the future based on the company's future performance. Sellers are benefited from staying with the company in some role during this earn out period, as it means they have some control (although typically limited) over the company hitting the earn out targets. If you and the seller don't have a valuation gap, , then there's no need for an earn out.

The seller note is meant to bridge the gap in financing. You've agreed on price with the seller, but don't have enough cash/financing to pay it at closing. In that case, the seller might agree to be paid over time via a seller note. If you can finance the entire purchase price, then you don't need a seller note.

One additional thing to consider is that if there isn't a seller note, or an earn out, then the seller doesn't really care how well the business does after closing. Jordan is right that sellers aren't generally interested in staying after closing, at least not for very long. MANY sellers enter into employment/consulting agreements with the new owner, but quickly realize they are not satisfied working at what they view as their business under someone else's control. It rarely works out. I wouldn't count on more than a few months from a seller under these circumstances.

Reply by an intermediary
from University of Arizona in Anchorage, AK, USA

Let's not forget why earn-outs and seller's notes exist in the first place. Sure, it's a great way for a buyer to reduce cash as closing, etc, however the real purpose is to share risk and keep the seller fully engaged in the continuity and growth of the business during a critical transition period (on average a three-year period post-closing). Earn-outs in combination with retention bonuses/profit sharing are common features in deals I close, depending on industry, and how long the seller really needs to stay on. Another alternative is the staged buyout, where the buyer takes a large majority of the business and the remaining equity is purchased over perhaps a three year period (often aligned to the term of an employment agreement). That remaining equity is valued using the same calculus deployed in the first closing. Sellers typically prefer a staged buyout over an earn-out, less potential for game playing.

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