Structuring Earn Outs or Forgiveness using Seller Financing

April 29, 2021

by a searcher from Wake Forest University in Denver, CO, USA

Any advice/tips or structures on creating an earn-out type structure when using seller financing? Or, getting a portion of the financing amount forgiven if certain revenue targets aren't met post-close? I know you can't technically have earn-out with an SBA loan but you can do a loan forgiveness for past-performance metrics. I'm curious on strategies using both SBA and non-SBA funding options.

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Reply by a lender
in Yorba Linda, CA, USA

With conventional financing, you can structure a true earn-out. The lender will generally be comfortable with this if the earn-out can be paid from business cash flow, while still remaining in compliance with covenants. With SBA financing, the forgivable seller note must be tied to historical performance metrics. Think of it as a way to mitigate risk (and therefore it is really not an earnout). As ^redacted‌ stated, you might use the forgivable seller note to mitigate a customer concentration, or tie it to maintaining 2020 EBITDA if the business had a Covid tailwind, or returning to 2019 EBITDA if the business had a Covid headwind. Whatever key risk you're trying to structure safely around, you can generally use the forgivable seller note for that purpose.

Reply by a searcher
from The University of Michigan in 1075 Gills Dr, Orlando, FL 32824, USA

You can't have a true earn-out with an SBA loan but you can have the seller's note adjust down (not up) based on performance. I did this to mitigate some customer concentration risk. The seller's note was tied to the profits from specific customers. In order for the note to be paid in full the profits needed to be the same or higher as the previous year before closing. If they were lower than the note was adjusted down proportionally.

It was relatively easy for me to convince the sellers to accept this because I could clearly explain and quantify the risk. So my advice would be to tie it to the largest risks and also to make sure how it will be calculated is very clearly defined in the purchase agreement so there is no room for interpretation when the time comes to settle it.

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