The buyer agrees with our valuation but does not have the cash to pay it all upfront, offering to bridge the gap with either a seller note or a performance-based earnout. How do we evaluate the trade-offs between these two structures from a risk and tax perspective to choose the right option?

Question

Tyler Smith · Accepted Answer

Choosing between a seller note and an earnout is a choice between debt and equity risk. A seller note is a fixed obligation. The buyer must pay you back the principal plus interest over a set period, regardless of how the business performs post-close. This makes it a debt instrument, giving you a predictable stream of income and a higher level of security, especially if you secure the note with a pledge of the company's assets.

An earnout, on the other hand, is highly variable. Your payout is directly tied to meeting future performance targets. If the business underperforms, you could end up with nothing. This represents equity-like risk, but it also offers higher potential upside if the business exceeds expectations.

From a tax perspective under Section 453, both options allow you to defer taxes on the unpaid portion of the purchase price, but they are treated differently. A seller note has a fixed payment schedule, making tax planning straightforward. An earnout is a contingent payment sale, meaning the tax calculations are more complex and can change based on the actual payouts.

To decide, evaluate your confidence in the buyer's operational capability. If your Accountability Chart is fully populated with capable leaders who are staying on to run the business, and you trust the buyer's strategy, an earnout may yield a higher return. If you are stepping away completely and do not trust the buyer to execute, insist on a secured seller note with a defined interest rate to protect your capital.