Earnouts, Seller Notes, and Rollover: Explaining Structure to an Owner

Start with the headline and take it apart

Owners anchor on the headline number. A buyer's IOI says $30 million, and the owner hears $30 million. The attorney's first job is to rewrite that number as its components. Perhaps $21 million is cash at close, $3 million is a seller note payable over three years, $4 million is an earnout tied to EBITDA targets, and $2 million is rollover equity in the buyer's holding company. The owner is being offered $21 million with certainty and $9 million that depends on events after closing.

This exercise should be done for every IOI, in a table with the same columns, so the owner sees the offers side by side. A $28 million all-cash offer may be worth more to this owner than the $30 million structured one, and the owner cannot see that without the breakdown. The attorney who prepared the IOI comparison this way has already done most of the explaining.

The second step is to ask the owner a question: of the deferred components, which ones would you be comfortable never receiving? The answer tells the attorney how to weight the offers and how to negotiate the LOI.

Earnouts: who controls the outcome

An earnout pays the owner additional consideration if the business hits agreed targets after closing, often revenue or EBITDA over one to three years. Buyers may propose earnouts to bridge a valuation gap: the owner believes next year will be better, the buyer is unwilling to pay for it today, and the earnout lets both sides defer the disagreement. The IRS treats a sale whose price depends on future profits as a contingent payment sale for installment-sale purposes, so the tax analysis is separate from the commercial comparison. [1]

The attorney should explain the central problem to the owner in plain terms. After closing, the buyer runs the business. The buyer decides on pricing, hiring, capital spending, and how overhead is allocated. Each of those decisions affects whether the earnout target is met. An owner who stays on as an employee has influence but not control. An owner who leaves has neither.

The protections are contractual and imperfect. The attorney can negotiate for a defined EBITDA calculation that addresses buyer-imposed management fees and integration costs, for covenants that the buyer will operate the business consistently with past practice, for acceleration if the buyer sells the business during the earnout period, and for audit and dispute rights. None of these makes the earnout certain. The owner should treat the earnout as upside, not as part of the price, and should compare offers accordingly. A client with $4 million of EBITDA who is offered a $5 million earnout on a $25 million deal should ask whether a $23 million all-cash offer from another bidder is better. Often it is.

Seller notes: the owner as lender

A seller note is a promise by the buyer to pay part of the purchase price later, with interest, under a promissory note. A buyer may use a seller note to reduce the equity it must contribute and to keep the owner invested in a smooth transition. The IRS separately recognizes buyer notes and other installment obligations in its installment-sale rules. [1]

The attorney should explain that a seller note makes the owner a creditor of the buyer, and the note may be junior to other debt. The note may be subordinated to the buyer's senior lender, which can mean that if the business underperforms, the bank is paid first and the owner may be paid late or not at all. The note may be unsecured or secured only by a subordinate lien. The interest rate may be below what the risk warrants. These are terms to confirm in the documents, not assumptions to treat as universal.

Questions the owner should ask about any seller note: What is it subordinated to? Can the senior lender block payments, and under what conditions? Is there a personal or parent guaranty? What happens on a sale of the business or a change of control? Is there a right to set off indemnity claims against the note, and if so, is that right limited? The attorney will negotiate each of these, but the owner should understand that a seller note is worth less than its face amount and that its true value depends on the buyer's credit.

Rollover: the owner as co-investor

Rollover is the portion of the purchase price the owner reinvests as equity in the buyer's entity. A sponsor may ask the owner to roll a portion of proceeds. The pitch is a "second bite": the sponsor grows the platform, sells it in five years, and the owner's rollover is worth a multiple of what it was.

That result is a possibility, not a promised outcome. The attorney should explain what the owner is buying. Rollover equity may be common or a junior class, behind the sponsor's preferred return and behind the debt. It is generally illiquid until an exit or other permitted transfer. The owner may have no control over the timing or terms of that exit. The owner's percentage can be diluted by future acquisitions and management incentive plans. The tax treatment depends on the structure and conditions of the transaction, which the owner's CPA should review. An SEC-filed rollover agreement illustrates that rollover can involve contributing shares in exchange for equity units governed by a new governing agreement, so the class, rights, and documents matter. [2]

The attorney should ask the buyer for the capital structure of the entity the owner would invest in, the terms of the sponsor's preferred, the management incentive plan, and the owner's rights as a minority holder: tag-along, information rights, and any put or call. An owner who is told "you will own ten percent of the new company" should learn what ten percent of which class is worth after the sponsor's preference is paid.

Putting it in one conversation

The attorney does not need to teach the owner corporate finance. The attorney needs the owner to leave one meeting with three sentences fixed in mind. An earnout is money I get only if the buyer runs the business well and counts it my way. A seller note is money I lend to the buyer and get back after the bank does. Rollover is money I invest alongside the buyer and get back when the buyer decides to sell, if the investment works.

With those three sentences, the owner can read the IOI comparison and make an informed choice. The owner who wants certainty will prefer cash at close and may accept a lower headline. The owner who believes in the business and wants a second bite may accept rollover and negotiate hard on the terms. The owner who is leaving the industry should be cautious about an earnout. These are the owner's decisions, and the attorney's role is to make them real decisions rather than reactions to the largest number on the page.

The thing to do this week

Take the last IOI or LOI you reviewed for a client and rebuild it as a table: cash at close, seller note (amount, rate, term, subordination), earnout (amount, metric, period, control provisions), rollover (amount, percentage, class). If any column is blank because the document did not say, that is the question to put to the buyer. Use the same table for every offer in the next process you run.

How Acquivo Pro fits

Acquivo Pro manages the offers phase for every client the firm is running in a single pipeline, so the attorney sees each buyer's IOI and LOI in one place and can build the structural comparison from the terms as submitted. The valuation engine is deterministic and traces every figure to its source, which gives the attorney a consistent baseline against which to measure a headline number built from deferred components. The client sees the process through a branded portal under the firm's name. Software prepares, organizes, matches, and tracks; the attorney and the client decide and act. To walk through a process on a client you have in mind, request a demo through the Contact page.