REsource library

Understanding Earn-Outs, Rolled Equity, and Seller Notes in M&A Transactions

When selling a business, the purchase price is just one part of the equation. How that price is structured can significantly impact a seller’s risk, reward, and future involvement in the company. Three common deal components that affect how sellers get paid are earn-outs, rolled equity, and seller notes. Each carries its own risks, rewards, and strategic purposes.

Here’s a breakdown of what each term means and how they differ:

1. Earn-Outs

Definition: An earn-out is a portion of the purchase price that is contingent upon the business achieving specific performance targets post-closing, usually tied to revenue, EBITDA, or customer retention.

Purpose: Earn-outs are often used when there's a valuation gap between the buyer and seller. They allow the buyer to mitigate risk while giving the seller the chance to earn more based on future results.

Key Characteristics:

• Contingent: Payment is not guaranteed.
• Time-bound: Typically lasts 1–3 years.
• Performance-based: Tied to agreed-upon financial or operational benchmarks.
• Incentivizes transition: Often requires the seller to stay involved during the earn-out period.

Pros:

• Opportunity to increase total payout
• Aligns interests between buyer and seller
• Can bridge valuation gaps

Cons:

• Risk of non-payment if targets aren’t met
• Potential for disputes over performance metrics
• Requires ongoing involvement and possible loss of control

2. Rolled Equity

Definition: Rolled equity refers to the portion of the seller’s ownership that is reinvested into the acquiring entity. Instead of taking 100% cash at close, the seller retains a minority equity stake in the new business.

Purpose: Rolled equity keeps the seller invested in the future success of the company. It’s common in private equity deals where the buyer wants the seller to stay motivated and participate in the next phase of growth.

Key Characteristics:

• Non-cash: Seller receives ownership in lieu of cash for a portion of the sale.
• Aligned interests: Seller becomes a partner in the buyer’s growth strategy.
• Potential upside: Seller may benefit from a future exit at a higher valuation.

Pros:

• Shared upside with buyer
• Continued involvement in business growth
• Signals confidence in the business’s future

Cons:

• Illiquid investment
• Risk of reduced control or influence
• Dependent on new management and market conditions

3. Seller Notes (Promissory Notes)

Definition: A seller note is a form of seller financing where the seller agrees to receive a portion of the purchase price over time, with interest, similar to a loan from the seller to the buyer.

Purpose: Seller notes can help bridge financing gaps, especially in deals involving SBA loans or where the buyer lacks full capital upfront. It also signals seller confidence in the buyer's ability to operate the business.

Key Characteristics:

• Debt instrument: Typically includes interest and a set repayment schedule.
• Secured or unsecured: May be subordinated to senior debt.
• Predictable: Payments are fixed and not tied to performance.

Pros:

• Steady income stream post-sale
• Can improve deal terms or pricing
• Lower risk than earn-outs

Cons:

• Credit risk: Seller depends on buyer’s ability to repay
• Potential delays if the business underperforms
• Often subordinated to other financing sources

Conclusion

Understanding the nuances between earn-outs, rolled equity, and seller notes is essential when evaluating an offer. Each mechanism can play a strategic role in a deal, depending on the seller’s risk tolerance, future involvement, and financial goals. Working with experienced M&A advisors ensures that the structure supports your long-term vision while minimizing unnecessary risk.