The Valuation Gap Problem
In most search fund acquisitions, the buyer and seller disagree on price. The seller, having built the business over decades, naturally values it based on its potential and personal significance. The buyer, trained to model conservative downside scenarios, anchors on risk-adjusted cash flows. This valuation gap is the single most common deal-breaker in SME transactions.
Seller notes and earn-outs are the two primary mechanisms for bridging this gap without requiring either party to capitulate on their view of value. But they are fundamentally different instruments with different risk profiles and behavioral implications.
Seller Notes: The Basics
A seller note is a loan from the seller to the buyer (or the acquired company), representing a portion of the purchase price that the buyer pays over time with interest. In structure, it functions like debt—the seller becomes a creditor of the business.
When to Use a Seller Note
- When you need to reduce upfront cash at closing. Seller notes reduce the immediate equity requirement, making the deal more financeable.
- When the seller wants certainty of total value. Unlike an earn-out, a seller note promises a fixed amount. The seller knows exactly what they'll receive—the risk is credit risk, not performance risk.
- When you want to align the seller's incentives during transition. A seller with a note outstanding has a financial interest in the business's continued success. This can motivate them to support a smooth transition, share institutional knowledge, and introduce customer relationships.
- When bank financing isn't sufficient to cover the full purchase price. Seller notes often fill the gap between senior debt and equity, effectively functioning as mezzanine financing at lower cost.
Key Structuring Points
- Seller notes are typically subordinated to senior bank debt, meaning the bank gets paid first in all scenarios
- Interest rates usually range from 4% to 8%, depending on the risk profile and negotiation leverage
- Repayment can be structured as interest-only with a balloon, fully amortizing, or with a standby period (no payments for 12–24 months)
- Many Spanish acquisitions include a partial standby clause where the seller note receives no payments during the first two years, allowing the business to stabilize post-closing
Earn-Outs: The Basics
An earn-out is a contingent payment tied to the business achieving specific performance milestones after closing. If the milestones are met, the seller receives additional compensation. If they're not, the buyer pays nothing beyond the base price.
When to Use an Earn-Out
- When there's genuine disagreement about future performance. Earn-outs allow buyer and seller to "agree to disagree" on value. If the seller's growth projections materialize, they get paid for it. If they don't, the buyer is protected.
- When the seller is staying on post-closing and has direct influence over whether targets are achieved. An earn-out in this scenario aligns their compensation with their contribution.
- When the business has identifiable growth catalysts that haven't yet materialized—a new product launch, a pending contract, a geographic expansion.
Key Structuring Points
- Metrics matter enormously. Revenue-based earn-outs are simpler to measure but can incentivize unprofitable growth. EBITDA-based earn-outs align with value creation but introduce disputes about expense allocation. Gross profit can be a useful middle ground.
- Earn-out periods typically range from 12 to 36 months. Shorter periods reduce uncertainty; longer periods capture more of the growth opportunity but increase complexity.
- Buyer obligations should be clearly defined: will the buyer operate the business in ordinary course? Are they permitted to make investments that reduce short-term EBITDA but create long-term value? These provisions are the most litigated aspect of earn-outs.
- Dispute resolution mechanisms should be explicit and include independent accounting review procedures.
Head-to-Head Comparison
Here's how the two instruments compare on key dimensions:
- Certainty for seller: Seller note = high (fixed obligation). Earn-out = low (contingent on performance).
- Cash flow burden on buyer: Seller note = predictable debt service. Earn-out = unpredictable but potentially higher.
- Complexity: Seller note = relatively simple. Earn-out = significantly more complex legally and operationally.
- Dispute risk: Seller note = low (terms are clear). Earn-out = high (metrics, obligations, and interpretations are common sources of conflict).
- Seller motivation: Both align incentives, but seller notes do so through credit risk (seller wants the business to survive), while earn-outs do so through performance risk (seller wants the business to grow).
The Hybrid Approach
In practice, many search fund acquisitions combine both instruments. A common structure in Spain:
- 60–70% of purchase price paid at closing (equity + senior debt)
- 15–20% in a seller note with 24-month standby, then 3-year amortization
- 10–15% in an earn-out tied to revenue retention and EBITDA thresholds over 18 months
This approach gives the seller certainty on the majority of value (through cash and note), upside participation (through the earn-out), and alignment during the transition period.
"The best deal structures don't just bridge the valuation gap—they create behavioral alignment between buyer and seller during the most critical phase of the business's transition."