When Should You Include Adjustable Seller Carry Notes in Your Offer to Buy a Business?

Adjustable seller carry notes can be a very effective condition to an offer when buying a business. However, they don’t apply to every business for sale. So what exactly are adjustable seller carry notes and when should they be used?

First, it's important to note that earnouts are not allowed with SBA loans, but some banks will allow adjustable seller carry notes. An adjustable seller carry note is when a percentage of the purchase price or an agreed-upon amount is paid to the seller at some point in the future, depending upon the business achieving certain milestones or conditions. For example, if the sales of the business hit a predetermined level within an agreed-upon time, the seller gets an additional payment. This doesn’t only apply to sales; it could be a wide array of milestones having to be met. Let’s discuss the more common scenarios when adjustable seller carry notes make sense.

When to Use Adjustable Seller Carry Notes:

1. Fluctuating Sales or Profits:

If the business has experienced a recent substantial increase or decrease in sales or profits, a buyer wants to be certain that this trend will continue (if an increase) or not continue (if there has been a decrease).

2. Customer Concentration:

If the business relies on a limited number of clients for a large percentage of its sales or profits, the buyer wants to ensure these customers will continue to buy from the business after the sale. An adjustable seller carry note provides a mechanism to not pay for these customers' contributions as part of the purchase price should they discontinue doing business with the company after the sale.

3. Pending Contracts:

If the seller has worked on some large contracts that will only come to fruition after the sale, the seller wants to be compensated for their recent past work, which isn’t reflected in the financials. The buyer will only pay for this potential if it pans out.

Key Points for Structuring Adjustable Seller Carry Notes:



1. Keep It Simple:

If the conditions are too difficult to measure and calculate, it often leads to disagreements.

2. Focus on One Metric:

Whether it’s revenue, profit, specific customer retention, etc., focusing on one metric keeps things straightforward.

3. Seller Apprehension:

Sellers may be hesitant about accepting an adjustable seller carry note but can be convinced if the buyer has a legitimate concern.

4. Broker Considerations:

Business brokers may dislike these deal terms because their contracts usually have them getting paid based on the total deal value. Sellers won’t want to pay their commission on the carry note

portion unless it’s realized. However, that’s for the seller and broker to figure out, not the buyer.

SBA Compliance for Adjustable Seller Carry Notes:

To ensure that an adjustable seller carry note is compliant with SBA guidelines, two important conditions need to be met:

1.    Seller Benefit Limitation: The seller's benefit can only decrease. It cannot exceed the agreed-upon amount. This means if the business performs better than expected, the payment to the seller will not increase beyond the initially agreed-upon limit.

2. Debt Service Coverage Ratio (DSCR): The debt service coverage ratio must still meet the bank's guidelines at the fully paid potential amount to the seller. The DSCR is a measure of the business's ability to service its debt with its operating income.

The business must maintain a DSCR that aligns with the bank's requirements, ensuring it can comfortably handle its debt obligations even if the full amount of the adjustable seller carry note is paid out.

Structuring an Adjustable Seller Carry Note:

Let's use the example of declining profits. Suppose the business has seen a drop of 25% in the last year. The seller has various reasons for this. Before the drop, the business was valued using a 3 times multiple on $200,000 of Owner Benefits, yielding a valuation of $600,000. However, in the most recent year, the Owner Benefits were $150,000. At a 3x multiple, the value changes to $450,000. Therefore, there’s a $150,000 gap ($600,000 - $450,000).

You offer the seller $450,000 with a $150,000 adjustable seller carry note, conditional upon the business generating an average of $200,000 in Owner Benefits over the next two years (or whatever period you can agree upon). If the Owner Benefits return to $200,000, the seller gets the additional $150,000. Adjustable seller carry notes do not need to be all-or-nothing deals. They can be on a scale. For example, if Owner Benefits average $180,000, then at a 3x multiple, the value would be $540,000, so the seller earns an additional $60,000.

Important Considerations:

It's critical that whatever you use as the basis for the multiple to determine the guaranteed price is a figure the buyer is absolutely comfortable with and will be sustainable after closing. If done right, adjustable seller carry notes can be an incredibly beneficial to both buyer and seller.