A recent study conducted by GF Data confirmed that the use of seller financing in the form of earnouts and seller notes in middle market transactions hit an all time high in 2011. Historically, seller financing has been used in between 40% and 50% of all lower middle market transactions.The exception was 2008, when seller financing was included in over 60% of deals. However, according to GF Data Resources' Second Quarter 2011 Report, almost 80% of deals in the under $25 million range were structured using earnouts and/or seller notes.   That's almost twice the historic average.

Given the uncertain economic times, this increase makes sense for both buyers and sellers. Seller financing has typically filled the gap in a transaction's capital structure that the buyer cannot fund with bank debt. While there is an abundance of private equity capital looking for deals right now and interest rates are at historic lows, banks have tightened the credit standards and are just not lending they way they did before 2008. As a result, if buyers can not get traditional funding for part of the capital structure, they will often turn to the seller to provide "gap financing" in the form of an earnout or seller note.

Some sellers are against the concept of seller financing, saying "I'm not going to allow you to pay me with money I would have received anyway if I continued to own the company", but for savvy sellers, seller financing can be a good deal. First, it gets the deal done and allows the seller to capture a significant portion of the deal in cash at closing.  Second, seller notes can be a good investment.  Since savings accounts and CDs are paying interest at or below 1%, a solid note from your company with interest at 6%-8% starts to look pretty attractive.

In addition, many sellers are hestitant to sell in the middle of an economic recovery because they believe that solid growth is right around the corner.  For these sellers, an earnout may be an appropriate way to bridge the gap between what buyers are willing to pay based on the company's historical earnings and what the seller wants, which is often based on expected future earnings. A well-structured deal allows a seller to be paid in cash based on the company's past performance, and to capture extra value when the company delivers the future performance that both the buyer and seller expect.

Unfortunately, seller notes and earnouts have gotten a bad name with sellers in the past.  This is primarily due to the fact that those deals were poorly structured.  The bottom line is that in uncertain times, seller financing can be an important and neceassary bridge that helps get deals closed. But to make sure your seller financing package is successful, make sure to work with an experienced M&A advisor and M&A lawyer to ensure that your interests are protected.