SBA seller financing requirements and the earnout prohibition
Short answer
A seller note in an SBA acquisition is allowed in two forms. On full standby (no principal or interest payments for the life of the SBA loan) it counts as equity, up to half of the required 10%. With payments, it's debt: its payments go into the 1.25x coverage test and its balance counts toward the rule that total debt can't exceed the valuation. Earnouts are prohibited, and a seller note can be refinanced only after 36 months in place and current.
Seller financing does two jobs in an SBA deal: it shows the seller believes in the business, and it fills gaps in the capital stack. SBA treats the two forms of seller note very differently, so the structure needs to be decided deliberately, ideally in the LOI.
Standby vs paying
| Full standby note | Paying note | |
|---|---|---|
| Payments during SBA loan | None, principal or interest | Scheduled payments |
| Counts as equity? | Yes, up to half of the required injection (shared with other limited sources) | No |
| In the DSC calculation? | No | Yes |
| Counts toward debt ≤ valuation? | No (only debt not on full standby counts) | Yes |
| Documentation | SBA Form 155 or lender's equivalent, note attached | Subordination per lender |
| Interest | May accrue, paid after SBA loan | Paid as scheduled |
How each piece is tested
The standby piece
Full standby means no payments of principal or interest for the term of the 7(a) loan. The SOP allows interest to accrue and be added to the standby debt, then amortized after the 7(a) loan is paid off. The seller subordinates any lien rights to the lender and can't take action against you or the collateral without the lender's consent. Together with other standby debt and minority investors, it can't provide more than half of the required injection. See equity rules.
The paying piece
The lender includes its payments in post-transaction debt service when testing coverage at 1.25x. If the note is interest-only, the lender must apply an amortization of no more than 10 years for that test. Its balance also counts toward the Appendix 15 rule that total debt supporting the change of ownership, including seller debt not on full standby, can't exceed the business valuation.
Worked example
Illustration, not a real deal
Say total project cost is $2,000,000 and the valuation concludes $1,850,000 against a $1,850,000 price. Equity required: $200,000. The seller agrees to $300,000 of financing: $100,000 on full standby and $200,000 paying over 10 years.
- Equity: your $100,000 cash + $100,000 standby = $200,000. The standby share is exactly half. Fine.
- SBA loan: $2,000,000 − $200,000 − $200,000 = $1,600,000.
- Debt vs valuation: $1,600,000 + $200,000 paying note = $1,800,000, under the $1,850,000 valuation. Fine.
- Coverage: EBITDA must cover payments on both the $1,600,000 SBA loan and the $200,000 seller note at 1.25x.
What the seller can't do
- Earnouts: prohibited. A buyer rebate if performance disappoints is allowed, and goes to pay down the SBA loan. See SBA earnout rules.
- Stay as owner or employee in an Initial Acquisition or Business Expansion. Consulting up to 24 months total is allowed.
- Take equity as a standby creditor. The provider of standby debt may not take an equity investment in the business.
- Get paid early on a standby note, which would break standby and its equity treatment.
Refinancing the seller note later
Seller debt structured as part of a change of ownership can be refinanced with SBA proceeds only after it has been in place and current, not on standby, for at least 36 months, and the refinance must meet SBA's 10% payment-improvement test and not reduce the lender's exposure. A standby note can't be paid off early from the business without the lender's consent. See SBA refinance rules.
Documents the lender needs for a seller note
- The seller note itself, with amount, rate, term and payment schedule (or the full standby terms).
- A standby agreement signed by the seller where the note is on full standby.
- Confirmation that no payments are hidden in side letters, consulting fees or lease terms.
- The note's payments included in the DSC table if it isn't on full standby.
Buyers negotiating a seller note can read OKtoBuy's guide to seller-financed businesses.
The earnout prohibition
Seller earnouts, where part of the price is paid later if the business hits targets, are prohibited in SBA change-of-ownership deals under SOP 50 10 8.1. The reverse is allowed: a buyer rebate from the seller based on performance, which must be applied to pay down the 7(a) loan's principal. A working capital true-up in the purchase agreement isn't treated as a rebate, so that cash can stay in the business.
Earnouts are the standard way larger deals close a gap between what a seller thinks the business is worth and what a buyer will pay. In SBA deals, that tool is off the table.
Three mechanisms compared
| Mechanism | What it does | SBA treatment |
|---|---|---|
| Seller earnout | Buyer pays the seller more later if targets are hit | Prohibited |
| Buyer rebate | Seller pays the buyer back if performance falls short | Allowed; proceeds pay down the 7(a) loan principal |
| Working capital true-up | Price adjusts after closing to a working capital target | Not a rebate; cash can stay in the business |
Using a rebate to bridge a gap
Illustration, not a real deal
Say the seller believes revenue will grow and wants $1,600,000; the valuation supports $1,450,000. An earnout of $150,000 isn't allowed. Instead you could agree $1,550,000 with a rebate: if gross profit in the first 12 months falls below an agreed figure, the seller refunds up to $100,000, which goes against your loan principal. You'd still need equity for the $100,000 above the valuation.
True-ups
A working capital adjustment in the purchase agreement remedies a shortfall of working capital at closing, so SOP 50 10 8.1 says it's not a rebate and the cash doesn't have to pay down the loan. Make the mechanism clear in the agreement so the lender can see which it is. See working capital in acquisition loans.
Spotting an earnout that isn't called one
Few purchase agreements on an SBA deal use the word "earnout". The risk for a lender is a clause that works like one under another name. Read the agreement, the seller note and any side letters for these patterns:
| Clause | Why it's a problem | Compatible alternative |
|---|---|---|
| Seller note principal that increases if revenue targets are hit | Contingent extra price paid to seller | Fixed note amount; buyer rebate if targets are missed |
| "Bonus" or consulting fee to the seller tied to post-closing results | Performance-based payment to the seller dressed as compensation | Consulting at a fixed, market fee, within the 24-month limit |
| Holdback released to the seller only if customers stay | Price depends on future performance | Price fixed at closing; rebate to buyer applied to the 7(a) loan |
| Price adjustment based on next year's EBITDA | Classic earnout | Price the business on verified historical earnings now |
Handling a buyer rebate correctly
A rebate from the seller to the buyer, triggered when the business underperforms, is allowed, but the SOP requires it to be applied to pay down principal on the 7(a) loan. Build that into the documents: the purchase agreement should say where the rebate goes, and the lender should be able to see the payment arrive and post against principal. A rebate that lands in the buyer's operating account and stays there doesn't meet the rule.
Illustration, not a real deal. Price $1,500,000, fixed at closing. The seller is confident a large contract will renew; the buyer isn't. Instead of an earnout paying the seller more if it renews, the parties agree the seller will rebate $100,000 if it doesn't renew within 12 months. It doesn't renew. The seller pays $100,000, the buyer's SBA loan principal drops by $100,000, and the monthly payment or remaining term adjusts according to the note. The lender's exposure falls at the moment the business got riskier, which is exactly why SBA permits this direction and bans the other.
Working capital true-ups
A post-closing adjustment that squares actual working capital against the agreed target isn't a rebate, so it doesn't have to pay down the loan. The lender's interest is in the definition: a true-up based on clear balance sheet items at closing is a true-up; one based on future profits is a performance payment. Buyers can read more in OKtoBuy's earnout guide and working capital peg guide.
Common questions
Can a seller note be partly standby and partly paying?
Yes. Many deals use two notes: one on full standby that counts toward equity, and one with payments that the cash flow can carry.
Can a standby seller note accrue interest?
Yes. Interest may accrue and be added to the standby debt and amortized after the 7(a) loan is paid in full.
Can the seller take a lien?
A standby creditor must subordinate its lien rights to the SBA lender and can't act against the borrower or collateral without the lender's consent. Paying seller notes are typically subordinated too.
Can the seller note be interest-only?
It can, but SOP 50 10 8.1 requires the lender to test coverage as if the note amortizes over no more than 10 years.
Why does SBA ban earnouts?
An earnout is contingent debt to the seller that isn't fixed at closing, which conflicts with SBA's rules that debt be capped at the valuation and covered by historical cash flow.
Related guides
Sources
This guide explains rules and practice in plain English. It isn't legal, tax or credit advice, and SBA and IRS rules change. Check the current SOP, regulations and your lender's requirements before you rely on anything here. Examples with made-up businesses are illustrations, not real deals.