When a buyer and a seller disagree on what a private company is worth, the transaction does not necessarily end. Lower-middle-market M&A has developed a set of structures that let the parties sign at a headline price both can accept by making part of the consideration contingent, deferred, or retained. None of these bridges resolves the underlying disagreement. Each one assigns the consequences of being wrong about the future to one side or the other, which is why who bears the risk under each structure matters as much as the headline number.
Why Valuation Gaps Arise
Most gaps trace back to a handful of recurring causes, and the cause of the gap usually points toward the structure the parties end up discussing.
- Differing growth assumptions. Sellers tend to price a business on projected results, giving full credit to a new contract, a product launch, or momentum in the pipeline. Buyers tend to price on demonstrated trailing performance and treat projections as possibilities rather than assets. The same business can carry two defensible valuations that sit far apart.
- Customer concentration. A buyer typically discounts revenue that depends on one or two large customers, since a single lost relationship could impair the investment. An owner with decade-long customer relationships often views them as durable and resists the discount.
- Add-back disputes. Private-company earnings are usually presented as adjusted EBITDA, with add-backs for owner compensation, one-time expenses, and personal items run through the business. Buyers and their quality-of-earnings advisors routinely trim aggressive add-backs, which lowers the earnings base and, multiplied through the valuation, widens the gap.
- Market comparables. Multiples vary by company size, sector, growth profile, and time period, and each side can usually find comparable transactions that favor its position. Shifts in interest rates and debt availability also move what financial buyers can pay, sometimes faster than seller expectations adjust.
The structures below are the standard tools for closing these gaps. This article is educational and is not legal, tax, or investment advice; the tax and legal treatment of any structure depends on the specific facts and drafting of a transaction.
Earnouts: Contingent Price Tied to Future Performance
An earnout defers part of the purchase price and pays it only if the business hits agreed targets after closing, typically measured over one to several years against revenue, EBITDA, gross profit, or defined milestones. Earnouts fit gaps caused by growth assumptions: the seller is paid for projected performance only if it actually arrives, so the buyer avoids paying today for results that may never materialize.
SRS Acquiom's 2025 M&A Deal Terms Study found that among deals with earnouts that closed in 2024, roughly two-thirds used more than one performance metric, and nearly all measurement periods ran four years or less. The same firm's payment data is sobering: across deals with earnouts, sellers have collected on the order of 20 cents of each maximum earnout dollar, and even deals that achieved at least one threshold paid out only about half the maximum. Experienced deal parties therefore tend to compare offers on cash paid at closing and treat earnout potential as upside rather than as assured price.
Who bears the risk. Primarily the seller. After closing the buyer controls both the operations that drive the targets and, in most cases, the accounting that measures them. Disputes cluster around post-closing operating decisions and calculation discretion, and courts, particularly in Delaware, generally enforce whatever efforts standard and accounting rules the parties actually wrote. Recent decisions summarized by Jones Day turn on precise contract language: broad buyer discretion imposes light obligations, while a defined commercially-reasonable-efforts standard can support substantial liability when a buyer shifts strategy away from the acquired business. Vague earnout drafting is, in effect, a transfer of risk to the seller.
Contingent Value Rights and Milestone Payments
A contingent value right, or CVR, is a related instrument used mainly in public-company deals: target shareholders receive a right to additional payment if a defined post-closing event occurs. Commentary published on the Harvard Law School Forum on Corporate Governance groups CVRs into three types: price-protection rights that compensate holders if the buyer's stock underperforms, performance rights tied to financial metrics, and contingency rights tied to discrete events such as a regulatory approval or a litigation outcome. Modern use is dominated by the event-driven variety, especially in life sciences, where a single binary outcome accounts for most of the disagreement about value.
In private lower-middle-market deals, the same idea appears as a milestone payment inside the purchase agreement rather than as a separate tradeable instrument: a fixed additional amount payable if a named contract renews, a license issues, or a lawsuit resolves within a stated window. Milestone structures suit gaps caused by one identifiable uncertainty, because they avoid the accounting-measurement fights that surround EBITDA-based earnouts.
Who bears the risk. The seller bears the event risk, and usually all of it, because milestone payments are all-or-nothing: a near miss pays zero. Holders of contingent rights also tend to discount them heavily, since the payments are deferred, often non-transferable, and dependent on decisions the buyer controls.
Seller Notes: Deferring Price and Accepting Credit Risk
With a seller note, the buyer pays part of the price at closing and signs a promissory note for the balance, repaid with interest over a term of years. Unlike an earnout, the amount owed is fixed; what is uncertain is whether it gets paid. Seller notes bridge gaps that are really financing gaps, where the buyer accepts the price but cannot or will not fund all of it in cash, and they signal confidence, since an owner who believes the business will keep performing is lending against that belief.
Seller notes are almost always subordinated to the buyer's senior bank debt, meaning the lender is paid first and can often block payments on the note if the business underperforms. The note's interest rate, amortization, security, and subordination terms determine how much protection the seller actually has.
Tax treatment generally follows the installment method described in IRS Publication 537: a seller who receives at least one payment after the tax year of the sale reports gain proportionally as principal payments arrive, with depreciation recapture recognized in the year of sale. If the note carries little or no stated interest, the IRS imputes interest at applicable federal rates, converting part of each payment into ordinary income. A seller can also elect out of installment treatment and report the full gain in the year of sale. These rules are fact-specific, and sellers ordinarily model them with a tax advisor before agreeing to a note.
Who bears the risk. The seller bears the buyer's credit risk. If the business fails under new ownership, a subordinated unsecured note may be worth little, regardless of how the company performs relative to projections.
Rollover Equity: Retained Ownership in the Buyer's Entity
In a rollover, the seller reinvests part of the sale proceeds, commonly a minority stake in the range of 10 to 40 percent, into the buyer's acquisition entity. Rollovers are standard in private equity deals, which prize the alignment of a motivated former owner and the reduced cash needed at closing. For the seller, the rollover bridges a valuation gap by converting the disputed portion of value into continued ownership: if the growth the seller projected materializes, the retained stake captures it at the next sale, the so-called second bite of the apple.
Structured properly, a rollover can defer tax on the reinvested portion. Guidance from Alston & Bird notes that most rollover structures rely on two nonrecognition provisions, Section 721 for contributions to a partnership and Section 351 for corporate stock exchanges, with the corporate route more demanding because of its control requirement. The same guidance flags two seller risks that recur in practice: the value of the buyer's equity may be hard to verify, especially when the buyer owns other businesses, and vesting conditions attached to rollover equity can create compensation-taxation issues if not addressed.
Who bears the risk. The risk is shared, but the seller's retained stake is a minority, illiquid position governed by the buyer's documents. The seller keeps upside exposure and also keeps downside exposure, now without control, so the governance and exit rights attached to the rolled equity carry real economic weight.
Escrows, Holdbacks, and Purchase Price Adjustments
Escrows and holdbacks do not bridge disagreements about headline value so much as they true up the price for facts measured after closing. A portion of the proceeds is set aside, with a third-party escrow agent or held back by the buyer, to fund post-closing purchase price adjustments and indemnification claims. SRS Acquiom's deal-terms data shows that a large majority of private deals now include a separate escrow for purchase price adjustments, with a median size around 1 percent of transaction value, and that average adjustments owed to buyers have run just under 1 percent of deal value, suggesting the market sizes these escrows roughly right. A meaningful minority of deals also carry a separate indemnity escrow.
Where escrow mechanics touch the valuation gap is in negotiations over adjusted EBITDA and working capital. A buyer that doubts the seller's add-backs or the sustainability of reported working capital may accept the seller's number at signing while insisting on a larger adjustment escrow, effectively deferring the disagreement into a post-closing measurement governed by defined accounting rules.
Who bears the risk. The seller's money is at stake, but the exposure is bounded and time-limited: escrows are capped at their stated amount and released on a schedule, which makes them the narrowest and most predictable of the bridging tools.
Staged and Partial Sales
Sometimes the cleanest bridge is to sell less of the company now. In a staged or partial sale, the owner sells a majority or minority stake at today's agreed value and retains the rest, with the retained portion to be valued and sold later, often at the buyer's next exit or under a negotiated put or call arrangement. The gap closes because the disputed value is simply deferred: the retained stake will be priced on realized performance rather than on competing projections.
Partial sales suit owners who believe strongly in near-term growth and are willing to stay exposed to it, and buyers who want continuity of leadership through a transition. The tradeoffs mirror rollover equity: the seller holds an illiquid position, usually without control if a majority was sold, and the eventual value of the retained stake depends on decisions the new owner makes.
Because each of these structures allocates risk differently, the practical question in any negotiation is which party is better positioned to bear the specific uncertainty driving the gap. Growth-assumption gaps point toward earnouts and rollovers, single-event gaps toward milestone payments, financing gaps toward seller notes, and measurement gaps toward escrows and adjustments. Sell-side platforms such as Bankerly model these structures as scenarios alongside a base valuation so the economics of each bridge can be compared before a letter of intent is negotiated. In every structure, the written terms rather than the parties' expectations determine who ends up holding the risk.
Sources
- SRS Acquiom: M&A Deals: Key Trends from the 2025 Deal Terms Study
- Jones Day: Earnouts in M&A Transactions: Recent Decisions From Delaware
- IRS: Publication 537, Installment Sales
- Alston & Bird: Equity Rollovers in M&A Transactions
- Harvard Law School Forum on Corporate Governance: CVRs: A Bridge Too Far?
Frequently asked questions
- What causes a valuation gap between a buyer and a seller?
- Most gaps come from a few recurring sources: sellers price on projected growth while buyers price on trailing results, buyers discount revenue concentrated in a few customers, quality-of-earnings reviews trim aggressive EBITDA add-backs, and each side selects market comparables that favor its position. Changes in interest rates and debt availability can also move what buyers are able to pay faster than seller expectations adjust.
- Which structure is most commonly used to bridge a valuation gap?
- Earnouts are the classic bridge for growth-assumption gaps in private deals, deferring part of the price until agreed revenue, EBITDA, or milestone targets are met. Seller notes address financing-driven gaps, rollover equity converts disputed value into a retained ownership stake, and milestone payments handle single-event uncertainty. Which structure fits depends on what is actually driving the disagreement and which party can better bear that specific risk.
- Who bears the risk in an earnout?
- Mostly the seller. After closing the buyer controls the operations that drive the targets and usually the accounting that measures them, and market data shows earnouts have historically paid well below their stated maximums. Courts generally enforce only the operating covenants and accounting rules written into the agreement, so loosely drafted earnout terms shift additional risk onto the seller.
- How is a seller note different from an earnout?
- A seller note is a fixed obligation: the buyer owes a stated amount with interest on a repayment schedule, and the open question is credit risk, whether the buyer can pay, especially since seller notes are usually subordinated to bank debt. An earnout is a contingent obligation: nothing is owed unless the business hits defined targets, so the seller bears performance risk rather than just credit risk. Sellers frequently receive installment-sale tax treatment on note payments under rules described in IRS Publication 537.
- Is rollover equity taxable at closing?
- Often not on the rolled portion, when the transaction is structured to qualify under a nonrecognition provision such as Section 721 for partnership interests or Section 351 for corporate stock, which defers tax until the retained stake is later sold. Structuring details matter: vesting conditions or a failed control requirement can change the result. This is general education rather than tax advice, and rollover tax treatment is typically reviewed by a qualified tax advisor before signing.
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