Seller Notes, Earnouts and a Big Uninsured Loss in Year One

A big uninsured or underinsured loss in your first year is paid from the same cash that services your senior loan, your seller note and any earnout. One bad fire or lawsuit can push you below a lender covenant and start a fight with the seller in the same quarter. The coverages that protect that cash are property insured at realistic replacement values, business income with a limit and time period that fit the business you bought, and liability limits sized to your contracts and worst realistic claims. This guide is for buyers who financed a deal with acquisition debt, a seller note or an earnout and want to know how one bad loss would ripple through the capital stack.

How does one uninsured loss reach your seller note and earnout?

Think of a deal financed with senior debt, a seller note and equity. Every month, cash from operations pays the senior lender first, then the seller note under whatever subordination terms you signed, and anything left supports working capital and growth. An earnout, where the seller earns more of the price if the business hits targets, depends on the same earnings.

A covered loss, within the limits and after the deductible and waiting period, mostly passes through: the insurer pays to rebuild and replaces lost income, though payments can take time, and the cash waterfall can keep running. An uninsured or underinsured loss does the opposite. It removes cash at the top and reduces the earnings your lender measures, often in the same quarter. Three pressures then arrive together:

• The lender. Many acquisition loans include a debt service coverage ratio (DSCR) covenant, which compares cash flow available for debt payments with the payments due. A drop in earnings can push you below it.
• The seller. If the seller note is current pay (principal and interest paid on schedule from closing), you may need to ask the seller to defer payments, which the note and any subordination agreement may or may not allow.
• The earnout. If the loss falls in a measurement period, the seller may argue the shortfall came from your decisions, including the insurance you chose to buy.

Business income insurance does not help with every revenue drop. It responds to direct physical loss or damage to property, not to a key customer leaving or the seller's relationships walking out. That separate risk is covered in business interruption when the owner was the business.

What does an uninsured loss look like on paper?

A hypothetical example. A buyer acquires a light manufacturer with a conventional senior loan (not an SBA loan) and $1,200,000 of annual earnings before interest, taxes, depreciation and amortization (EBITDA). Annual debt service is $800,000: $650,000 to the senior lender and $150,000 on a current-pay seller note. That is a coverage ratio of 1.5 times, and the loan agreement requires at least 1.25 times. The deal also has an earnout tied to year-two EBITDA. Eight months after closing, a fire closes the plant for four months.

With the inherited program, the buyer is negotiating a covenant waiver with the bank, asking the seller to defer note payments and defending the earnout calculation, all while rebuilding. With limits sized to current values, the same fire would more likely be a hard few months than a financing event. This assumes the higher business income limit either meets the policy's coinsurance requirement or is written on an option that removes it, and those options cap payment in other ways (by month, or at 120 days). An agreed value option does not get around this: if the limit is below the agreed value, which is based on a full year of net income and operating expenses, claims are cut in the same proportion. The numbers are illustrative; real claims depend on the policy wording, the waiting period and how the loss is adjusted.

Which coverages protect debt service the most?

Start with the coverages where a gap turns directly into lost cash. The table pairs each with the question to ask and why it matters to your lenders and seller.

Two details in the standard Insurance Services Office (ISO) business income form surprise buyers. Income coverage usually starts only after a 72-hour waiting period, and coverage for interruption caused by damage to electronic data is limited to $2,500 a year unless a higher limit is shown. Carrier forms vary, so check yours. For the line-by-line checks, see the business income review and the commercial property review. A commercial umbrella usually does not sit over professional liability, cyber, directors and officers or employment practices policies, so size those limits on their own.

Why do sellers' programs leave these gaps?

Most sellers were not careless. Owner-run businesses often keep the same limits for years while revenue, payroll and equipment costs rise, and a seller with no debt and cash in the bank could absorb a loss that a leveraged buyer cannot. A program that suited the seller can be too thin for you even if the old broker served the old owner well. Watch for business income limits that look like an old round number, property values that match the purchase price allocation rather than replacement cost, and liability limits that customer contracts now exceed. Was the seller underinsured? covers the warning signs, and coinsurance explains how low values can shrink a claim.

How do SBA rules and seller notes change the picture?

If you financed the deal with an SBA 7(a) change of ownership loan, two rules in SBA's current standard operating procedure (SOP) 50 10 8.1 matter here:

• No seller earnouts. Seller earnouts are prohibited in these loans, though buyer rebates based on business performance are allowed and must be applied to pay down the 7(a) loan.
• Standby seller notes. Seller debt counts as equity only if it is subordinated and on full standby, meaning no principal or interest payments for the term of the 7(a) loan. A seller note that is not on full standby counts toward your total debt service.

So in an SBA deal, a big loss mostly pressures the senior loan and any current-pay seller debt. Outside SBA deals, such as many search fund and holding company acquisitions, earnouts and current-pay seller notes are often used, and the three-way squeeze is more likely. Buyers sometimes plan to set off indemnity claims against seller note payments. Whether you can do that against a standby note during an SBA loan is not settled by the SOP, so ask your lender and deal counsel. Lenders can also add insurance requirements beyond SBA's own; see SBA lender insurance requirements.

What should you ask deal counsel about insurance and the earnout?

Insurance and deal documents interact in ways a policy review alone will not catch. These are questions for your attorney and accountant, not conclusions:

1. Does the earnout's definition of EBITDA include or exclude business income insurance proceeds, casualty losses and deductibles?
2. Does the purchase agreement or note require you to keep certain insurance, or to run the business consistent with past practice?
3. Does the seller note let you defer payments after a casualty, and what does the subordination agreement say?
4. Can indemnity claims be set off against the note, and does the lender have to consent?
5. Does the senior loan agreement require insurance proceeds to go to the lender first, and does it let you use them to rebuild?

Getting answers now is cheaper than arguing about them after a fire. For how seller promises compare with insurance, see seller indemnities vs insurance.

What should you do if a big loss hits before you fix the gaps?

If the fire or lawsuit comes first, your job is to keep cash moving and keep every stakeholder informed before they hear it elsewhere.

1. Notify every carrier that might respond, in writing, right away.
2. Ask the carrier about partial or advance payments on business income, extra expense and property, so debt service and equipment orders keep moving while the claim is adjusted.
3. Tell your senior lender before the next covenant test, not after, and ask how it will treat insurance proceeds and the casualty in the coverage ratio.
4. Talk to the seller early if the note or earnout will be affected, and follow the notice steps in the documents.
5. Track every extra expense and every lost sale. Earnout disputes are often settled on those records.
6. Brief your board with the facts, the insured and uninsured amounts and your plan.

Ask deal counsel before you defer any payment.

What should you do in the first 90 days?

1. Rebuild the business income worksheet on projected numbers for the next 12 months: net income plus operating expenses, including payroll, which is the base many coinsurance clauses measure. Then estimate how many months a realistic rebuild and customer recovery would take.
2. Get replacement cost values for buildings and key equipment, not the purchase price allocation.
3. Run the coverage ratio test: if your largest realistic loss happened next month, what would your covenant look like with and without the inherited limits?
4. Match liability and umbrella limits to customer contracts and lease requirements.
5. Set deductibles your cash reserves can absorb; see raising deductibles the smart way.
6. Report the results to your board or investors so the insurance budget is a decision, not an accident.

Morrow can review the program you inherited against your debt structure, flag gaps and request quotes. A quote is not coverage; new terms apply only once a carrier binds them.

Keep reading

• New Owner Review: Business Income and Extra Expense
• Was the Seller Underinsured? How to Tell and What It Costs You
• Seller Indemnities vs Insurance: What They Are Really Worth
• SBA Lender Insurance Requirements After Closing: A Detailed Checklist
• Budgeting Insurance in Your Acquisition Model
• All guides for new business owners

Frequently asked questions

Can a single uninsured loss really put me in default on my acquisition loan?

It can, if the loan has a coverage ratio covenant and the loss cuts earnings enough. Some lenders will discuss a waiver after a casualty, but that is usually a negotiation rather than something the loan agreement entitles you to. Read your loan agreement and ask your lender how it treats casualty losses and insurance proceeds.

Does business income insurance count toward EBITDA for my earnout?

It depends on how your purchase agreement defines the earnout's EBITDA. Some agreements address insurance proceeds and one-time losses and some say nothing. Ask your deal counsel and accountant how yours reads before a loss happens.

Can I stop paying the seller note if a fire shuts down the business?

Only if the note, the subordination agreement or a negotiated deferral allows it. Stopping payments without that can create a default. Talk to your attorney and the seller early, and keep your lender informed.

Are earnouts allowed in SBA acquisitions?

Not in SBA 7(a) change of ownership loans under SOP 50 10 8.1, the version in effect since October 1, 2026. Seller earnouts are prohibited there, though buyer rebates tied to business performance are allowed and must be applied to the 7(a) loan. Confirm with your lender which SOP version applies to your loan.

How high should my business income limit be?

There is no single formula. Start with projected net income plus operating expenses, including payroll, for the next 12 months (the base a coinsurance clause usually measures), then adjust for how long a rebuild and customer recovery would really take. A broker can help you test the numbers against your actual financials.

References

• Insurance Services Office: Business Income (And Extra Expense) Coverage Form CP 00 30 10 12 (hosted copy)
• U.S. Small Business Administration: SOP 50 10 8.1, Lender and Development Company Loan Programs (effective Oct 1, 2026)
• Morgan and Westfield: Acquired, Chapter 22, Purchase Agreement: Indemnification

This article is general information, not legal, tax or financial advice, and not a coverage determination. Coverage depends on the actual policy wording, carrier underwriting, your purchase agreement and your contracts. Ask your attorney and accountant about deal and legal questions.