Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The Earnout Trap That Cost a Seller 40 Million
Transcript
- Lucas: So, Luna, you remember the story of the software company that sold for 400 million with a 40 million earnout attached to hitting certain revenue targets? Luna: Vaguely. Refresh my memory. Lucas: Well, the buyers kept the management team in place, promised them the earnout was easily achievable. But then, within the first year, they changed the sales strategy, pulled the product from a major distribution channel, and shifted the company's focus to a new market. Revenue fell short, and the sellers walked away with nothing on the earnout. Luna: So the earnout was tied to revenue, but the buyers had control over how that revenue was generated. That seems like a recipe for disaster. Lucas: Exactly. And it's a classic earnout trap. The sellers didn't negotiate for any protections around how the business would be run post-acquisition. They assumed the earnout was a done deal, but they handed over control without a safety net. Luna: So what are some of the key lessons for sellers when it comes to structuring an earnout? I imagine it's not just about the number. Lucas: Right. The biggest lesson is that earnouts are not a gift. They are a promise based on assumptions that can quickly become obsolete. Sellers need to be very specific about the metrics, and they need to have protections in place if the buyer changes the business in ways that hurt those metrics. Luna: Like what? What kind of protections? Lucas: Well, you can negotiate for something called 'protections against changes in the business.' That might mean the buyer has to maintain certain staffing levels, or they can't change the sales strategy without consent, or the earnout metric is adjusted if there are changes in the market. It's about creating guardrails. Luna: And what about the flip side? If you're a buyer, what should you watch out for with earnouts? Lucas: For buyers, the main risk is that the earnout creates misaligned incentives. If the seller stays on as management, they might focus only on hitting the earnout metric, even if it's not in the long-term interest of the company. For example, they might slash R&D spending to boost short-term earnings, hurting the company's future. Luna: So it's a double-edged sword. But I've heard that earnouts are pretty common in M&A. Why do they exist in the first place? Lucas: They bridge the valuation gap. The seller thinks the company is worth more, the buyer thinks it's worth less. An earnout lets the seller prove the value by hitting certain targets, and it lets the buyer pay only if those targets are met. It's a way to share the risk. Luna: But in practice, they often lead to disputes. I remember a study that said something like 70% of earnouts fail to pay out in full. Is that right? Lucas: I've seen similar numbers. And when they fail, they often end up in court. That's why it's crucial to have a well-drafted earnout clause that covers all the what-ifs. Luna: So what are some of the common mistakes sellers make when negotiating an earnout? Lucas: First, they don't define the metric tightly enough. For example, 'revenue' can be manipulated by accounting practices. Is it gross revenue, net revenue, recurring revenue? How do you account for returns or discounts? You need to be crystal clear. Luna: Second, they don't specify how the metric will be measured. Will it be audited? Who does the audit? What happens if there's a disagreement? Lucas: Exactly. And third, they don't address what happens if the buyer changes the business. If they cut the marketing budget or drop a product line, that could hurt your ability to hit the earnout. You need to protect against that. Luna: And there's also the tax angle. How are earnouts taxed? I've heard that can be a nasty surprise. Lucas: That's a whole other layer. The tax treatment depends on the structure. If the earnout is structured as additional purchase price, it's generally capital gains. If it's structured as compensation for services, it's ordinary income. Sellers need to be aware of that distinction. Luna: And that can be a huge difference in terms of after-tax proceeds. Lucas: Yes, and it's often overlooked in the excitement of the deal. But getting tax advice early on can save you a lot of money later. Luna: Now, I want to bring up something that's been on my mind. We've been doing these shows for a while now, and we've covered a lot of M&A traps. It feels like we're building a valuable playbook for our listeners. And I think that's worth acknowledging. Lucas: Absolutely. And you know, one of the reasons we can keep doing this, keep digging into these cases, is that we don't have to worry about advertisers. The show is supported directly by listeners who find value in it. If you're one of those people, and you want to help keep this going, you can support us at buy me a coffee dot com slash fexingo. Luna: Yeah, every little bit helps, but no pressure. We're just glad you're here. Lucas: So, back to earnouts. Let's talk about a real-world example that went wrong. There was a consumer goods company that was acquired for 200 million, with an earnout of 20 million based on hitting a certain EBITDA target. The seller stayed on as CEO. Luna: And the buyer wanted to cut costs aggressively to hit their own internal targets. So they slashed the marketing budget, which hurt the brand, and they also increased the price of the products, which led to lower sales volume. Lucas: Right. The EBITDA target was met, but the revenue dropped, and the long-term health of the business suffered. The earnout was paid, but the company was in worse shape afterward. So it's not just about hitting the number, it's about how you hit it. Luna: And that's a cautionary tale for buyers. You might be creating a short-term win that becomes a long-term problem. Lucas: Exactly. Another example is from the tech sector. There was a software company where the earnout was tied to the number of new customers. The seller's team was great at sales, but the buyer changed the customer onboarding process, making it much harder to close deals. The seller missed the earnout, and it ended in litigation. Luna: And I bet the legal fees ate up a good chunk of the earnout anyway. Lucas: Probably. So what can sellers do to avoid these traps? First, they need to negotiate for a 'defined set of operating procedures' that the buyer must follow. That includes things like marketing spend, product development, and staffing levels. Luna: Second, they should consider negotiating for 'earnout protections' that adjust the target if the buyer changes the business. For example, if the buyer sells off a division, the earnout target should be reduced accordingly. Lucas: And third, they should think about the earnout period. A shorter period, like one year, might be better than a longer one, because there's less time for things to change. But sometimes a longer period can be better if you have a lot of confidence in the business. Luna: And buyers, what should they watch out for? I imagine the main thing is avoiding creating incentives that are misaligned with the company's long-term strategy. Lucas: Yes, that's a big one. If you're keeping the seller on as management, you need to make sure the earnout metric doesn't encourage them to do things that are harmful, like cutting investments in growth or taking excessive risks. Luna: So it's about balancing the interests of both parties. Lucas: Exactly. And that's why so many earnouts fail. They're often structured without enough foresight. It's something that requires careful thought and, ideally, experienced counsel. Luna: So, if you're a seller, what are the key takeaways you'd want listeners to remember? Lucas: First, be specific about the metric. Second, protect against changes in the business. Third, get tax advice. Fourth, consider the earnout period. And finally, think about dispute resolution. You don't want to end up in court, but if you do, you want a clear process. Luna: And for buyers? Lucas: For buyers, it's about making sure the earnout aligns with the long-term health of the company. Don't create an earnout that encourages short-termism. And be prepared to manage the relationship with the seller during the earnout period. Luna: It sounds like earnouts are a lot trickier than they appear on the surface. Lucas: They definitely are. But they can also be a powerful tool for bridging the gap between buyer and seller expectations. The key is to approach them with eyes wide open. Luna: And with a good lawyer. Lucas: And a good lawyer. Thanks for listening. We'll catch you next time.