Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / How a Tiny Earnout Cap Saved $200 Million
Transcript
- Lucas: Imagine you sell your company for fifty million dollars upfront, with an earnout that could pay you another ten million if you hit a revenue target. And then your product gets FDA approval much faster than anyone expected, your addressable market quintuples, and the buyer books an extra two hundred million in profit directly because of that approval. Luna: That sounds like a dream scenario for the seller. Lucas: It would be, except for one detail buried in the earnout clause: a five-million-dollar cap. That cap means the seller gets exactly five million of that ten million dollar earnout, no matter how much value the approval creates. The buyer keeps the other five million, plus the entire two hundred million windfall. Luna: So the cap protected the buyer from their own good luck. That's a specific deal – is this a real case? Lucas: It's a composite from several mid-market pharma deals I've seen, but it's structurally accurate. And it gets to the heart of why the earnout cap is quietly the most contentious term in contingent consideration right now. Luna: Most earnout failures I hear about are about the seller not hitting the target. This is the opposite – the cap preventing the seller from sharing in outsized success. Lucas: Exactly. And in 2026, with earnouts appearing in roughly forty percent of indie M&A transactions under one hundred million dollars, the cap is the term that separates a fair deal from a seller's nightmare. Today we'll unpack what a cap actually is, why buyers push for them, and the one question every seller should ask before signing. Luna: Start with the basics. What exactly is an earnout cap? Lucas: The cap is the maximum amount the buyer will ever pay under the earnout, regardless of performance. If the earnout formula says the seller should get twelve million, but the cap says eight million, the seller gets eight million. It's the ceiling. Buyers argue it's needed to limit their exposure to things they can't control – like a sudden market boom that has nothing to do with the seller's efforts. Luna: But the seller would say, 'Hold on, you bought my company's future potential. If that potential explodes, shouldn't I share in it?' Lucas: And that's exactly the tension. In the deal I mentioned, the buyer's position was: the FDA approval was a binary event that the seller had already been working on for three years. The earnout was designed to incentivise post-close commercial milestones, not pre-close regulatory work. The seller's position was: we handed you a platform that made that approval possible. Both arguments have merit. Luna: So how do these caps get set? Is it just a number the buyer throws out? Lucas: There's typically a range. In my experience, the cap is usually between one and three times the maximum earnout payout that the seller's financial model projects under a realistic upside scenario. But here's the trap: if the seller's model is conservative, the cap might be set too low relative to what's actually possible. Luna: Meaning the seller effectively caps their own upside by underestimating their own business. Lucas: Exactly. I sat in on a negotiation last year where the seller's CFO presented a model showing a best-case earnout of four million. The buyer offered a cap of six million. The seller thought that was generous. But two weeks after the deal closed, a competitor withdrew a key patent, and the seller's product line suddenly had a clear path to an additional fifteen million in revenue. The cap locked them out of that. Luna: Ouch. So the seller's own conservative assumptions became the buyer's protection. Lucas: That's the pattern I see most often. The seller doesn't want to seem greedy or unrealistic, so they lowball their projections. The buyer then uses those low projections to justify a low cap. And if something unexpected goes right, the buyer reaps ninety percent of the upside. Luna: What's the alternative? Is there a way to structure a cap that's fairer? Lucas: One approach is a 'high-water mark' cap that resets upward if certain external events occur. For example, if a new regulation opens a market that didn't exist at signing, the cap could increase by a formula tied to that market's size. But buyers hate this because it introduces uncertainty into their maximum payout. Luna: And uncertainty is the enemy of the buyer's own forecasting. Lucas: Right. So more common is a 'time-limited' cap – the cap applies only for the first year of the earnout, then steps up annually based on actual performance. That gives the seller some protection if the business takes off early, while still giving the buyer a ceiling in the near term. Luna: Let's talk about the one-in-a-thousand scenario. The FDA approval that quintupled the addressable market. In your composite deal, how did the buyer even justify such a low cap? Lucas: The buyer's argument was that the earnout was tied to revenue from existing commercial contracts, not from future regulatory approvals. They said the earnout was about execution, not luck. And they had the data to back it up: in the three years before the deal, the seller had never achieved more than eight million in annual revenue. The earnout target was twelve million. A five-million-dollar cap on a ten million dollar maximum earnout seemed generous relative to that track record. Luna: But the FDA approval was a binary event the seller had been pursuing. The buyer knew that risk was there. Lucas: Exactly. And that's where the seller's leverage was weaker than it should have been. The seller's legal team had not pushed for a 'regulatory approval' exclusion in the cap calculation. If they had, the cap might have been doubled to ten million, specifically for revenue tied to that approval. Luna: So the lesson is: if your business has a known binary catalyst – a patent, a regulatory filing, a key partnership – structure the cap around it explicitly. Lucas: That's exactly the takeaway. And the time to do it is in the term sheet, before the lawyers start drafting. Once you're in the definitive agreement, the cap is one of the hardest terms to move because it directly affects the buyer's internal rate of return calculations. Luna: What's the buyer's typical internal argument for a cap? They say it's about limiting 'windfall risk'? Lucas: Yes. But also about aligning incentives. If there's no cap – or a very high cap – the buyer worries the seller will focus only on the earnout metric to the detriment of the business's long-term health. For example, if the earnout is based on revenue, the seller might push for aggressive discounting that boosts top line but kills margins. The cap is supposed to signal that there's a limit to how much the buyer will reward that behaviour. Luna: But that logic only works if the cap is set at a level that doesn't demotivate the seller. A cap that's too low can make the seller feel like there's no point trying. Lucas: Exactly. I've seen deals where the cap was so low – like two times the earnout target – that the seller's team basically checked out after the first quarter. They hit the cap by month three, and then had no financial incentive to keep growing the business for the rest of the earnout period. The buyer ended up with a disengaged management team. Luna: So the cap can become a self-defeating prophecy for the buyer. Lucas: If it's set too tight, yes. The best caps I've seen are set at two to three times the realistic upside case, with a 'clawback' provision that lets the buyer recapture some of the earnout if the seller's actions cause long-term damage. That gives the seller room to benefit from real outperformance while still protecting the buyer from manipulated metrics. Luna: And from the seller's perspective, they need to model multiple scenarios – not just the base case. Lucas: Right. Run a 'blue sky' scenario that assumes every catalyst hits perfectly. Then ask: if this happens, what earnout would I feel is fair? That number should be your starting point for cap negotiations. And don't let the buyer anchor you with their own conservative model. Luna: This is the kind of practical insight that keeps these conversations grounded. And real talk – we're able to go deep on a topic like this because the show is listener-supported. No ads, no sponsors. Just a small group of people who find value in it and chip in on buy me a coffee dot com slash fexingo. That's literally what makes covering niche deal terms like this possible. Lucas: Yeah, and we don't say that lightly. It's because a handful of listeners take two minutes every month to support the show. That keeps us free from any outside pressure and lets us pick topics that matter to operators, not what an advertiser wants to hear. Luna: Exactly. So back to the cap – you mentioned the clawback. How common is that in mid-market deals? Lucas: It's becoming more common, but it's still rare – maybe one in five deals I've reviewed. And it's almost always paired with a higher cap. The buyer says, 'We'll give you a cap of ten million instead of six, but if we can prove that you cut R&D spending to inflate short-term earnings, we can claw back up to three million.' That trade-off can actually align incentives better. Luna: So the seller gets a higher ceiling, but with a guardrail against short-termism. Lucas: Exactly. And that guardrail is usually tied to a specific metric – R&D spend as a percentage of revenue, or customer satisfaction scores. Something that's a leading indicator of long-term health. Luna: Let's go back to the composite pharma deal. After the FDA approval, what happened to the seller's team? Lucas: They were frustrated, but they had signed the cap. They tried to renegotiate, but the buyer held firm. The seller's CEO later told me he regretted not pushing harder for a specific regulatory approval exclusion. He said he had focused on the earnout target itself – the twelve million – and assumed the cap was just a formality. He didn't model the one-in-a-thousand scenario. Luna: And that one-in-a-thousand scenario cost him potentially millions. Lucas: Cost the seller, and saved the buyer roughly two hundred million. That's the power of a well-placed cap. But it's also a cautionary tale for any operator selling their business. The cap isn't just a ceiling – it's a statement about who gets to benefit from the future you've built. Luna: And that future, as we've seen, can arrive faster than anyone expects.