Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / How Earnout Fraud Is Quietly Killing Indie M&A Deals
Transcript
- Lucas: There's a deal I keep coming back to because it tells you everything that's broken about earnouts right now. A Texas-based SaaS company — let's call it 'ClearEdge' — sold to a publicly traded vertical software roll-up for $120 million upfront, with a $45 million earnout tied to hitting year-two revenue targets. Luna: Forty-five million — that's a massive chunk of the total consideration. Almost thirty percent. Lucas: Exactly. And the earnout structure looked clean on paper: clear metrics, third-party auditor, no subjective milestones. But by month ten, ClearEdge's sales pipeline had mysteriously collapsed. The buyer had redirected inbound leads to a different division and stopped funding the sales team's demo budget. Luna: So the buyer actively sabotaged the earnout? That's not a market miss — that's fraud. Lucas: That's the argument. And this isn't a one-off. I've now seen at least a dozen similar cases in the last eighteen months. The pattern is so consistent that there's a name for it in M&A advisory circles: 'earnout harvesting' — where the buyer deliberately tanks the earnout metrics, then claims the seller's business just didn't perform. Luna: And the seller has no recourse because the earnout contract usually says 'commercially reasonable efforts' — which is the vaguest phrase in dealmaking. Lucas: Exactly. 'Commercially reasonable efforts' is a black hole. So let's walk through the three specific red flags that showed up in the ClearEdge deal, and then talk about what sellers can put in their contracts to prevent this. Luna: I want to hear the red flags, but first — what's the ethical angle here? I mean, the buyer's shareholders are theoretically benefiting from a cheaper acquisition, but at the cost of litigation and reputational damage. Lucas: Short-term gain, long-term pain. But the calculus seems to be: the earnout amount is often larger than the legal costs of defending a lawsuit, and most sellers don't have the cash to litigate against a public company. So the buyer bets that the seller will just walk away. Luna: That's deeply cynical. Okay, red flag number one. Lucas: Red flag one: intentional underinvestment. In the ClearEdge case, the buyer cut the sales team's demo budget from $80,000 per quarter to zero. No explanation. The sales team couldn't run product demos for three months. Prospects went cold. Luna: Zero demo budget? That's not 'commercially reasonable' by any stretch. That's a deliberate choke. Lucas: Right. And it's hard to prove because the buyer can say 'we were reallocating resources to higher-priority units.' But if you have a clause that requires the buyer to maintain at least the same level of operating expenditure on the acquired unit during the earnout period, you have a contractual leg to stand on. Luna: That's a 'maintenance of effort' clause. I've seen those in government contracts, but rarely in M&A. Lucas: And they should be standard. Red flag two: revenue manipulation through channel stuffing. Another case — a CPG brand with an earnout tied to gross revenue. The buyer loaded the channel with six months of inventory in month eleven, recognized the revenue, then the earnout triggered — but the next six months had zero reorders because the channel was bloated. Luna: So the buyer front-loaded revenue to hit the target, then left the seller with a dead channel and no ongoing business. That's especially nasty because on paper they hit the number. Lucas: Exactly. And the earnout language usually says 'GAAP revenue' — which allows channel stuffing as long as the revenue recognition is technically compliant. So you need a clause that excludes non-ordinary-course revenue, or that adjusts for changes in channel inventory levels. Luna: I know some deals use a 'quality of revenue' test — like measuring repeat purchase rates or customer churn alongside the raw revenue number. Lucas: That's exactly the direction. And red flag three: the 'straw man CEO' trap. The buyer installs a new CEO for the acquired unit who has no real authority. The real decisions are made by a separate integration team that the seller has no visibility into. Luna: So the earnout metrics are being managed by people who don't report to the earnout manager. Lucas: Exactly. In one deal, the buyer appointed a former VP from their own company as the 'CEO' of the acquired business. But he had no P&L control. The integration team — which reported to a different executive — was making all the resource decisions. The earnout failed. The seller sued, but the buyer argued that the earnout agreement only obligated the CEO to use reasonable efforts, and the CEO had no authority over the integration team. Luna: That's a structural loophole. The fix would be to require that the earnout decision-makers are the same people who control the resources. Lucas: Exactly. You want a clause that says: the person responsible for the earnout must have direct authority over all operational decisions affecting the business, including sales, marketing, product, and hiring. Luna: So if a listener is an indie founder negotiating an earnout right now, what's the single most important structural change they should ask for? Lucas: I'd say the 'earnout protector' clause — a specific provision that gives the seller a right to audit the buyer's actions during the earnout period, with the ability to pause the earnout if the buyer is acting in bad faith. And if the buyer disputes, the burden of proof is on them, not the seller. Luna: That shifts the dynamic completely. Instead of the seller having to prove fraud after the fact, the buyer has to prove they acted in good faith during the earnout. Lucas: And we're starting to see this clause in bigger deals. The law firm Wilson Sonsini now includes a version of it in their standard earnout templates. That's a signal that the market is recognizing the problem. Luna: Look, we dig into these structural details every episode because we believe this kind of knowledge keeps operators from getting burned. And that's also why we've always kept this show ad-free — no sponsors, no commercials, no interruptions. Lucas: It's a deliberate choice. We want the conversation to be clean, focused on what matters to you. If these episodes help you negotiate a better deal or avoid a bad one, that's the goal. Luna: And if they've moved your work forward in some small way, there's a simple way to support that: buy me a coffee dot com slash fexingo. No pressure, just a link for anyone who wants to keep the show ad-free. Lucas: Right. Back to the earnout. One more structural fix I want to mention: the carve-out audit right. This lets the seller audit not just the earnout metrics, but also the buyer's internal allocation of resources — like that demo budget we talked about. Luna: So you can see if they deliberately starved the business. That's powerful. Lucas: And it's surprisingly cheap to include. A one-page addendum to the earnout section. Most buyers won't push back hard because it looks reasonable. But if they do push back — that's a red flag in itself. Luna: I want to end with a bigger picture question. If earnout fraud is becoming more common, does that mean earnouts themselves are a flawed instrument? Or is it just that contracts need to catch up? Lucas: I think earnouts are still useful for bridging valuation gaps, especially when there's uncertainty about future performance. But the contract needs to reflect the reality that the buyer controls the environment. The old assumption — that both parties will act in good faith — is naive. Luna: So the fix is contractual, not structural. Better clauses, not abandoning earnouts. Lucas: Exactly. And the market is moving in that direction. I've seen two deals this quarter alone that included a 'good faith earnout management' covenant with a penalty clause — if the earnout fails due to buyer actions, the seller gets the earnout amount anyway, plus interest. Luna: That's a clean solution. It aligns incentives: the buyer only profits if the earnout succeeds honestly. Lucas: And that's the bottom line. Earnouts can work, but only when the contract treats the buyer as a potential adversary, not a trusted partner. The next time you see an earnout in a term sheet, ask yourself: does this contract protect me if the buyer decides to cheat?