Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The Earnout Trap That Cost a Seller $14 Million
Transcript
- Lucas: So you sell your company for $50 million, with an earnout that could pay you another $20 million if revenue grows 15 percent over the next two years. Feels like a nice upside kicker, right? Luna: On paper, sure. But earnouts have this dirty reputation in M&A for a reason. Lucas: They do. And the data backs it up. A study by the University of Chicago looked at several hundred earnouts and found that the median payout was only 55 percent of the target. So the average seller leaves nearly half the promised upside on the table. Luna: That's brutal. So the deck is kind of stacked against the seller from the start. Lucas: It is. And today's case — let's call it a mid-market logistics software company sold to a private equity-backed roll-up platform — illustrates exactly how it happens. The deal closed in early 2022. The seller, who we'll call Tom, had built the business over 15 years. Revenue was around $30 million, growing about 12 percent annually. Luna: So the earnout target — 15 percent growth — was achievable, but aggressive. Tom probably thought he could hit it. Lucas: Exactly. And the buyer offered $50 million at close plus an earnout of up to $20 million if Tom hit that 15 percent revenue compound annual growth rate over the next two fiscal years. Tom's advisors pushed back — they wanted a shorter earnout period, maybe 12 months — but Tom felt confident. He'd be staying on as CEO of the division. Luna: Staying on is key. He still had operational control, so he figured he could drive the growth himself. Lucas: That's the assumption. But here's where the trap snaps shut. The earnout agreement didn't just say 'revenue.' It defined revenue as 'consolidated revenue of the acquired entity as determined in accordance with the Buyer's accounting policies.' That one phrase — 'the Buyer's accounting policies' — is loaded. Luna: Because the buyer can change those policies after closing. Lucas: Exactly. And in this case, they did. Before the deal, the seller's revenue recognition was pretty standard SaaS-like: they recognized revenue when the software was delivered and the customer accepted. The buyer, post-closing, adopted a policy of recognizing revenue only after the customer paid — effectively cash basis for revenue. Luna: That would push revenue recognition out, potentially by months. Especially if customers had net-30 or net-60 terms. Lucas: Right. So in year one of the earnout, Tom's division grew bookings by 13 percent — solid, but bookings aren't revenue. Under the new policy, a lot of that growth didn't hit the revenue line until after the earnout period closed. So the reported revenue growth was only 9 percent. Luna: He missed the metric by six percentage points, almost entirely because of a policy change he didn't control. Lucas: And there's more. The earnout also had a definition of revenue that excluded 'non-recurring items.' The buyer later classified about $2 million of professional services revenue as non-recurring — even though the seller had booked that revenue stream for years. It was a standard implementation fee they charged on every new customer. Luna: So the buyer unilaterally decided that a recurring revenue stream was non-recurring, and the earnout language gave them room to do it. Lucas: Exactly. Tom fought it. He hired lawyers, sent formal dispute notices. But the earnout agreement had no audit clause — there was no mechanism for an independent accounting firm to review the buyer's calculations. So he was stuck arguing against the buyer's own interpretation, with no leverage. Luna: That's a huge red flag. Every earnout should have a provision that lets the seller audit the numbers. Lucas: You'd think. But a lot of seller-side attorneys don't push for it. In this case, the earnout period ended, Tom's maximum potential payout was $20 million. The buyer calculated he'd earned $6 million. They paid it, and that was that. Tom spent another $300,000 on legal fees trying to challenge it, and got nowhere. Luna: So his $20 million earnout was effectively worth $6 million. That's a 70 percent haircut. And he had no recourse. Lucas: Let's walk through what he could have done differently. First, define revenue in the earnout agreement with explicit reference to the seller's historical accounting policies. Pin it down. Say 'Revenue shall be calculated consistently with the Seller's historical accounting policies as set forth in Schedule X.' Don't let the buyer change the rules. Luna: And add a clause that any change in accounting policy requires mutual consent. Lucas: Exactly. Second, include an audit right. If there's a dispute, a neutral Big Four firm resolves it at the buyer's expense if the seller prevails. That alone changes the buyer's incentive to play games. Third—and this is the one Tom really missed—negotiate a minimum earnout floor. Say, 'If the earnout targets are not met due to a change in the buyer's accounting policies, the seller shall receive the earnout as if the targets had been met.' Luna: That's aggressive, but it puts the risk on the buyer for changing the rules. Lucas: It does. And a good buyer might push back, but it's a starting point. The broader lesson is: if you're a seller, treat earnout dollars as upside, not certainty. And if you can avoid an earnout altogether — take more cash at close — do it. The data says you'll probably come out ahead. Luna: Yeah, I've seen studies that show earnouts underperform the seller's expectations in something like 70 percent of cases. And the more complex the earnout, the worse the outcome. Lucas: And this is the kind of stuff that keeps showing up in our inbox, honestly. People write in and say, 'I wish I'd known this before I signed.' It's a big part of why we do these episodes. Luna: Absolutely. And if these conversations have moved your work forward in some small way, a couple of dollars a month is genuinely what keeps these going — buy me a coffee dot com slash fexingo, if you've gotten something out of them. Lucas: It really does make a difference. No ads, no sponsors — just listener support. So thank you to everyone who's chipped in. Luna: Alright, back to the earnout. So we've covered the accounting definition trap and the audit right. What other clauses should sellers watch out for? Lucas: The next big one is the 'efforts' clause. Some earnouts require the seller to use 'best efforts' or 'commercially reasonable efforts' to hit the targets. Sounds harmless, but it can be weaponized. In another case I saw, the buyer fired the seller ceo and then argued he hadn't used best efforts because he didn't achieve the growth — even though he'd been removed. Luna: So the clause was used against him retroactively. That seems like something a court would throw out. Lucas: Maybe, but litigation is expensive and slow. Better to make the earnout objective: tie it to actual performance metrics that are measured independently, not to subjective efforts. And if you're staying on as a manager, negotiate a separate employment agreement that protects your role for the earnout period — so they can't fire you and then claim you failed. Luna: So it's really about making the earnout as mechanical and verifiable as possible. Remove any room for interpretation. Lucas: Exactly. And here's a final twist: some earnouts include a 'catch-up' or 'look-back' provision, where if you miss in year one but beat in year two, you can get the full amount. That sounds seller-friendly, but often the catch-up is capped or computed in a way that still shortchanges you. Read the math carefully. Luna: So the lesson is: if you're a seller, assume the earnout will pay less than you expect, and structure it so it hurts as little as possible when it does. Lucas: Right. And if you're a buyer, well, earnouts can be a useful tool — but abusing them burns relationships and can lead to litigation. Tom's case never went to court, but the buyer's reputation in the market took a hit. They had trouble recruiting seller-CEOs for their next roll-up. Luna: So karma has a way of showing up in deal flow. Lucas: It does. So to sum up: define your terms concretely, get audit rights, push for a floor, and treat earnout dollars as a bonus, not a guarantee. That's how you avoid losing fourteen million dollars on a handshake. Luna: Well said. That's it for this episode of The Acquisition Talk. We'll see you next time.