Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / How the Earnout Trap Strangles M&A Sellers After Close
Transcript
- Lucas: Let's talk about earnouts. They sound reasonable in the letter of intent — you sell your company for $45 million, and if you hit a $12 million EBITDA target in year two, you get another $12 million. It feels like a win-win. Luna: Right, the seller gets to participate in future growth, and the buyer defers some risk. What's not to like? Lucas: Except the data tells a different story. A 2024 study from SRS Acquiom looked at over 600 private M&A deals with earnouts and found that only about 35 percent of sellers collected the full amount. Nearly half collected nothing at all. And the average earnout period is two to three years — that's a long time to have your payout dependent on someone else's accounting. Luna: So the odds are stacked against the seller from the start. But I think the real pain comes from how the earnout is defined, right? Lucas: Exactly. Let me give you a concrete example. I spoke with a founder of an industrial parts distributor in Texas. He sold his business in 2023 for $45 million — $33 million at close, $12 million in an earnout tied to 2025 EBITDA. The earnout agreement said EBITDA would be calculated 'in accordance with the buyer's standard accounting policies, consistently applied.' That phrase — 'consistently applied' — is where the trap lives. Luna: Because the buyer can allocate overhead costs to the division after the sale. Corporate IT, HR, legal, even a portion of the CEO's salary. Lucas: That's exactly what happened. After the deal closed, the buyer started charging the acquired division $2.4 million a year in shared services costs that had never been allocated before. The seller's 2025 EBITDA came in at $8.3 million — well short of the $12 million target. The seller hired a forensic accountant, spent $400,000 in legal fees over two years, and eventually settled for $2.8 million. That's a $9.2 million shortfall on what he thought was a guaranteed payout. Luna: And the buyer's argument was that those allocations were 'consistent' with how they treat all their divisions. The seller signed off on that language in the purchase agreement. Lucas: Right. The earnout clause itself was only three paragraphs long. It didn't define what 'standard accounting policies' meant. It didn't cap allocated costs. It didn't specify a dispute resolution mechanism. The seller's lawyer flagged it during due diligence, but the seller was so focused on the headline $45 million that he didn't want to slow down the deal. He thought, 'I'll trust the buyer, we have a good relationship.' Luna: And relationships change after the check clears. The buyer's management team is incentivized to maximize their own division's EBITDA, and allocating costs to the acquired company helps them do that. Lucas: Exactly. So what should a seller do? First, never accept an earnout that's tied to EBITDA without a detailed definition in the agreement. You want to specify exactly which costs can and cannot be allocated. You want a cap on shared services charges — say, no more than 3 percent of revenue. You want the earnout calculation to be audited by an independent third party, and you want binding arbitration if there's a dispute. Luna: And ideally, you want to avoid earnouts altogether. What are the alternatives? Lucas: The best alternative is a fixed deferred payment — a promissory note that pays out over two or three years with interest, not tied to performance. The buyer still defers cash, but the seller's payout is guaranteed. Another option is a larger cash payment at close, even if that means a lower total valuation. Cash in hand is worth more than a potential future payment with a 35 percent chance of full collection. Luna: There's also the 'revenue-based earnout' as an alternative. If you tie the earnout to top-line revenue instead of EBITDA, it's harder for the buyer to manipulate. They can't allocate costs to reduce revenue. Lucas: That's a good point. Some sellers negotiate a hybrid — a smaller earnout tied to revenue, and the rest as a fixed note. But even then, you need to define revenue clearly. Is it gross revenue or net? Are returns and chargebacks deducted? The same principle applies: specificity is your only protection. Luna: Let's talk about the negotiation dynamics. If you're a seller and you push back on an earnout, the buyer might say, 'Well, that shows you don't have confidence in the business's future growth.' How do you counter that? Lucas: You flip it. You say, 'I have full confidence in the business. That's why I'm asking for a fixed payment. If I'm willing to take a lower total price in exchange for certainty, that's actually a signal of conviction. The earnout shifts risk to me that I can't control — your corporate allocations, your integration decisions, your management changes. I'm happy to be paid based on what I can control, which is the business performance pre-close.' Luna: And if the buyer still insists on an earnout, you can at least negotiate the terms. Cap the allocation costs, get a dispute mechanism, and shorten the earnout period from three years to one. Lucas: Exactly. The Texas seller I mentioned — he told me afterward that if he could do it over, he would have walked away from the deal rather than accept that earnout. He said, 'I spent two years of my life fighting for money I thought I already earned.' And that's the emotional cost that doesn't show up on any P&L. Luna: You know, episodes like this are exactly why we keep this show ad-free. We don't want to interrupt a conversation that might save someone $9 million with a commercial for a mattress or a meal kit. If you find this kind of practical, no-nonsense deal talk useful, you can support the show at buy me a coffee dot com slash fexingo. It's a simple way to keep this independent. Lucas: Yeah, we don't run ads, and listener support is what makes that possible. Appreciate anyone who chips in. Now, back to the earnout — one thing I want to emphasize is that earnouts aren't always bad. For a technology company with a new product that hasn't launched yet, an earnout can actually align incentives. The key is to understand where the risk lies. Luna: So when does an earnout make sense for the seller? Lucas: When the seller retains operational control during the earnout period. If you're staying on as CEO and you have authority over decisions that affect the earnout metric, you have some protection. But most earnout agreements don't give the seller that control — the buyer integrates the business, replaces the CFO, changes the sales team. Suddenly, you're a minority shareholder in your own company. Luna: And the earnout fails not because the business declined, but because the buyer's decisions changed the trajectory. Lucas: Exactly. There's a famous case from 2020 — a software company called Enviance sold to a larger industrial firm for $80 million with a $20 million earnout. The buyer moved the sales team to a different CRM, changed the pricing model, and reassigned key account managers. Revenue actually grew, but gross margins collapsed because of the new pricing. The earnout was calculated on gross profit, so the seller got almost nothing. Luna: So the seller is exposed to the buyer's operational decisions. That's the core problem. Lucas: Right. If you're a seller and you're considering an earnout, ask yourself: can I control the variables that drive the metric? If the answer is no, don't take the earnout. Take a lower fixed price. Your future self will thank you. Luna: And if you do take an earnout, get everything in writing. Specific definitions, caps, dispute resolution. Treat it like a litigation insurance policy. Lucas: That's the takeaway. The earnout trap isn't about bad faith — it's about asymmetric information and control. The buyer knows how they allocate costs. The seller doesn't. The buyer knows their integration plans. The seller doesn't. The only way to level the playing field is to negotiate the terms with the same rigor you applied to the purchase price. Luna: And if you need a template for what those terms look like, we'll put a link in the show notes to a sample earnout clause we've reviewed with M&A attorneys. Lucas: Good idea. Until next time, keep your eyes on the fine print.