Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The M&A Earnout Accounting Trap That Cost a Founder $1.2 Million
Transcript
- Lucas: You sign a deal with a $3 million earnout tied to hitting a net new sales target. You hit the number. But the acquirer tells you your earnout is worth $1.8 million — not $3 million. And they have a signed contract that says they're right. Luna: That sounds like the kind of fine print that makes founders bitter for years. What was the trap? Lucas: The trap was in how the earnout defined 'net new sales.' The seller — a B2B SaaS company called Coalesce Analytics — had a standard subscription model. They sold one-year contracts for $120,000, recognized ratably over twelve months. The earnout clause said the target was $2 million in net new sales, measured as total contract value booked during the earnout period. Luna: And they booked $2.1 million in new contracts. So what went wrong? Lucas: The acquirer — a larger private equity-backed rollup — used a different revenue recognition method. They treated multi-year subscriptions as month to month for internal accounting, under ASC 606. That meant the $2.1 million in contract value was recognized as roughly $175,000 per month. And the earnout administrator — an accountant hired by the buyer — ruled that 'net new sales' meant revenue recognized during the period, not contract value signed. Luna: So the earnout only paid out on the recognized revenue slice. That's brutal. But is that standard? I've seen earnouts defined as bookings, not revenue. Lucas: It's common to use bookings, but plenty of acquirers push for 'recognized revenue' because it aligns with their financial reporting. The problem is, if the definition isn't explicit about method — and if it doesn't lock the buyer into the seller's pre-acquisition accounting — the buyer can change the recognition pattern post-close and shrink the earnout. Luna: I remember a case where a hardware company's earnout was tied to units shipped, but the acquirer changed the definition of 'shipped' to 'delivered and accepted by the end customer.' Same kind of squeeze. Lucas: Exactly. And the Coalesce story gets worse. The founder had a lawyer review the earnout clause. The lawyer flagged that the definition was ambiguous — it said 'net new sales as determined in accordance with GAAP.' But GAAP gives companies choices, especially around revenue recognition. The lawyer asked for a clarification, but the buyer's counsel said it was standard language and the founder didn't push. Luna: That's the moment where a $1.2 million mistake was made. If these conversations have moved your work forward in any way, we keep this podcast ad-free because of listener support. If you've gotten value from episodes like this, you can help at buymeacoffee.com/fexingo. Even a small contribution helps us keep digging into these real-world deal traps. Luna: Yeah, it's a good reminder that what seems like a small concession can cost you millions. So the founder didn't push, and then the earnout period starts. What happened next? Lucas: The earnout period was 18 months. The founder's team sold $2.1 million in new contracts. But the acquirer's accounting team recognized only $1.05 million of that as revenue during the period, because they spread multi-year deals over longer terms. The earnout administrator applied the 'recognized revenue' interpretation, and the payout was calculated at 50 percent of target — $1.5 million, minus a $300,000 holdback for potential refunds. Net: $1.2 million. Luna: So the founder got $1.2 million on a deal where they thought they'd get $3 million. And the acquirer got to book the remaining $900,000 of recognized revenue for free, essentially. Lucas: Right. The earnout was designed as an incentive, but the accounting arbitrage turned it into a discount. The founder tried to dispute it, but the earnout clause had a 'determination by the acquirer's accountant, whose decision shall be final and binding' language. No dispute escalation process. No independent arbitrator. Luna: That's a huge drafting failure. I always tell founders to demand a dispute resolution mechanism for earnouts. Even a simple escalation to a mutually agreed third-party accounting firm. Lucas: And the Coalesce case shows why. Without that, the founder had no leverage. They could sue, but that's expensive and risky. Most founders won't sue their acquirer — they have relationships, ongoing earnout periods, or just don't have the cash for litigation. Luna: So what's the fix? What should a founder put in the earnout clause to avoid this? Lucas: I think there are three key protections. First, define 'net new sales' explicitly as contract value booked, using the same revenue recognition method the seller used historically. Second, lock the accounting method — require the acquirer to maintain that method for earnout purposes regardless of any change in their own accounting. Third, include a dispute escalation clause, ideally with an independent accounting firm binding on both parties. Luna: And what about the earnout administrator? The buyer's accountant in this case was clearly incentivized to minimize the earnout. Lucas: That's another issue. Ideally, the administrator should be a neutral third party, not the buyer's auditor. But buyers often resist because they say it's their financial statements. The compromise is to agree that the administrator will follow a pre-defined methodology, and that any dispute goes to a neutral referee. Luna: I've also seen earnouts where the definition of 'revenue' excludes any revenue from existing customers, even upsells. That's another trap. Lucas: Yes. In Coalesce's case, the earnout counted all new sales to new customers only. That's common. But if the buyer reclassifies an existing customer as a new entity — say, a subsidiary — that can also shrink the pool. The devil is in the definitions. Luna: I want to go back to the dispute mechanism. You mentioned a third-party accounting firm. But who pays? And how do you ensure it's truly independent? Lucas: Typically, both parties split the cost. The independence comes from picking a firm with no prior relationship — like a Big Four firm that hasn't done work for either side in the past three years. You can also specify that the firm must be a member of the PCAOB, which adds a layer of accountability. Luna: Let's talk about the timeline. The Coalesce earnout was 18 months. That's a long time to be in limbo. Does the earnout accounting trap get worse over longer periods? Luna: Yes, because the longer the period, the more opportunities for the buyer to change accounting methods, reorganize, or shift revenue recognition. Also, the founder's team often leaves during the earnout, so there's less ability to monitor or push back. Lucas: So shorter earnout periods — 12 months or less — reduce the risk. But they also reduce the potential payout. It's a trade-off. Luna: What about the specific metric? In the Coalesce case, it was revenue. But I've seen earnouts tied to gross profit, EBITDA, or even customer retention. Each has its own accounting traps. Lucas: EBITDA earnouts are notorious for adjustments. Buyers can allocate more corporate overhead to the acquired unit, or change depreciation methods. Gross profit can be distorted by changes in cost allocation. The general principle is: the more complex the metric, the more room for accounting discretion. Luna: So the safest earnout metric is something simple — like cash received from new customers. Hard to manipulate. Lucas: Exactly. Cash is hard to fudge. But buyers often push for GAAP metrics because they want alignment with their financial reporting. The seller's job is to build in protections. Luna: One more thing: the earnout in the Coalesce case had a 'good leaver/bad leaver' clause tied to the founder's employment. Did that play a role? Lucas: Not in this case, but it's a related trap. If the founder is required to stay employed and is terminated without cause, they might lose the earnout. That's another layer of risk. The Coalesce founder stayed employed, but the accounting trap was enough. Luna: So what's the takeaway for a founder negotiating an earnout today? What's the one thing they should focus on? Lucas: I'd say: define the metric with surgical precision, lock the accounting method, and never accept a 'final and binding' determination by the buyer's accountant. If you can get that, you've closed the biggest holes. Luna: And maybe add a minimum payout floor. Some earnouts have a guaranteed minimum regardless of accounting interpretations. Lucas: That's a great point. A floor protects against total loss. But buyers resist it because it reduces the incentive effect. Still, it's worth asking for. Luna: Alright, next time we'll look at another earnout trap — the one where the buyer changes the sales compensation structure to depress performance. That's a fun one. Lucas: It's a classic. See you then.