Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The Earnout Milestone Definition That Cost a Seller 25 Million
Transcript
- Lucas: Twenty-five million dollars. That's what a seller walked away from in a deal that closed in 2024, all because one phrase in the earnout clause — 'successful commercial launch' — wasn't defined anywhere in the purchase agreement. Luna: Oof. That's a big number. So the buyer just decided the launch wasn't successful and kept the money? Lucas: Basically, yeah. The seller thought they'd hit the milestone — they had a signed contract with a major distributor, product was in warehouses, first shipments were going out. But the buyer pointed to the language and said a commercial launch means sustained revenue over two quarters. The seller's interpretation was about activity; the buyer's was about results. Luna: So it comes down to interpretation. And I'm guessing the contract didn't help. Lucas: Right. And that's what we're digging into today — the earnout milestone definition. Prior episodes covered earnout traps from the seller's side and the adjustment side, but this one is specifically about how a milestone gets defined, or not defined, and what it costs. Luna: Honestly, if today's episode saves you from losing twenty-five million, that's worth a coffee. And the link for that is buy me a coffee dot com slash fexingo. Low-key, no pressure, just if the show's been useful to you. Lucas: Yeah, and it's what keeps this podcast ad-free. So if you've ever taken a tip from this show to a negotiation, that's a great way to pay it forward. Anyway, let's get into the mechanics. Lucas: So the earnout in question was tied to a milestone: 'successful commercial launch' of the company's flagship product. The buyer was a larger strategic player, the seller was a founder-led med-tech firm. The earnout was worth up to 25 million, paid over two years. Luna: And the founder assumed everyone knew what a successful launch looked like. Classic. Lucas: Classic indeed. The purchase agreement defined 'earnout period,' 'earnout payment,' even 'net revenue,' but 'successful commercial launch' was left undefined. The seller's lawyer apparently flagged it in a comment, but the suggestion to add a definition was never incorporated — it just fell out of the negotiation. Luna: So the milestone was basically a blank check for the buyer to interpret. What happened after closing? Lucas: The seller did everything they thought was necessary: they secured a distribution agreement with a national chain, the product passed regulatory checks, and they shipped initial orders. But revenue was slow — the product had a long sales cycle, and by the end of the first year, only about 2 million of the projected 8 million in sales had materialized. Luna: So the buyer looked at that and said, 'Not a successful launch.' Lucas: Exactly. The buyer argued that a launch isn't successful until it generates meaningful, sustainable revenue. They pointed to the fact that the product hadn't gained traction in the market. The seller countered that the launch was successful because they had achieved the operational milestones — distribution, logistics, first sales. Luna: I imagine the seller's argument was 'we did everything we could control.' But the contract didn't say that. Lucas: Right. And the dispute went to arbitration, as these things do. The arbitrator looked at the plain meaning of 'successful' and the context of the deal — the buyer paid a premium based on projections, so they expected revenue. The arbitrator sided with the buyer, and the seller got zero of the 25 million. Luna: Ouch. So what could the seller have done differently? I'm guessing 'define the milestone' is step one. Lucas: Step one, absolutely. But there's a nuance. Even if you define it, you need to be careful about what you're measuring. Here, the seller could have defined 'successful commercial launch' as 'the first commercial sale to an unrelated third party' or 'the execution of a distribution agreement with a national retailer.' That would have been objective and outside the buyer's control. Luna: So instead of 'successful', you want something like 'the date the first purchase order is received.' That's hard to argue with. Lucas: Exactly. The more objective, the better. But there's a second trap here: even if you have an objective definition, the buyer can still try to argue that the milestone wasn't met because of some other clause, like a material adverse change. So you need to tie the definition to specific, verifiable events that the buyer can't manipulate. Luna: And I'm guessing the seller also didn't have any dispute resolution mechanism that favored them? Lucas: Well, the arbitration clause was standard — one arbitrator, governed by the state's commercial code. But the seller could have insisted on a specific process, like a joint determination with an independent third party if the buyer disputed. That would have leveled the playing field. Luna: So what's the lesson for sellers listening today? If you have an earnout, what should you check before signing? Lucas: First, every milestone should be defined with objective criteria. Don't leave room for 'successful' or 'satisfactory' or 'commercially reasonable.' Second, define the measurement period and the data source. Third, include a dispute mechanism that is balanced. And fourth, think about what happens if the buyer changes the business — if they kill the product, you should still get your earnout. Luna: That last one is key. What if the buyer deliberately underperforms? There's a term for that, isn't there? Lucas: Yeah, it's called 'non-compete' or 'covenant to use best efforts.' In this deal, the buyer had a 'best efforts' clause, but it was vague. The seller argued that the buyer didn't promote the product aggressively, but the buyer said they did. Without specific metrics — like 'the buyer shall allocate at least X dollars to marketing in the first year' — it's hard to prove. Luna: So the moral of the story is: earnouts are dangerous if you're not specific. But they can be structured well. What's an example of a well-defined milestone? Lucas: A good example is in software deals: 'the achievement of gross recurring revenue of $10 million as measured by the company's standard accounting practices, excluding revenue from existing customers.' That's specific, it has a number, and it excludes double-counting. Another is in biotech: 'the receipt of FDA approval for the investigational new drug application.' That's a concrete event. Luna: Right. So you want to tie the earnout to something that's binary — either it happened or it didn't. Lucas: Or to a measurable outcome that can be verified. And the best practice is to attach a schedule to the agreement that defines every term that could be ambiguous. That way, 'successful commercial launch' becomes 'the date of the first commercial sale to a third-party customer, as evidenced by a written purchase order.' Done. Luna: That's the kind of thing that would have saved those 25 million. Do you have a sense of how common this is? Are there stats on earnout disputes? Lucas: Studies suggest that about 60 to 70 percent of earnouts fail to pay out in full, and a significant chunk of those disputes center on milestone definitions. It's the wild west out there. But there are things you can do to protect yourself. Luna: Like what? Give us the checklist. Lucas: One: define every milestone with objective, verifiable criteria. Two: specify the measurement method — what data, who provides it, and when. Three: set a maximum earnout period and avoid perpetual earnouts. Four: include an acceleration clause if the buyer breaches their obligations. And five: have a dispute mechanism that doesn't automatically favor the buyer — for example, an independent expert who is not an arbitrator but a technical specialist. Luna: That's a solid list. But the hardest part is getting the buyer to agree to those protections, especially when they're the ones with the leverage. Lucas: That's true. But remember, you can trade other terms for a more favorable earnout—like a lower purchase price for a more defined milestone. Buyers often prefer a cleaner earnout because it reduces their own risk of litigation. So it's not a lost cause; it's a negotiation. Luna: So if listeners are heading into a sale with an earnout, the biggest takeaway is to make the milestone definition almost boringly precise. Boring means safe. Lucas: Exactly. Boring and bulletproof. As we close, I want to leave you with this: that seller walked away with nothing but a lesson. But you don't have to repeat that mistake. Take the extra hour to define your milestones, and it could be the difference between a windfall and a nightmare. Luna: And if you want to hear more stories like this, don't forget to check out our earlier episodes on working capital traps and reps and warranties. Until next time, keep your contracts tight.