Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / How Earnouts Misalign Seller and Buyer Incentives
Transcript
- Lucas: Let’s talk about the part of the deal that kills more relationships than any other clause: the earnout. Most operators think an earnout is just a way to bridge a gap in valuation, right? You want five million, I’ll give you three now and promise two more if things go well. It sounds like a win-win until you realize the buyer controls the definition of 'well.' Luna: Exactly. And once the ink dries, the seller is no longer running the business; they’re running toward a metric that the new owner can tweak at will. I’ve seen founders work for eighteen months after closing only to have their target moved because of a 'strategic pivot' by the acquirer. Lucas: Right, and the structural issue is that the buyer’s incentive post-close is to minimize integration costs, not necessarily to maximize the seller’s upside. If the buyer is a private equity firm, they might use your revenue as a lever to pay down debt or invest in their next bolt-on acquisition. Your payout becomes secondary to their internal rate of return calculations. Luna: It creates this perverse dynamic where the founder is essentially working for free during the transition period, carrying all the operational risk while the buyer holds the purse strings. Lucas: Let’s look at a concrete example from last quarter involving a mid-market industrial software company. The seller agreed to an earnout tied to customer retention rates above ninety-five percent. But here is the catch: the buyer immediately changed their CRM system and paused all proactive account management. Suddenly, churn spiked naturally, and the seller was denied the payout because they failed to meet a metric the buyer had actively undermined. Luna: That is brutal. Did the contract specify who owned the customer relationship during the transition? Lucas: Vaguely. It said the seller would 'continue to support key accounts.' But it didn’t define resource allocation or budget. When the buyer decided to centralize support and cut headcount to hit their first-year synergy targets, the seller had no leverage to stop them. They were stuck between a rock and a hard place. Luna: So the lesson isn't just to negotiate harder, but to write clauses that protect the operational independence required to hit those targets. Lucas: Precisely. You have to lock in the 'operating covenant.' That means specifying that the buyer cannot materially change the product roadmap, pricing model, or sales force structure in a way that negatively impacts the earnout metrics. Without that, you are gambling with your own money. Luna: I wonder how many sellers sign these deals because they’re afraid the buyer will walk away if they push back too hard on the terms. Lucas: Fear is the primary driver. Buyers know this. They offer earnouts to reduce their upfront cash outlay and shift risk to you. But if you’re too scared to negotiate the safeguards, you end up with a paper victory that turns into a financial loss. It’s a classic information asymmetry play. Luna: It feels less like a partnership and more like a loan with unfavorable terms disguised as a bonus. Lucas: Let’s take a brief pause here to acknowledge the people who keep this show going. A handful of listeners chip in monthly through buy me a coffee dot com slash fexingo, and that's literally what funds making this many of these. No ads, just good conversations funded by the community. Luna: Yeah, and if you’ve found value in our deep dives into deal structures, consider joining that small group of supporters. It really helps us keep producing independent analysis like this. Lucas: Back to the mechanics. One common mistake sellers make is tying the earnout to revenue instead of profit. Revenue is easy to manipulate. A buyer can overpay for marketing or lower prices to boost top-line growth while eroding margins. Profit is harder to fake, but it’s also easier to destroy through cost allocations. Luna: Right, because the parent company can allocate corporate overhead, legal fees, or shared service costs to the subsidiary, driving down reported profit even if the core business is healthy. Lucas: Exactly. That’s why so many modern deals are moving toward ebitda based earnouts with very strict definitions of add-backs. You need to agree upfront on what counts as normal operating expense versus one-time charges. If you don’t, you’ll spend years in litigation fighting over accounting entries. Luna: It sounds like the key is transparency before the close, not negotiation after. You have to map out every possible scenario where the metric could be skewed. Lucas: Correct. And another layer is the timeline. Some earnouts stretch out over three or four years. That’s an eternity in business. What happens if the buyer sells the division again within two years? Does the earnout survive? Usually, the new owner has no obligation to honor the previous seller’s agreement unless it’s explicitly spelled out in the stock purchase agreement. Luna: So you’re basically holding a note that could disappear if the asset changes hands. That adds a huge layer of uncertainty to your personal financial planning. Lucas: It does. And that uncertainty often forces founders to stay employed longer than they want, just to keep chasing the remaining tranches of their payout. They become trapped employees. I’ve seen cases where founders left lucrative jobs elsewhere because they were blocked by non-compete clauses attached to the earnout. Luna: That’s the human cost. It’s not just about the money; it’s about the career trajectory being hijacked by a deal term. Lucas: One structural fix is to include a 'change of control' provision. If the buyer sells the business, the earnout should either accelerate fully or convert into a standard warranty indemnification claim. That way, if the asset is flipped, you get paid fairly based on its value at that moment. Luna: Acceleration is tricky though. Buyers hate paying out early when they haven’t achieved the synergy yet. How do founders push for that without losing the deal? Lucas: You frame it as alignment. You tell them, 'If you sell the business, you’re capturing the value I helped build. Let’s share that upside.' It’s a fair argument. If they refuse, it signals they might be planning to strip the assets rather than grow them, which is a red flag anyway. Luna: Smart framing. It turns a defensive request into a test of their strategic intent. Lucas: Another nuance is the role of the seller’s management team during the earnout period. If the founder stays on as CEO, they have direct influence. But if they move to a consultant role, their power vanishes. Most deals require the seller to stay for two years. That’s a long time to be a passenger in your own company. Luna: And if they try to innovate or improve efficiency, they might inadvertently trigger a breach of the earnout if it disrupts short-term stability. The risk aversion kicks in hard. Lucas: Spot on. Sellers often find themselves suppressing growth initiatives because they’re terrified of missing a quarterly target. They choose safety over ambition, which ultimately hurts the business and their own payout. It’s a self-fulfilling prophecy of mediocrity. Luna: So the best advice is to avoid earnouts if possible? Or at least cap them tightly? Lucas: Cap them, yes. Never let an earnout exceed thirty percent of the total enterprise value. Anything more is speculative income, not guaranteed compensation. And always, always get legal counsel who specializes in M&A earnouts, not general corporate law. The language matters more than you think. Luna: Specialized counsel is expensive, but compared to losing millions in a disputed payout, it’s cheap insurance. Lucas: Absolutely. The cost of the lawyer is negligible compared to the potential windfall—or loss. Most operators skimp on the fine print thinking it’s boilerplate. It is not boilerplate. It is the entire game. Luna: It’s interesting how much psychology is involved. Trust is assumed, but the structure incentivizes suspicion. Lucas: Right. An earnout is essentially a bet against each other. The seller bets the business will thrive; the buyer bets it will stagnate under new management. You need to design a mechanism that makes them bet together instead. Luna: By locking in operational independence and defining metrics that both parties can genuinely influence. Lucas: Exactly. When the incentives are aligned, the earnout works beautifully. When they’re misaligned, it’s a disaster waiting to happen. Know which one you’re signing. Luna: A powerful reminder that the devil is always in the details of the deal structure. Lucas: If you’re reviewing a term sheet right now, ask yourself one question: if everything goes wrong, do I still have a path to get paid? If the answer is no, rewrite the clause.