Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / How the Earnout Structure Backfired on a Billion-Dollar Deal
Transcript
- Lucas: So you're selling your company for a hundred million dollars. But you don't get it all at closing. Some of it — maybe thirty, forty percent — gets paid out later, if you hit certain numbers. That's the earnout. Luna: And it sounds reasonable in theory. Keep the seller incentivized to stick around and grow the business post-deal. But in practice? Lucas: In practice, it often blows up. I was looking at a study from SRS Acquiom — about forty percent of earnouts underperform or fail outright. And when they fail, the relationship between buyer and seller deteriorates fast. Sometimes into litigation. Luna: That's a huge number. And if these conversations have moved your work forward in some small way — helped you think about your own deal structure, or avoid a pitfall — 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: Yeah, honestly, it's the listener support that lets us keep this ad-free and focused on the mechanics. Appreciate it. Lucas: Alright, so let's talk about a specific deal where the earnout backfired spectacularly. Back in 2021, a public company — let's call it TechCo — acquired a niche software firm called DataSync for about one point two billion dollars. The deal had a two-year earnout worth roughly three hundred million, tied to revenue targets. Luna: And those revenue targets? They were set based on DataSync's historical growth of about twenty-five percent a year. Lucas: Right. But after the deal closed, TechCo restructured the sales team, changed the compensation model, and shifted the product roadmap. DataSync's original management — who stayed on — had very little control over the resources they needed. Revenue grew only twelve percent in year one. Luna: So the earnout was missed. But was that the seller's fault? Or the buyer's integration decisions? Lucas: Exactly the question. The earnout contract said TechCo would use 'commercial best efforts' to achieve the targets. That phrase is incredibly vague. The sellers argued that changing the sales comp plan and pulling resources from the product line violated that clause. TechCo said they acted in good faith. Luna: And that ambiguity is exactly what litigators love. It ended up in Delaware Chancery Court, right? Lucas: Yes. The case dragged on for eighteen months. Eventually it settled — but not before both sides spent millions in legal fees and the earnout was essentially wiped out. The sellers got maybe ten cents on the dollar. Luna: So what's the lesson for someone structuring an earnout today? How do you avoid that outcome? Lucas: First, define 'best efforts' with specificity. Don't leave it to interpretation. Spell out what the buyer can and cannot change post-close — things like sales headcount, marketing spend, product roadmap. Some deals even include a clause that certain decisions require the seller's consent during the earnout period. Luna: Second, make the metrics truly objective. Revenue is often a bad metric because it can be influenced by accounting changes, channel mix, or pricing decisions the buyer controls. Lucas: Right. Better to use gross profit or EBITDA, or even a combination of financial and operational metrics. And think about the time horizon. Two years is common, but if the business has long sales cycles, maybe three to five years makes more sense. Luna: There's also the question of control. If the seller is staying on to run the business, the earnout should align with decisions they actually control. If the buyer is going to integrate rapidly, maybe an earnout isn't the right tool at all. Lucas: That's a key point. A lot of advisors say earnouts work best when the seller remains as a standalone CEO, not when they're folded into a larger division. The more integration, the more friction. Luna: And there's a tax angle too, right? Earnout payments are usually treated as contingent purchase price, which means capital gains treatment, but if the earnout is structured as a consulting or employment agreement, it can be taxed as ordinary income. Lucas: Yeah, that's a huge difference. Capital gains rates cap at twenty-three point eight percent with the net investment income tax, versus top ordinary rates of thirty-seven percent. So the structure matters not just for alignment, but for the seller's net proceeds. Luna: Let's go back to the DataSync case. Could they have structured the earnout differently to avoid the blowup? Lucas: I think so. If they had used a rolling twelve-month revenue target, with a floor and a cap, and tied it to specific metrics like customer retention and new logo acquisition, and if they had included a clause that any material changes to the sales comp plan required mutual consent — that might have survived the integration. Luna: But then the buyer might have pushed back on those protections, saying they need operational flexibility. Lucas: Right, and that's the tension. The earnout is a compromise. It bridges the valuation gap when buyer and seller disagree on future growth. But if the protections are too weak, the earnout is illusory. If they're too strong, the buyer won't agree. Luna: So what's the middle ground? I've seen some deals use a 'ratchet' mechanism — if the earnout is missed because of buyer actions, the seller gets a guaranteed minimum payout. Lucas: That's a smart approach. Another tool is the 'earnout insurance' product that's emerged in the last few years. You can buy a policy that covers the earnout payout if certain pre-defined events occur — like a change in control or a material integration decision. It's not cheap, but it can prevent litigation. Luna: And then there's the simplest fix: don't use an earnout at all. If the seller believes in the growth, they can roll equity into the acquiring company. That aligns incentives without the messy performance metrics. Lucas: Exactly. Rolling equity is cleaner. But it's less liquid, and the seller may not want to be a minority shareholder in a larger entity. So earnouts remain popular. According to SRS Acquiom, about sixty percent of private-target deals in 2024 included an earnout clause. Luna: That's surprisingly high. I would have guessed lower, given all the horror stories. Lucas: It's because they solve a real problem. When a buyer and seller are ten million dollars apart on valuation, an earnout can bridge that gap without either side walking away. The key is to design it with the same rigor you'd apply to the base purchase agreement. Luna: And to remember that the earnout period is really a second negotiation. The behavior during that period determines whether the earnout pays out or not. Lucas: Right. It's not a set-it-and-forget-it instrument. Both sides need to communicate regularly, agree on the interpretation of metrics, and have dispute resolution mechanisms in place. Some deals appoint a neutral third party — an accounting firm, say — to resolve disagreements on earnout calculations before they go to court. Luna: That's a good practice. Like an independent referee. Lucas: Yeah. And it's cheap relative to litigation. A lot of sellers don't realize that if they walk into an earnout dispute without a clear contractual resolution path, they're effectively handing over control of their payout to the buyer's discretion. Luna: So to wrap up: the earnout is a powerful tool, but it's also a minefield. The DataSync case shows how vague language and post-close integration can destroy value. For sellers, the takeaway is to define metrics clearly, protect your operational control, and consider insurance or ratchets. Lucas: And for buyers, remember that an earnout that feels unfair to the seller will poison the working relationship. If you're integrating a company, you want the seller motivated, not resentful. So design earnouts that are achievable and transparent. Luna: Amen to that. I think the next time I see a deal with a big earnout, I'll pay closer attention to the fine print. Lucas: Same. And maybe ask: is there a simpler way to bridge this gap? Because sometimes the best earnout is no earnout at all.