Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The Earnout Seller's Best Friend: The Independent Arbitrator Clause
Transcript
- Lucas: So last week I was on the phone with a founder who sold his software company for forty million dollars, with an earnout that could add another eight. And he told me the earnout calculation came in at just under a million. He was furious, because he'd built the metrics himself, and by his own books, he was owed close to five. Luna: And I'm guessing the purchase agreement didn't have an independent arbitrator clause. Lucas: Exactly. The agreement said the earnout would be calculated by the buyer's CFO, in accordance with generally accepted accounting principles, and that the CFO's determination would be final and binding. There was no mechanism for the seller to challenge it. Luna: So the seller had zero recourse. He could sue, but that's expensive and slow, and the buyer knows it. Lucas: Right. And this is a pattern I see all the time. The seller focuses on the headline earnout number, but the real battle is over who gets to compute it. If the buyer's CFO is the sole decider, the seller is basically giving away the store. Luna: What's the fix? I mean, you mentioned the independent arbitrator clause. How does that actually work in practice? Lucas: So the fix is a clause that says, if the buyer and seller disagree on the earnout calculation, they'll hire a neutral third party — usually a CPA or a valuation firm with experience in the specific industry — to review the numbers and make a binding determination. Luna: And that person is the independent arbitrator. Lucas: Exactly. But the key is the details. You need to specify how the arbitrator gets selected, who pays, what happens if they can't agree on a candidate, and what standard of review they apply. Without those details, the clause can be toothless. Luna: Give me an example of a toothless version. Lucas: Sure. I've seen agreements that say something like, 'disputes will be resolved by a mutually agreed upon accounting firm.' But they don't say what happens if the parties can't agree on the firm. So the buyer can just refuse to agree, and the deal stalls. Luna: So the clause becomes a dead letter. Lucas: Exactly. A strong clause will include a mechanism like, if the parties can't agree within thirty days, then each side picks a candidate, and the two candidates select a third. That third person is the arbitrator. That way, there's always a path to resolution. Luna: And who pays for the arbitrator? Usually, in my experience, the costs are split, or the losing party bears the full cost. Lucas: Both are common. Splitting the cost is fair, but it can still be expensive — a good arbitrator might charge five hundred to a thousand dollars an hour. But if the earnout is worth millions, that's a rounding error. Luna: So the cost is rarely the real obstacle. The real obstacle is that sellers don't think to ask for this clause. Lucas: Right. And that's because they're so focused on the earnout number itself that they neglect the formula. I always tell sellers: 'You're not just negotiating the earnout. You're negotiating who gets to do the math.' Luna: That's a great line. And I think it's worth getting into the weeds a bit. What are some of the other details that can make or break an independent arbitrator clause? Lucas: One big one is the standard of review. You want the arbitrator to apply a 'materiality' standard — meaning they only overturn the buyer's calculation if the difference is material, say, more than five percent. If the clause says the arbitrator can just pick the number they think is right, you get a different dynamic. Luna: So you want the arbitrator to be a referee, not a replacement for the CFO. Lucas: Exactly. You don't want a second guesser. You want someone to catch the egregious errors, not to re-litigate the whole earnout. And that also helps keep the process efficient. Luna: What about the specific expertise of the arbitrator? For a software company, you probably want someone who understands SaaS metrics and revenue recognition, not just a general accountant. Lucas: Absolutely. That's why you want to specify that the arbitrator has experience in the company's industry. For a software business, you might say, 'a CPA with at least ten years of experience in software revenue recognition.' Otherwise, you could get a general accountant who doesn't understand how recurring revenue works. Luna: And that could be a disaster. Lucas: It can be. I remember a case where a manufacturing company had an earnout tied to gross profit, and the arbitrator didn't understand how the company allocated overhead. He ended up making a decision that cost the seller twenty million dollars. Luna: That's brutal. So the lesson is: you need the right person, and you need the right process. Lucas: Exactly. And that brings me to a related concept: the difference between an independent arbitrator and an appraiser. An appraiser is typically used to value assets or equity, not to determine earnout payments. An arbitrator is more like a judge. They hear arguments, review evidence, and make a binding decision. Luna: So for an earnout dispute, you want an arbitrator, not an appraiser. Lucas: Right. And that distinction matters because some agreements mistakenly say 'appraiser' when they mean 'arbitrator.' An appraiser might not have the authority to rule on disputed calculation methods, and they might not follow the same procedural rules. Luna: That's a subtle but crucial difference. And I imagine the same goes for the term 'expert determination' — some jurisdictions use that instead of arbitration. Lucas: Yes, 'expert determination' is a valid alternative, and it can be faster and cheaper than formal arbitration. But the key is that the expert is truly independent, and the clause specifies the scope of their authority. I've seen expert determination clauses that limit the expert to reviewing just the arithmetic, not the accounting methodology, which defeats the purpose. Luna: So you really need to be specific about what the arbitrator or expert is allowed to review. Lucas: Absolutely. And that's why I always recommend that sellers engage a good M&A attorney who specializes in earnouts. They know how to draft these clauses to protect you. But even before that, the seller should understand the basic mechanics, so they can ask the right questions. Luna: What would you say is the single most important sentence a seller should add to their agreement? Lucas: I'd say: 'Any dispute regarding the calculation of the earnout payment shall be resolved by an independent arbitrator with industry-specific expertise, selected as follows...' And then you fill in the details. Luna: And one practical tip: you might want to include a timeline for the dispute resolution process. Otherwise, it can drag on for months, and the seller might be out of cash by the time the arbitrator rules. Lucas: Great point. A typical timeline might be forty-five days to appoint the arbitrator, then another sixty days for the arbitrator to issue a decision. That's a hundred days, which is reasonable. But if there's no timeline, the process can stretch into a year or more. Luna: And in that time, the seller might have to pay legal fees and maybe even lose the business because of the distraction. Lucas: Exactly. So the independent arbitrator clause is not just about getting the right number. It's about getting a fair and efficient process. And that's something worth fighting for in the negotiation. Luna: You know, we talk a lot about traps that cost sellers millions, and this is one of the most avoidable ones. A well-drafted clause doesn't cost much to include, but it can save you from a world of pain. Lucas: Yeah, and honestly, the best time to negotiate this is before the deal closes, not after the dispute arises. Once the buyer has your signature, they have no incentive to be flexible. Luna: And that's a good reminder that the purchase agreement is the foundation of your post-closing relationship with the buyer. You want it to be fair, and you want it to be clear. Lucas: Absolutely. And if you're listening and you're thinking about selling your business, and these conversations have moved your work forward in some small way, that's the spirit behind buy me a coffee dot com slash fexingo. It's a small way to keep us ad-free, and we appreciate it. Luna: Yeah, and it really does help. We keep the podcast independent, and that means we can dive into topics like this without sponsors pulling the strings. Lucas: Right. So back to the practical side. Another detail to consider is whether the arbitrator's decision is final and binding, or whether there's a right to appeal. In most cases, you want it to be final and binding, to avoid endless litigation. But some agreements allow a limited appeal on points of law, which can add another layer of protection. Luna: That's a good nuance. And I'd add that the clause should also specify what happens if the arbitrator dies or becomes incapacitated mid-process. It's morbid, but it's a real risk. Lucas: Good catch. You want a mechanism to replace the arbitrator, otherwise the process can grind to a halt. A simple clause can say that the parties will appoint a replacement within thirty days, or use the same selection process as before. Luna: So, in summary, the independent arbitrator clause is your best friend as a seller. It gives you a fair shot at getting the earnout you earned, without having to go to court. Lucas: And that's the takeaway. When you're negotiating your next deal, don't just think about the earnout number. Think about who gets to do the math. And make sure that person is neutral, qualified, and bound by a fair process.