Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The Earnout Adjustment Trap That Cost a Seller 55 Million
Transcript
- Lucas: So, Luna, you remember that industrial software company we covered back in the spring? The one that got acquired for two hundred million, with forty percent of the price tied up in an earnout? Luna: The one where the earnout was based on hitting eighty million in EBITDA by year three? That deal ended up in the news for all the wrong reasons. Lucas: Exactly. And the seller just settled the dispute for a fraction of what they thought they were owed. I'm talking about a fifty-five million dollar gap between what the earnout could have paid and what they actually got. This is the earnout adjustment trap, and it's cost sellers more than a few sleepless nights. Luna: Fifty-five million is a number that gets your attention. But before we dive into the dirty details, I want to say something. If you're listening to this and you've ever gotten value from these conversations — maybe you're preparing to sell your own business, or you're negotiating a deal right now — the fact that this show stays ad-free is because listeners like you chip in a few dollars a month. It genuinely makes a difference. If you've got a couple of bucks to spare, you can support us at buy me a coffee dot com slash fexingo. Lucas: Yeah, that's a real help. It keeps the lights on and lets us keep digging into cases like this one. So, back to the earnout. The problem wasn't that the company missed its numbers — it actually beat them. The problem was the definition of EBITDA in the earnout clause. Luna: You mean the 'EBITDA as adjusted' language? I've seen that in a hundred term sheets. It's like a grab bag of adjustments that nobody specifies upfront. Lucas: Right. In this deal, the earnout formula said the payout would be based on 'EBITDA as adjusted for synergies, one-time costs, and changes in accounting principles.' But it didn't define which synergies, which one-time costs, or what those accounting changes were. The buyer's integration team ran the show, and guess what they treated as one-time costs? Luna: Let me guess — the severance for the seller's own salespeople they fired after closing? That's a classic. Lucas: You're close. They also included the cost of migrating to the buyer's ERP system, plus a 'restructuring charge' for closing two redundant warehouses. All told, they carved out about twelve million in costs that the seller had never anticipated. But here's the kicker — they also deducted the revenue synergies they claimed to have achieved, even though those synergies were supposed to be the whole reason for the earnout. Luna: Wait, so they're saying, 'We hit your revenue targets, but because our integration was so good, we're going to subtract the extra profits from your earnout'? That's backwards. Lucas: It's exactly backwards, and it's what makes this trap so insidious. The earnout was meant to reward the seller for post-closing performance, but the buyer defined performance as 'EBITDA excluding the impact of our own integration efforts.' So the better the buyer did at integrating, the lower the seller's earnout. They even had a clause that said 'EBITDA shall be calculated in accordance with the buyer's accounting policies as applied in its consolidated financial statements.' Luna: That's a red flag the seller's counsel should have caught. The moment you tie EBITDA to the buyer's accounting policies, you lose all control. Lucas: Absolutely. The seller's CFO had actually flagged it in the data room, but they were pressured to close quickly because they had a bank loan coming due. So they signed off on a vague definition and an earnout that had no dispute resolution mechanism other than going to court. Luna: And court is where they ended up. But they settled, you said. What did the settlement look like? Lucas: The earnout could have paid up to eighty million if they hit the top end. They ended up with twenty-five million after two years of litigation. The buyer's argument was that the earnout EBITDA never exceeded seventy-five million because of the adjustments. The seller's experts argued that under a 'normal' definition — one consistent with the historical EBITDA used in the purchase price — they should have hit ninety million, triggering the full earnout. Luna: That's a fifty-five million dollar swing. And the judge just looked at the contract and said, 'What did you write?' Lucas: Basically. The court ruled that the earnout clause was too ambiguous to enforce as the seller wanted, but also that the buyer's calculation was 'not supported by the plain language.' So they forced a mediation, and they split the difference. Both sides walked away unhappy, but the seller walked away with a lot less than they thought they had earned. Luna: Okay, so what's the takeaway for someone who's about to sign an earnout? What's the fix? Lucas: First, define EBITDA with surgical precision. Don't say 'as adjusted.' Say 'EBITDA calculated in accordance with GAAP, consistently applied with the historical financial statements of the company, and excluding any costs or income related to integration, restructuring, or changes in accounting principle, unless otherwise agreed in writing.' Luna: And you need a list of permitted adjustments. Not just 'one-time costs,' but an actual schedule of what qualifies and a cap. Lucas: Exactly. In that schedule, you list things like severance for pre-closing employees, transition costs, and litigation expenses — but you also put a dollar cap and a requirement that the buyer provide documentation within thirty days. And you need a neutral third-party accountant to resolve disputes, not just a court. Luna: That's the big one. If you have a Big Four firm or an independent valuation expert as the tiebreaker, you avoid years of legal fees. What about the synergies problem? How do you handle that? Lucas: You carve out synergies entirely. The earnout should be based on the standalone performance of the business, not on what happens when the buyer overlays its own operations. So you say something like, 'EBITDA shall be calculated as if the business were operated on a standalone basis, excluding the effect of any post-closing actions taken by the buyer.' Luna: That's clean. But some sellers argue that's unrealistic — the earnout should capture the upside of being part of a bigger company. Lucas: Sure, and that's a strategic choice. If you want to share in the synergies, then you need a formula that actually splits them, not one that lets the buyer subtract them. You could say, 'The earnout will be calculated as fifty percent of the incremental EBITDA attributable to the business, including synergies, as mutually agreed.' But that's harder to value, and it opens the door to more fights. Luna: So the safer route is to keep the earnout simple and based on what you can control. But also, what about the working capital peg? I heard that in this case, the buyer adjusted the net working capital target after closing, which also hit the earnout. Lucas: Yeah, that's a lesser-known but equally nasty trick. The earnout was tied to EBITDA, but the purchase price included a working capital adjustment. The buyer reclassified some of the seller's receivables as 'uncollectible' at closing, which lowered the working capital balance and effectively pushed revenue into the post-closing period. That inflated the first-year EBITDA, so the buyer could say, 'See, you hit the earnout in year one, so you don't need a larger payout later.' Luna: Ugh. So they're using the working capital mechanism to manipulate the EBITDA timeline. That's why you need to tie the working capital definition to the historical levels, and have an independent auditor review the closing balance sheet. Lucas: Right. And you want a dispute resolution provision that says any disagreement over the earnout calculation goes to a neutral accountant within sixty days, and their decision is binding, with the loser paying the fees. That's a powerful deterrent against gamesmanship. Luna: A lot of sellers are afraid to push for that because they think it's a sign of distrust. But in a deal like this, it's just prudent. Lucas: Yeah, and honestly, if a buyer resists a neutral accountant, that's a red flag. They're telling you they want the discretion to interpret the numbers their way. Luna: So, to sum up, the three things you need in any earnout: a precise EBITDA definition, a cap on adjustments, and a neutral third-party dispute resolution mechanism. Did I miss anything? Lucas: I'd add one more: put a floor on the earnout. Some deals have a minimum guaranteed payout, even if the earnout targets aren't met. That gives the seller some downside protection and reduces the incentive for the buyer to sandbag. Luna: A floor is nice, but it also raises the purchase price, so buyers resist. But in a competitive auction, you can often get it if you give up a bit of upside. Lucas: Exactly. And that's the art of the deal. The key is to go in with your eyes open, not just focusing on the headline earnout number. You have to model out the worst-case scenarios, ask your advisors to stress-test the language, and never sign on a Friday afternoon when everyone's tired. Luna: That's good advice. And I think it's worth remembering that this isn't about being paranoid — it's about aligning incentives. A fair earnout is one where both sides feel they got what they deserved. Lucas: Well said. And if you're in the middle of negotiating an earnout right now, take the time to draft that schedule of adjustments. It's boring, it's tedious, but it could save you tens of millions. That's the kind of thing I'd want to hear before I sat down at the table. Luna: And we'll have a link to a sample earnout checklist in the show notes, so you can bring it to your next meeting. Lucas: Perfect. Until next time, keep your eyes on the numbers — and your contract language even sharper.