Latest / The Buyer & Seller Podcast with Fexingo: Business Brokers, Exits, and Private Sales Explained / The Earnout Trap What Every Business Seller Needs to Know
Transcript
- Lucas: So you sell your business. You shake hands, you sign the papers, you get a check—but not the whole check. Six figures, maybe seven, is tied to something that happens two or three years down the road. That's an earnout. And a lot of sellers don't realize how dangerous they can be until it's too late. Luna: We've mentioned earnouts in passing before, but I think it's worth digging into. Because on paper, they sound fair—'I'll pay you more if the business keeps growing.' In practice, it's often a disaster. Lucas: Right. And there's one case I keep coming back to. A mid-sized industrial coatings company in the Midwest—let's call it Great Lakes Coatings. About $50 million in revenue, very steady EBITDA margins around 15 percent. The founder, a guy named Bob, had been running it for thirty years. He wanted to retire. He found a strategic buyer—a larger coatings conglomerate that wanted his customer relationships and his facility. Luna: Classic bolt-on acquisition. The buyer pays a premium because they can squeeze synergies out of it. Lucas: Exactly. The purchase price was $40 million. Bob got $28 million at close. The remaining $12 million was structured as an earnout payable over three years, tied to hitting revenue targets—$52 million, $54 million, $56 million. Bob stayed on as CEO for the earnout period. Luna: That's already a red flag. The person who built the business is now an employee of the buyer, but his payout depends on hitting numbers that the buyer's post-acquisition decisions can completely sabotage. Lucas: That's exactly what happened. Year one, the buyer decided to consolidate Great Lakes' sales force into their own. Bob's long-time sales reps were reassigned or let go. The revenue target that year was $52 million—they did $47 million. Bob got zero earnout for year one. Luna: And he had no control over it. The earnout agreement probably said something like 'buyer shall use commercially reasonable efforts to achieve the targets.' But 'commercially reasonable' is one of those phrases that looks great in a contract and means almost nothing in court. Lucas: That's the critical lesson. Earnouts shift risk from the buyer to the seller after the deal closes. The buyer gets the business and the control. The seller gets a promissory note that depends on the buyer's behavior. And the buyer's incentives are not aligned with hitting the earnout targets—in fact, they might be better off if the earnout fails, because they keep more of the upside. Luna: Unless the earnout is structured on something the seller can control independently. I've seen earnouts tied to gross margin of a specific product line, or to customer retention in a book of business that the seller continues to manage. That's a better design. Lucas: Right. So let's talk about what a seller should look for. First, the metric. Revenue is a bad choice because the buyer can mess with pricing, discounting, channel strategy. EBITDA is slightly better because it includes cost control, but still vulnerable. The best earnout metric is something narrow and auditable—like 'new customers acquired from the seller's existing referral network,' or 'gross profit from the seller's original product line.' Luna: And second, the duration. Three years is too long. I've seen a lot of one-year earnouts, or even six months. The shorter the earnout period, the less time the buyer has to undermine it. Lucas: Third, the seller should negotiate protections. Things like a 'most favored nation' clause—if the buyer offers better terms to a later acquisition, the earnout targets adjust downward. Or a 'good faith' covenant that specifically lists actions the buyer cannot take during the earnout period—like reassigning key salespeople, or moving production to another facility. Luna: A lot of sellers are so focused on the headline price that they neglect the earnout terms. They think, 'I'll get $40 million if I hit the targets,' and they don't think about what happens if the buyer changes the game. Lucas: And it's not just about the buyer acting maliciously. Sometimes the buyer just has a different strategy. They integrate the business and the earnout metric becomes irrelevant. Bob from Great Lakes Coatings—his earnout was tied to revenue, but the buyer decided to shift the company's focus to higher-margin specialty coatings, which meant walking away from low-margin volume. That was actually a smart business decision for the buyer. But it killed the earnout. Luna: So the seller is left with nothing. And they can't sue because the buyer acted in the best interest of the combined company. The earnout agreement probably had a clause saying the buyer could operate the business 'in its sole discretion.' Lucas: That's the standard. And it's why some advisors say 'never take an earnout.' But that's too extreme. Earnouts exist because they solve a real problem: information asymmetry. The seller knows the business better than the buyer. The buyer wants a guarantee that the business will perform. An earnout bridges the valuation gap. The key is to make it as bulletproof as possible. Luna: Let's talk about what Bob could have done differently. He could have asked for a fixed earnout—$12 million paid in three installments regardless of performance, but contingent on him staying employed. That's basically a retention bonus. Or he could have taken a smaller upfront payment and a larger note with interest. Lucas: Or he could have negotiated a 'floor'—a guaranteed minimum earnout even if targets are missed. Or tied the earnout to something he directly controlled, like the EBITDA of the original coatings line. But he didn't have a good advisor. He used the same lawyer who handled his will. That's another lesson: when you sell a business, hire a lawyer who does M&A deals every day. Luna: And a good business broker. A broker who's seen a hundred earnouts can tell you which structures work and which are traps. Lucas: If today's episode was useful to you and you want to keep it ad-free, buy me a coffee dot com slash fexingo helps. It's a small thing that makes a big difference for us. Luna: Yeah, I'll second that. We don't have sponsors, we don't run ads. That's intentional. And listener support is what keeps it that way. Lucas: So back to earnout design. Another important element is the definition of 'earnout period' and how quickly the earnout is calculated and paid. Bob's agreement said the earnout was calculated 90 days after each fiscal year end. That's a long time to wait. Meanwhile, the buyer is making decisions that affect that year's numbers. A better approach is quarterly earnout payments with a true-up at year end. That way the seller sees results sooner and can raise concerns. Luna: And the earnout should be secured. If the buyer goes bankrupt or gets sold, the earnout can disappear. Sellers should ask for a letter of credit or a holdback in escrow. Lucas: Right. Let's talk about the dispute resolution mechanism. Most earnout agreements say that disputes go to arbitration. But the standard is 'arbitration under the rules of the American Arbitration Association.' That's vague. I've seen cases where the arbitration costs more than the earnout itself. A better approach is to specify a particular arbitration forum, a timeline—say, 30 days to appoint an arbitrator—and a cap on costs. Luna: And the arbitrator should have experience in the specific industry. A general commercial arbitrator might not understand that a drop in revenue is seasonal, not a failure to perform. Lucas: Exactly. So let's sum up. If you're selling a business and you're offered an earnout—or you're considering offering one as a buyer—ask yourself: what metric, what duration, what protections, and how is it enforced? And if the answer to any of those is 'we'll figure it out later,' that's a problem. Luna: I think the biggest takeaway is that an earnout is not a simple 'bonus' for hitting targets. It's a complex financial instrument that transfers risk. Sellers need to treat it like a derivative, not a salary bonus. Lucas: And buyers should be careful too. A poorly designed earnout can create a disgruntled seller who stays on and poisons the integration. I've seen deals where the earnout was so contentious that the seller left after six months and the business cratered. Luna: So both sides need to get it right. And that means involving experienced advisors early. Lucas: Next episode, we'll talk about how to negotiate the actual purchase agreement—the representations and warranties, the indemnification, the escrow. That's the nitty-gritty that can save or sink a deal. Luna: Looking forward to it. For now, thanks for listening, and we'll catch you next time.