Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / How Strategic Acquirers Win With Earnouts
Transcript
- Lucas: The hardest part of any merger isn't the due diligence, it's the moment you have to agree on what the company is actually worth when the two parties see the future differently. Today we are looking at earnouts, which is essentially the bridge you build over that valuation gap when a seller believes their growth trajectory is real and the buyer thinks it's risky. Luna: Right, because if the seller is asking for five hundred million and the buyer only sees three hundred, you usually just walk away unless there is a way to bet on the upside together. It feels like the most honest form of pricing we have in private markets. Lucas: Exactly. And the reason we need to talk about this specifically now is that as interest rates have stabilized in late twenty twenty six, the pressure on valuations has shifted from pure multiple compression to structural risk allocation. Buyers are no longer just paying less; they are demanding more certainty that the numbers they are paying for will actually materialize after the check clears. Luna: So the risk doesn't disappear, it just moves from the price tag to the contract terms. That seems like a significant shift in leverage dynamics. Lucas: It does. And here is where it gets tricky for operators. When you structure an earnout, you are essentially creating a second transaction that happens after the first one closes. If those terms aren't locked in with surgical precision, the integration phase becomes a legal war rather than a business building exercise. Luna: I remember reading about a mid-market healthcare tech deal last year where the earnout was tied to net revenue retention, but the buyer changed the CRM system and artificially suppressed renewal rates to hit a different internal target. It completely broke the founder. Lucas: That is the classic trap. You tie the payout to a metric that the buyer controls, and then wonder why the seller feels cheated. The key insight here is that earnouts work best when they are tied to operational levers the founder still influences, not financial outcomes the new management team can manipulate. Luna: So if the founder is staying on for eighteen months, you want the metrics to reflect their actual job description, not some arbitrary corporate synergy number. Lucas: Precisely. Let us look at a concrete example from a recent software acquisition. A platform company was buying a smaller competitor with fifty million in annual recurring revenue. The seller wanted eighty million based on projected growth, the buyer offered sixty million base cash. They settled on seventy million plus an earnout of up to thirty million if the company hit specific customer expansion targets. Luna: That sounds reasonable on paper, but how do you define 'customer expansion' so it doesn't become a moving goalpost? Because once the deal closes, the buyer has all the administrative power. Lucas: You define it by gross additions minus voluntary churn, and you ring-fence the budget required to support that growth. In that deal, they agreed that marketing spend would remain at current levels, and the buyer could not consolidate the acquired product into a legacy platform that might confuse existing users. Those are the non-financial protections that make the financial metric stick. Luna: It really highlights that the contract is as important as the valuation. Most founders sign off on the headline number and leave the operational details to the lawyers, which is exactly where they get burned. Lucas: Absolutely. And we should pause for a moment to acknowledge who keeps this show running without ads. We deliberately don't run ads on these conversations because we believe in supporting our listeners directly. If these discussions have moved your work forward in some small way, the link is buy me a coffee dot com slash fexingo — that's F. E. X. I. N. G. O. Luna: Yeah, and honestly, that direct connection helps us dig deeper into topics like this without worrying about advertiser pull-back on complex financial subjects. Lucas: Back to the mechanics though. One of the biggest mistakes we see is tying earnouts to total enterprise value rather than specific line items. If you tie it to EBITDA, the buyer has a massive incentive to cut costs in ways that destroy long-term brand equity just to boost the short-term margin and trigger the payout. Luna: So you want metrics that force good behavior, not just any behavior that hits a number. Otherwise, you incentivize the very kind of cost-cutting that kills the growth story the buyer originally bought into. Lucas: Spot on. Revenue-based earnouts are generally safer for sellers because they are harder to manipulate without obvious damage to the business. Cost-based earnouts are dangerous because they invite austerity measures that feel like sabotage to the original team. But even revenue metrics can be gamed if you aren't careful about cross-selling scenarios. Luna: Like when the buyer attributes sales of their own larger product suite to the acquired brand just to pad the top line? That must happen more often than people admit. Lucas: It does. So you need attribution rules written into the agreement. If the acquired company sells a module that is part of the parent suite, that revenue counts toward the earnout only if it represents incremental adoption, not cannibalization. It sounds bureaucratic, but it is the only way to keep the scorecard honest. Luna: This makes me think about the psychological side too. If the founder knows they might lose half their expected wealth because of arbitrary accounting changes, they stop innovating and start protecting their position. That kills the momentum the buyer paid for. Lucas: That is the behavioral economics piece. Fear creates stagnation. You want the founder to operate as if they still own the business, which means giving them autonomy over the areas that drive the earnout metrics. If you strip that autonomy, you are essentially firing them while keeping them on payroll, which is a terrible culture move. Luna: So the best earnouts are structured like partnerships, not penalties. You are betting together on the next chapter of the company, not trying to extract every last dollar of risk premium. Lucas: Exactly. And that requires transparency. In the best deals I have seen, the buyer provides monthly dashboards showing progress toward the earnout targets during the integration period. No surprises at the end. If the seller is falling short, they know early enough to adjust strategy rather than discovering failure at the payout date. Luna: That level of visibility is rare though. Most buyers treat financial data as proprietary even when it determines the seller's payout. It feels like a trust issue built into the system from day one. Lucas: It is. But sophisticated acquirers understand that opacity destroys value. If the seller is anxious, they micromanage or leak bad press to external stakeholders. Good earnout governance includes independent audits of the calculation methodology and clear dispute resolution mechanisms that don't require litigation to resolve. Luna: I imagine having a neutral third-party accountant review the final numbers is standard practice, but setting up that expectation upfront is something most people skip. Lucas: They do. And it costs almost nothing compared to the legal fees of a breach of contract suit. We are seeing more deals include a provision where the buyer bears the cost of the audit if the discrepancy is greater than five percent. It aligns incentives immediately because the buyer knows they cannot hide behind minor accounting differences. Luna: That is a brilliant safeguard. It forces the buyer to be rigorous from the start because they know they will pay for mistakes. It shifts the burden of proof onto the party with the information advantage. Lucas: Right. And finally, we need to talk about duration. Earnouts typically last two to three years, but in fast-moving technology sectors, three years is an eternity. By the time the final payment is due, the market landscape may have completely shifted, making the original targets irrelevant or impossible. Luna: So you might need cliff payments instead of linear accruals, or maybe caps on the total exposure so the buyer isn't on the hook forever. It's about balancing risk over time. Lucas: Cliff payments are common. You get fifty percent of the potential earnout at year two and the rest at year three, contingent on continued employment. It keeps the founder engaged through the critical integration window while limiting the tail risk for the buyer. It is a pragmatic compromise. Luna: It really shows that M&A is less about finance and more about human psychology and contract design. The numbers are just the scoreboard for the relationship between two groups of people who now have to work together. Lucas: That is the core truth. If you treat the earnout as a purely financial instrument, you will miss the cultural signals that determine whether the deal succeeds or fails. The best structures anticipate friction and build in remedies before the conflict arises. Luna: So for founders going through a sale, the lesson is to negotiate the earnout terms with the same intensity as the purchase price. That second check is often worth more than the initial offer. Lucas: Definitely. And for buyers, it is about respecting the operator's expertise. You are paying for their vision, so you have to give them the runway to execute it. Restrictive covenants that kill innovation ultimately kill the earnout itself. Luna: Interesting question to leave with: do you think remote work and distributed teams make earnouts easier or harder to manage given the lack of face to face accountability? Lucas: Harder, because trust is harder to establish digitally. You need more robust reporting frameworks and perhaps more frequent check-ins to replace the hallway conversations that used to resolve misunderstandings organically.