Latest / The Buyer & Seller Podcast with Fexingo: Business Brokers, Exits, and Private Sales Explained / The Earnout Trap in Small Deal Pricing
Transcript
- Lucas: So we've spent a lot of episodes talking about multiples — what a business sells for, times EBITDA. But here's a number that doesn't get enough airtime: in deals under ten million dollars, something like forty percent now have an earnout clause. And that's up from maybe a quarter a decade ago. Luna: An earnout — that's when part of the price is contingent on future performance, right? Like the seller has to hit certain numbers after the deal closes to get the full amount. Lucas: Exactly. And it sounds reasonable on paper — you're just aligning incentives. But in practice, for a lot of small business owners, it becomes a trap. The headline multiple looks great, but the actual money they walk away with is often a fraction of what they thought they sold for. Lucas: Let me give you a concrete case. I talked to a broker in the Midwest who closed a deal in March for a boutique IT staffing firm — about four million in revenue, maybe eight hundred thousand in EBITDA. Buyer offered seven times EBITDA, which for that space is a strong multiple. But two of those seven turns were tied to an earnout over two years. Luna: So they'd get five times upfront, and the rest if they hit targets. That's roughly four million upfront and another one-point-six million in potential earnout, if my math's right. Lucas: Right. And here's where it got interesting. The earnout was based on revenue, not profit. So the buyer was fine with the owner pushing more billable hours and subcontractor costs into the earnout period — it inflated revenue, kept the seller on track, but it crushed the margin. The business actually lost money in year one of the earnout, and the seller barely collected a third of the earnout. Luna: Ouch. So the buyer essentially got a discount on the real value, and the seller was working their tail off for less than they'd planned. Lucas: Exactly. And this isn't a one-off horror story. It's the structure that creates the trap. When a big chunk of your price is based on future numbers, the buyer has every incentive to make those numbers hard to hit. They control the budget, the sales strategy, the hiring — often the same week you hand over the keys. Lucas: So the question I want to drill into today: when is an earnout actually a good idea for a seller, and when should you walk away or at least price it like a discount? Because sometimes, an earnout is the only way to bridge a valuation gap, and it can work out fine. But you have to go in with your eyes open. Luna: And I'd imagine the size of the earnout matters. Is there a threshold where it's just too risky? Lucas: There's a school of thought that says if the earnout is more than about twenty percent of the total consideration, you're essentially selling a lottery ticket. You're taking on all the downside risk of the business continuing to perform, without any of the upside of actually owning it. I'd say that's a decent rule of thumb. Lucas: But the bigger issue is how the earnout is measured. Revenue is the most common metric in small deals, but it's also the easiest to game. Any buyer can pull forward orders, add a big customer contract, or push your team to close business that would have come anyway — and suddenly the earnout looks achievable, but the quality of that revenue is terrible. Luna: Yeah, that's basically what happened in the staffing deal. Revenue went up, but profit went down. So the seller hit the top-line goal but not the bottom line — and the earnout didn't pay out. Lucas: Right. And that's why I tell sellers to negotiate earnouts on profit, not revenue, if they have any leverage at all. Or at least tie it to gross margin dollars, not just raw revenue. But even then, you need to define what 'profit' means very carefully — because the buyer can allocate overhead to your business unit in ways that eat into it. Lucas: Let's talk about the other side of the coin, though. There are situations where an earnout is actually the smartest move. Like when the buyer genuinely can't pay more upfront because of financing constraints, but the seller believes strongly in the growth trajectory. That's when an earnout becomes a tool to get a higher total price, not a discount. Luna: And I've heard that earnouts can also protect the seller from downside if the buyer ruins the business. Like if they tank it, you don't want to be on the hook for a lower price. But does that actually work in practice? Lucas: That's the theory, but the reality is that earnout contracts are notoriously vague. They rarely specify what the buyer can and can't do to the business. So if the buyer decides to cut your sales team or stop investing in marketing, the earnout suffers, and you have very little recourse unless you've written in specific protections. Lucas: I remember a case with a landscaping company that sold in 2024. The earnout was tied to net profit, but the buyer immediately moved the accounting to a shared services model and allocated a hundred thousand dollars of corporate overhead to the business unit. The seller's profit dropped by that amount, and the earnout effectively evaporated. The seller sued, but the contract didn't specify how overhead would be allocated — so he lost. Luna: That's brutal. So the lesson is, if you're going to have an earnout, you need to define every single term — what's included in profit, how overhead is allocated, what happens if they change the business model. It's almost like you have to write the operating manual for the earnout period. Lucas: Exactly. And that's the kind of detail that separates a good deal lawyer from one who just downloads a template. I've seen earnout agreements that run five pages, and the ones that work well run thirty. The difference is in the definitions. Lucas: Another thing that often gets overlooked: the duration. Earnouts typically run one to three years. A common mistake is agreeing to a two-year earnout without any clause that lets the seller renegotiate if the buyer changes the business strategy. So if the buyer pivots the company into a different market, your earnout could be based on numbers that are no longer relevant. Luna: So should a seller just refuse earnouts altogether? I mean, given all these traps, why would anyone take that risk? Lucas: A lot of advisors would say exactly that — that in a seller's market, you should push for all cash or at least a seller note with good security. But the reality is, if the buyer is offering a higher multiple because of the earnout, sometimes it's the only way to get to a number that makes sense for both sides. The key is to price the earnout at its expected value, not its face value. Lucas: My rule of thumb is to assume you'll collect sixty cents on the dollar for any earnout portion. So if the deal is five million upfront and two million in earnout, you should evaluate it as if it's really five million plus one-point-two million. If that total is still above your walk-away number, then maybe it's worth considering. If not, you need to push for more upfront or walk away. Luna: That's a practical way to think about it. And it also puts the pressure on the buyer to justify the earnout — if they're not willing to put more upfront, they can't expect you to bet your retirement on their business plan. Lucas: Absolutely. And that's where a good broker or M&A advisor earns their fee. They can run the scenarios, stress-test the earnout metrics, and tell you honestly whether the deal structure makes sense. I've seen too many owners get starry-eyed over a headline multiple and sign away their upside without a second thought. Lucas: There's also the non-compete issue. A lot of earnout agreements tie the seller's payout to them staying on and not competing. But if the earnout is tied to revenue, and the seller has a non-compete that prevents them from selling to their old customers, that's a complete mismatch. I've seen deals where the earnout was essentially impossible because of the non-compete language. Luna: So the earnout and the non-compete have to be negotiated as a package, not in isolation. If you're expected to generate revenue, you need to be able to touch the customers you built those relationships with. Lucas: Exactly. And that's actually a good segue to a broader point. Earnouts are just one example of how deal structure can either protect or undermine a seller. The same logic applies to things like working capital targets, indemnification clauses, and even the payment timeline. All of these are places where the buyer's interests and the seller's interests diverge, and where a little knowledge can save you hundreds of thousands of dollars. Lucas: So if you're an owner thinking about selling, my advice is not to obsess over the multiple. Obsess over the structure. What's the cash at close? What's the earnout, and what are the metrics? What's the working capital adjustment? Those are the numbers that determine what you actually walk away with. Luna: And I think that's the kind of conversation that can genuinely change the outcome for someone. You know, it's conversations like these that make me glad we're doing this show without ads — because it means we're not trying to sell you a course or a broker service. We're just trying to give you the tools to negotiate better. Lucas: That's actually a good point. We've talked about this before, but it's worth repeating: we deliberately keep Fexingo's shows ad-free. If you've found value in these episodes, whether it's this one or one of the two hundred before it, and you want to support that choice, the link is buy me a coffee dot com slash fexingo. No pressure, no rewards — just a way to keep these conversations going without commercial interruption. Luna: And it genuinely helps. Every little bit goes toward keeping the lights on and the research budget alive. So, yeah, if it's moved your work forward in some way, that's the place to say thanks. Lucas: Alright, back to the trenches. Let's talk about what happens when the earnout actually pays off. Because it's not all doom and gloom. I've seen deals where the earnout was the best part of the transaction for the seller — but only because they negotiated the right metrics and had a buyer who was genuinely aligned. Lucas: There was a digital marketing agency in Austin that sold in 2023. The buyer offered four times EBITDA upfront and an earnout of up to another two times, tied to gross profit growth. The seller stayed on as president, and the earnout was structured so that if the buyer made changes to the service offering, the earnout would be recalculated based on a predetermined formula. Luna: So they had protections in place. And I bet the gross profit metric was smarter than revenue because it kept everyone focused on profitable growth. Lucas: Exactly. And that deal paid out in full. The owner collected the entire earnout, and the buyer kept them on with a great retention package because the business grew twenty percent in year one. So when it works, it can be a win-win. But the difference was the level of specificity in the contract and the cultural alignment between buyer and seller. Lucas: So my final takeaway for this episode is simple: don't demonize earnouts, but don't treat them as free money either. Treat them as what they are — a negotiated risk-sharing mechanism. And if you're going to take on that risk, you need to be compensated for it. That means a higher total price, better metrics, and airtight definitions. Luna: And if the buyer pushes back on your protections, that's a red flag. A legitimate buyer should welcome clarity because it reduces their risk of a post-closing dispute too. Lucas: Right. In the end, the best deals are the ones where both sides feel like they got a fair shake. And that starts with understanding exactly what you're signing. So next time you hear about a company selling at eight times EBITDA, ask the question that really matters: how much of that was cash at close?