Latest / Franchise Conversations with Fexingo: Buying, Running, and Scaling Franchise Businesses / How Franchisees Use Earnouts to Buy Existing Units
Transcript
- Lucas: So last week I was talking to a franchisee who runs 14 quick-service restaurants across three states. He told me that almost every acquisition he's done — buying out a retiring franchisee — he used an earnout. And it struck me how underused that tool is. Luna: An earnout being part of the purchase price tied to future performance, right? So the seller only gets the full amount if the business hits certain targets after they leave. Lucas: Exactly. And the reason it matters for franchisees is specific. When you buy an existing unit, you're paying for tangible assets — equipment, leasehold improvements, inventory. But you're also paying for goodwill. Customer relationships, staff continuity, supplier trust. That stuff is real. But it's also fragile. Luna: It can evaporate the day the old owner walks out the door. Especially in a franchise where the brand standards are uniform, the real differentiation is the operator. Lucas: Right. So an earnout protects the buyer from overpaying for goodwill that doesn't transfer. Let's make it concrete. Say you're buying a three-unit pizza franchise from a seller who's retiring. The asking price is $1.2 million. You think it's worth $1 million. That $200,000 gap is basically the seller's confidence that their relationships will stick. Luna: So you structure an earnout. You agree on $1 million upfront, and an additional $50,000 per unit — so $150,000 total — if same-store sales stay above 3 percent year-over-year growth for 18 months after close. Something like that? Lucas: Exactly that. And the beauty is, it aligns incentives. The seller now has a financial reason to introduce you to their key customers, train your staff thoroughly, stay on for a phased transition. They're not just cashing out and disappearing. Luna: And from the buyer's perspective, you're only paying if the business actually performs. If the goodwill doesn't transfer, you don't owe the extra. That's a huge de-risker. Lucas: It is. But there are nuances. One is defining what 'performance' means. In franchises, you often have limited control over pricing and product mix because the franchisor sets those. So you want the metric to be something the seller can influence through transition support — like same-store sales, not gross margin. Luna: Gross margin could be affected by food cost inflation or a franchisor-mandated menu change. That's outside the seller's control. Same-store sales is cleaner. Lucas: Cleaner, but still requires clear accounting. You need to define exactly how you calculate it. Is it average daily sales per store? Excluding new menu items? Including online orders? The more specific the earnout agreement, the fewer disputes later. Luna: I've heard horror stories about sellers cutting prices or running promotions in the earnout period to juice sales numbers, then the buyer inherits a customer base trained to expect discounts. Lucas: That's a real risk. So you put guardrails in. You can cap promotional spending as a percentage of sales during the earnout period. Or you can tie the earnout to profitability, not just top-line revenue. But then the accounting gets more complex. Luna: And you might need the seller to stay involved longer. Some earnout periods are 12 to 24 months. That's a long time for a seller who wanted to retire. Lucas: It is. But you can structure it in tranches. Say $25,000 per unit if they stay for six months of transition, another $25,000 if same-store sales hold for 12 months. That way the seller has an incentive to do a thorough handover without being tied up for years. Luna: I want to go back to a point you made earlier about valuation gaps. In your experience, how often does an earnout actually bridge that gap and get the deal done? Lucas: More often than you'd think. In franchise acquisitions, especially multi-unit deals, the buyer and seller are often pretty close on asset value. The friction is over the intangible stuff. An earnout gives both sides a way to say, 'Let's let the business tell us what it's worth.' I've seen deals that were dead for months come back to life once someone suggested an earnout. Luna: It's a creative solution that doesn't require either side to concede their valuation. It's a bet on the future. Lucas: Exactly. And it's not just for retiring sellers. Even when a franchisee is selling because they're underperforming — maybe they've neglected the business — an earnout can work. You tie part of the price to post-sale performance, and the seller has an incentive to help you turn things around rather than just walking away. Luna: But if the business is already declining, setting realistic earnout targets is tricky. You don't want to set the bar so low the seller gets a free payout, or so high it's unattainable. Lucas: Right. That's where due diligence matters. You look at three years of financials, same-store sales trends, local market conditions. If the decline is due to something fixable — like poor management or underinvestment — you can set a target that reflects a reasonable turnaround. Luna: Give me an example of that. Lucas: Sure. I worked with a buyer looking at a two-unit sandwich franchise that had seen same-store sales drop 5 percent year-over-year for two straight years. The seller had stopped reinvesting. The equipment was old, the stores looked tired. The buyer offered $300,000 upfront — basically asset value — and a $100,000 earnout if same-store sales returned to flat within 18 months. Luna: Flat? That seems generous. But I guess if the buyer could fix the stores with a $50,000 remodel each, flat sales would still be a win. Lucas: Exactly. The buyer had a plan. And the seller, who was burned out, actually helped during the transition because they wanted that earnout. Sales went positive within a year. Everyone won. Luna: It's a different mindset from just buying a turnkey operation. You have to believe you can improve the business. Not every franchisee has that confidence. Lucas: No, and that's fair. But if you're a multi-unit operator who already runs similar units successfully, you should have a pretty good sense of what's achievable. You know your own cost structure, your own labor model. You can model out what the acquired stores should do under your management. Luna: And then the earnout becomes a hedge against your own assumptions being wrong. If you're right, you pay extra. If you're wrong, you don't. Lucas: Precisely. And that's why I think earnouts are underused. Franchisees tend to think in binary terms — either you buy the business at a fixed price or you don't. The earnout opens up a middle ground where both parties can take a calculated risk. Luna: I want to pivot to a practical question. How do you actually document an earnout in a franchise acquisition? Is it a separate agreement, or part of the asset purchase agreement? Lucas: It's typically part of the asset purchase agreement, but it can be a separate schedule. The key terms are: the earnout amount, the performance metric, the measurement period, and the calculation method. You also need to spell out what happens if the buyer sells the units during the earnout period, or if the franchisor changes the system. Luna: And the franchisor has to approve the transfer anyway. Some franchisors might have rules about earnouts — they might not want the seller to have ongoing financial involvement because of confidentiality or control issues. Lucas: That's a real concern. So you should always check the franchise disclosure document and the operations manual. Some franchisors prohibit earnouts altogether because they don't want the seller to have any continuing interest. Others are fine as long as the seller isn't involved in day-to-day operations. Luna: So due diligence includes the franchisor's approval. That can be a deal-breaker if you don't check first. Lucas: Absolutely. But assuming the franchisor is okay, earnouts are a fantastic tool for franchisees who want to grow through acquisition without overleveraging. And they force you to be disciplined about what you're really buying. Luna: Speaking of discipline, we've been doing this podcast for a while now, and one thing that keeps it going is listener support. Not big corporate sponsors — just a few dollars from people who find these conversations useful. Lucas: Yeah, it's genuinely a small amount that makes a big difference. If you've ever gotten a concrete idea from an episode — like an earnout structure you could actually use — consider tossing a couple of bucks into the kitty. It's buy me a coffee dot com slash fexingo. Luna: And it really does help us stay independent and ad-free. So anyway, back to earnouts. One thing we haven't touched on is tax treatment. Lucas: Good point. The earnout payment is generally treated as additional purchase price, not compensation. So it's capital gain for the seller, and the buyer capitalizes it as part of the asset cost. But you need to allocate the earnout among the assets — goodwill, equipment, leasehold improvements — because different assets have different depreciation lives. Luna: That can get messy. Do you need a valuation expert to do that allocation? Lucas: Not necessarily for a small deal, but if the earnout is significant — say, more than 20 percent of the total price — it's worth getting a professional. The IRS has rules about contingent payments under Section 483 and the imputed interest rules. If you don't handle it right, the seller could end up with ordinary income instead of capital gains. Luna: So you need a good tax advisor. And a good lawyer to draft the earnout clause. Lucas: Absolutely. But it's worth the cost. The earnout can save you from overpaying by hundreds of thousands of dollars. And it can make deals happen that otherwise wouldn't. Luna: Let's talk about one more scenario: a franchisee who wants to sell their units to an employee. Could an earnout work there? Lucas: It's actually a great fit. The employee knows the business, but they probably don't have the capital. The seller can finance part of the purchase price through an earnout — the employee pays a lower upfront price, and the seller gets additional payments if the business performs. It's a way to transition ownership without the employee needing a huge bank loan. Luna: And the employee has a strong incentive to keep the business running well. They're already invested emotionally. The earnout just adds financial alignment. Lucas: Exactly. I've seen several franchise systems where the most successful multi-unit operators started as employees who bought out their bosses using earnouts. It's a path to ownership that doesn't require outside investors. Luna: So for a franchisee listening who's thinking about selling in the next few years, an earnout might make your business more attractive to a buyer — especially a younger operator who can't write a big check upfront. Lucas: Absolutely. And for buyers, it's a tool to reduce risk while still getting the deal done. I honestly think every franchisee who's looking to acquire should have earnouts in their toolkit. Not every deal needs one, but when the numbers are close, it's often the thing that gets you across the finish line.