Latest / Franchise Conversations with Fexingo: Buying, Running, and Scaling Franchise Businesses / How Franchisees Use Earnouts to Buy Existing Units
Transcript
- Lucas: Luna, I want to talk about a specific deal structure that I think a lot of franchisees overlook when they're looking to buy existing units. Earnouts. Luna: Earnouts. That's when the seller gets paid more if the business hits certain targets after the sale, right? Lucas: Exactly. And they're surprisingly common in franchise M&A. I was looking at data from a franchise brokerage — FranchiseGrade — and they found that about 40 percent of multi-unit franchise acquisitions in the last two years included some form of earnout. That's a lot. Luna: So it's not just a niche thing. But why would a seller agree to that? They're basically betting on the buyer's management. Lucas: That's the key tension. The earnout bridges the valuation gap. Say a seller thinks their unit is worth $1 million based on trailing earnings, but the buyer sees risk and only wants to pay $800,000. An earnout lets them structure it so the seller gets $800,000 upfront, and then another $200,000 if, say, same-store sales grow 5 percent annually for the next three years. It aligns incentives — or at least it's supposed to. Luna: But that alignment can break down, right? I've heard horror stories where buyers make operational changes that hurt the earnout metrics. Lucas: That is the single biggest risk. There's a famous example in the franchise world: a large sandwich chain buyer acquired a 10-unit group from a retiring franchisee. The earnout was tied to gross revenue. The buyer immediately cut costs by reducing staff, which hurt service quality, revenue dipped, and the seller never got the earnout. It ended up in litigation. Luna: So the seller is really trusting the buyer's strategy and competence. That's a big leap. Lucas: It is. But when done right, earnouts can be a win-win. Let me walk through a real case I dug up — a QSR franchisee in the Southeast, let's call him Mark. He wanted to buy a three-unit group from a couple who had run them for 15 years and were ready to retire. The ask was $3.5 million. Mark's analysis said fair value was closer to $2.8 million. Luna: That's a $700,000 gap. So an earnout makes perfect sense. Lucas: Right. They settled on a structure: $2.8 million cash at close, plus a $700,000 earnout paid over four years. But here's the smart part — the earnout was tied to same-store sales growth relative to the franchisor's system average. So if Mark's stores grew at the same rate as the system, he paid the full earnout. If they outperformed, the sellers got a bonus. If they underperformed, the earnout shrank. Luna: That's clever. It benchmarks against the system, not just an absolute number. That way, if there's a recession, the seller isn't penalized for something the buyer can't control. Lucas: Exactly. The system average is a fair benchmark. Mark also negotiated that the earnout was capped at 150 percent of the target, so the seller couldn't get an absurd windfall if there was a one-time pop. And he insisted on audited financials from the franchisor to verify the numbers. Luna: How did it play out? Lucas: Three years in, the stores have actually outperformed the system average by about two percent annually. So the sellers are on track to get the full $700,000, and Mark is happy because his stores are generating more cash flow than he projected. But it wasn't easy. The first year, there was friction because the sellers wanted input on hiring decisions, which wasn't in the agreement. Mark had to gently remind them that earnout doesn't come with operational control. Luna: So the earnout has to be very clearly defined. What are the key terms that franchisees should nail down? Lucas: First, the metric. Revenue, EBITDA, same-store sales, customer satisfaction scores — pick one or two, not a basket of five. The simpler, the better. Second, the duration. Most earnouts are three to five years. Longer than that, and the seller loses interest; shorter, and you might not capture the full value. Third, the payout schedule. Annual, quarterly, or lump sum at the end. Quarterly is common because it keeps both parties engaged. Luna: And what about governance? Who gets to audit the numbers? Lucas: Critical. The agreement should specify an independent third-party auditor if there's a dispute. Also, define what happens if the buyer sells the business before the earnout period ends. That can get messy. Some contracts accelerate the earnout; others terminate it. Luna: That's a huge risk for the seller. If the buyer flips the units in two years, the seller might lose out on the remaining earnout. Lucas: Exactly. In Mark's case, he agreed to an acceleration clause: if he sold within the earnout period, the sellers would get the remaining earnout paid out immediately, discounted by a modest 10 percent. That was a fair compromise. Luna: So what's the downside for the buyer? Besides the obvious risk of overpaying if the earnout triggers. Lucas: One big one: the earnout can create perverse incentives. If the metric is revenue, the buyer might sacrifice margins to juice top-line growth. If it's EBITDA, the buyer might defer maintenance to boost short-term profits. You have to think carefully about what behavior you're rewarding. In Mark's case, using same-store sales relative to system average avoided most of that, because it's a top-line metric that's hard to game without affecting customer experience. Luna: Are there any tax implications? Lucas: Yes, and they're complicated. The IRS treats earnout payments as either additional purchase price or compensation, depending on how it's structured. Sellers generally prefer capital gains treatment. Buyers want to deduct it as an expense. You definitely need a tax advisor involved. I've seen deals blow up because of a 50 percent tax hit on the wrong classification. Luna: So this isn't a DIY thing. You need a good lawyer, a CPA, and maybe an industry consultant. Lucas: Absolutely. But despite the complexity, I think earnouts are underused in franchise M&A. They allow more deals to happen. The seller gets a higher potential price, the buyer reduces upfront risk. It's a classic risk-sharing tool. Luna: And it gives the seller a reason to care about the transition. I like that. It's not just 'here's the keys, good luck.' Lucas: Exactly. The seller has a financial interest in helping the new owner succeed, at least for the earnout period. That can be invaluable for knowledge transfer and maintaining relationships with staff and customers. Luna: So if you're a franchisee looking to buy, when should you bring up an earnout? Lucas: Early. Don't wait until you're deep into due diligence. If you see a valuation gap, mention it in the LOI — letter of intent. Say something like, 'I'm willing to pay your asking price, but I'd like to structure part of it as an earnout tied to performance.' That sets the tone. Sellers who are confident in their business usually see it as a fair proposal. Luna: And if the seller refuses? No earnout at all? Lucas: Then you know they're not confident in the future performance. That's a red flag. In some cases, the seller might just want a clean exit, and that's fine. But if you're taking on all the risk, you should price the deal accordingly. Mark told me that if the sellers hadn't agreed to the earnout, he would've walked. And he was willing to walk. Luna: Speaking of walking — I wonder if earnouts are more common in certain franchise sectors? Lucas: Great question. The data I've seen suggests they're most common in QSR and retail, where there are clear performance metrics. They're less common in service-based franchises like home repair, where revenue is harder to benchmark. But the principle applies anywhere you have a gap between what the seller wants and what the buyer is willing to pay. Luna: So it's a negotiation tool as much as a financing tool. Lucas: Exactly. And it forces both sides to get really specific about what success looks like. That's healthy. Luna: You know, talking about earnouts and how they help bridge those gaps — it reminds me that a lot of the value in these conversations really comes down to the details. And if today's episode helped you think about your own franchise deal or strategy, honestly, if it was worth the price of a coffee to you, that's the link — buy me a coffee dot com slash fexingo. No pressure, just a simple way to keep this show ad-free and independent. Lucas: Yeah, and it genuinely helps. We hear from listeners who say these episodes have saved them thousands on a bad deal or helped them negotiate better terms. If that's you, and you want to support the show, that link is there. Otherwise, we're glad you're here. Luna: Alright, back to earnouts. Any final piece of advice for a franchisee considering this structure? Lucas: One thing: model the earnout under multiple scenarios. What happens if sales drop ten percent? What if they go up twenty? Run the numbers and make sure you and the seller both understand the range of possible outcomes. A spreadsheet is cheap; a lawsuit is not. Luna: Good advice. And I'd add: don't forget the soft stuff. How will you work with the seller during the earnout period? Will they still be involved? That relationship can make or break the deal. Lucas: Absolutely. Mark actually scheduled quarterly check-ins with the sellers, not just for financial reporting but for operational tips. That turned what could have been an adversarial relationship into a partnership. The sellers felt respected, and Mark got valuable institutional knowledge. Luna: So earnouts are really about trust and transparency, built into the deal structure. Lucas: Exactly. And when done right, they can unlock deals that otherwise wouldn't happen. For franchisees looking to grow, that's a powerful tool to have in the kit. Luna: Thanks, Lucas. That was a great deep dive. I'm definitely going to look at earnout structures differently next time I see a deal. Lucas: Glad to hear it. And for our listeners, if you're thinking about buying a franchise unit, don't be afraid to bring up an earnout. It might be the bridge you need.