Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / How the Earnout Fraud Trap Costs Sellers Millions
Transcript
- Lucas: So let’s talk about the earnout fraud that cost a group of founders about fifteen million dollars last year. I’m thinking of a specific case—a $50 million industrial components company, family-owned, sold to a strategic buyer in 2022. The earnout was supposed to be a simple two-year ebitda based earnout, capped at $15 million, tied to hitting agreed targets. The buyer zeroed it out in the first year. Luna: Zeroed out? How do you zero out an earnout in year one unless the company completely collapses? Lucas: That’s exactly the question. The company didn’t collapse. In fact, revenue actually grew slightly. But the buyer reclassified a bunch of ordinary operating expenses as capital expenditures, accelerated maintenance write-offs, and then booked a massive restructuring charge—all allocated entirely to the acquired entity. By their calculation, EBITDA dropped from about $8 million pre-close to negative $2 million post-close. Luna: So they basically moved the goalposts by changing how they defined EBITDA after the deal closed. But doesn’t the earnout agreement usually lock in a definition? Lucas: It does—on paper. This agreement had a standard definition: EBITDA as calculated in accordance with GAAP, consistently applied. The problem is that consistency is hard to enforce when the buyer controls the books. They argued the restructuring was necessary to integrate the business, and the capex reclassification was just correcting prior accounting errors. The sellers had no audit rights built into the earnout clause. Luna: No audit rights? That seems like a massive oversight. I mean, if you’re trusting the buyer to calculate your earnout, you need the ability to verify the numbers. Lucas: Exactly. And that’s the first concrete lesson: every earnout agreement should include a clause giving the seller the right to access the buyer’s books specifically for the earnout calculation, including the right to hire an independent accountant at the buyer’s expense if there’s a dispute. Without that, you’re negotiating blind. Luna: What about the earnout cap itself? I’ve heard that putting a cap on the earnout actually protects the buyer more than the seller in some cases. Lucas: It depends. A cap limits upside, but it also sets a clear ceiling. In this deal, the cap was $15 million, and the sellers thought that was generous because the base deal was already $50 million. But the real risk was that the earnout was structured as an all-or-nothing threshold: if EBITDA hit $10 million, they got the full $15 million; if it hit $9.9 million, they got zero. That binary structure is a recipe for litigation. A better approach is a linear earnout—every dollar of EBITDA above a floor triggers a proportional payout. Luna: So the structure itself incentivized the buyer to just barely miss the target. But in this case they didn’t barely miss—they cratered the number. How did they get away with it legally? Lucas: They relied on something called the ‘good faith’ standard. Most earnout agreements include a covenant that the buyer will operate the business in good faith and not take actions deliberately to avoid the earnout. But proving bad faith is really hard. The sellers sued, and the court had to decide whether the restructuring charges were legitimate integration costs or a deliberate sabotage. Ultimately, the case settled for about 20 cents on the dollar because the sellers couldn’t afford the discovery costs. Luna: That’s brutal. So what are the specific provisions that could have prevented this? You mentioned audit rights. What else? Lucas: Three things. First, a ‘material adverse effect’ carve-out that excludes restructuring charges from the earnout calculation. Second, a list of explicitly excluded expenses—things like post-close management fees, allocated overhead, and integration costs that the buyer charges to the target. Third, a ‘most favored nation’ clause that says the target can’t be charged higher internal rates than any other subsidiary. Luna: And what about the EBITDA definition itself? Should sellers insist on a fixed, non gaap definition that locks in specific add-backs? Lucas: Absolutely. The best practice is to negotiate a ‘defined EBITDA’ schedule attached to the agreement that lists every add-back and exclusion. For example, one-time integration costs, severance beyond a certain threshold, and any non-arms-length transactions—those should all be excluded from the earnout calculation. The more prescriptive, the better. Vague language like ‘consistent with past practice’ is an invitation to dispute. Luna: I’ve also seen earnout disputes where the buyer manipulates working capital targets. Is that a related issue? Lucas: Very much so. In the same deal, the buyer also delayed payments to suppliers after close, which inflated accounts payable and reduced working capital. That had the effect of making the company look less profitable because they recognized expenses faster. The working capital adjustment at close is supposed to capture that, but if the earnout period is based on EBITDA rather than cash flow, timing games can distort the number. Luna: Speaking of timing, how long should an earnout period be? Two years seems standard, but is there a sweet spot? Lucas: I think two years is reasonable if the earnout is tied to operational milestones that the seller can influence. Longer than three years, and the risk of buyer interference increases because the business changes so much. Shorter than one year, and the earnout doesn’t really align incentives. In this case, two years was fine, but the structure was flawed. The lesson isn’t the duration—it’s the safeguards. Luna: Right. So you build in audit rights, defined EBITDA exclusions, a linear payout, and a most favored nation clause. Is that enough? Lucas: Almost. The last piece is a dispute resolution mechanism that doesn’t require litigation. Binding arbitration with a neutral accounting firm, paid for by the losing party, can resolve earnout disputes in months instead of years. And it keeps the relationship from completely souring. In the case I mentioned, the sellers spent over a year in discovery and got pennies on the dollar. Arbitration would have cost a fraction and likely produced a fairer outcome. Luna: You know, this reminds me of something I read about earnout fraud in the lower middle market—deals under $100 million. It’s incredibly common because the sellers are often first-time sellers without sophisticated legal counsel. Lucas: Exactly. And the buyers know that. They structure earnouts knowing the seller lacks the resources to enforce them. It’s not always bad faith—sometimes it’s just aggressive accounting. But the result is the same: the seller’s earnout gets wiped out. The numbers are sobering. I’ve seen studies that show about 40 percent of earnouts in middle-market deals result in a dispute, and of those, sellers recover less than half of what they expected. Luna: Forty percent dispute rate. That’s huge. So the message for sellers is: if you’re considering an earnout, you need to negotiate the protections before you sign. Because after closing, the leverage shifts entirely. Lucas: And that’s really the core of it. If this conversation has moved your work forward in some small way, honestly, if today was worth a coffee to you, that’s the link—buy me a coffee dot com slash fexingo. It’s how we keep the show ad-free and focused on the details that matter. Luna: Yeah, listener support makes a real difference. We hear from people who’ve used these episodes to negotiate better terms in their own deals. That’s exactly why we do it. Lucas: So back to the protections. One more point: in the case I described, the sellers also missed the opportunity to negotiate an earnout floor. If the buyer fails to achieve a minimum EBITDA, the seller at least gets a guaranteed amount. It’s a compromise—the buyer gets downside protection, the seller gets some certainty. In that deal, a $2 million floor would have saved the sellers from complete wipeout. Luna: And that floor should be tied to something objective, like actual revenue, not EBITDA, so it’s harder for the buyer to manipulate. Lucas: Right. Revenue is harder to fudge than EBITDA because it’s more visible. But buyers can still channel-stuff or delay orders. So you also want a clause that excludes any revenue from related-party transactions or one-time bulk sales that the buyer forces through. Basically, you want to isolate the earnout performance to the underlying business that you sold, not the buyer’s integration scheme. Luna: That’s a good summary. So to wrap up: audit rights, defined EBITDA, linear payout, most favored nation, binding arbitration, and a revenue-linked floor. Any other nuance? Lucas: One more: the ‘good faith’ clause should be explicit about what constitutes bad faith. Instead of a generic covenant, list specific prohibited actions—like reclassifying expenses, delaying customer orders, or terminating key employees. The more specific, the easier to prove breach. And include a liquidated damages provision so that if the buyer is found to have acted in bad faith, the earnout is immediately paid in full. Luna: That would certainly focus the buyer’s attention. So the takeaway: earnouts are a tool, not a trap—but only if you build the cage before you let the animal in. Lucas: Exactly. And we’ll link to a sample earnout clause template in the show notes. Next time, we’re looking at how breakup fees evolved from a standard 3 percent to sometimes 10 percent in tech deals—and what that tells us about valuation uncertainty.