Latest / The Buyer & Seller Podcast with Fexingo: Business Brokers, Exits, and Private Sales Explained / How the Earnout Guarantees Your Business Sale Price
Transcript
- Lucas: So you sell your business for twelve million dollars — congratulations. But here's the catch: you only get eight million at closing, and the other four million depends on whether your customers actually stick around for the next three years. Luna: That sounds like a recipe for sleepless nights. And it's exactly what happened in an industrial services deal I came across last month. Lucas: Right. That's the earnout — one of the most common, and most contentious, tools in private business sales. It's a way to bridge the gap between what the seller thinks the business is worth and what the buyer is willing to pay upfront. Luna: But when it goes wrong, it can get ugly. Let's break down why. Lucas: Let's start with the case. I spoke to a business broker who handled a deal for a mid-sized industrial services company — we'll call it Acme Industrial. They specialized in maintaining heavy machinery for manufacturing plants. Revenue was about five million, EBITDA around one point two million. Luna: And the buyer was a larger competitor looking to expand geographically. Lucas: Exactly. The buyer offered twelve million, but only eight million cash at close. The remaining four million was tied to an earnout: the seller would get it if they retained at least 85 percent of their customer base over three years. Luna: So the seller stays on as a consultant, helps with the transition, and if customers leave, they lose millions. That's a big incentive. Lucas: It is — but it can also backfire. In this case, the earnout was structured around a metric the seller could influence. Customer retention made sense because the seller knew the relationships. Luna: But here's the thing I've seen: earnouts tied to revenue or profit can be manipulated. The buyer might allocate overhead costs to the acquired unit, or change pricing, and suddenly the seller's earnout shrinks. Lucas: That's the classic problem — moral hazard. The buyer has control over the business after closing, so they can make decisions that hurt the earnout. And the seller has no say. Luna: There's actually a study from the University of Chicago that looked at over twelve hundred private M&A deals with earnouts. They found that nearly 40 percent ended in a dispute. Lucas: Forty percent — that's huge. And those disputes often end up in arbitration or court, costing both sides time and legal fees. Luna: So what's the fix? How do you structure an earnout that actually works for both sides? Lucas: The best earnouts have three characteristics. First, the metric should be objective and verifiable — something like revenue from a specific set of customers, not something like 'goodwill' or 'strategic alignment'. Luna: Second, the seller should have some control over that metric. If it's customer retention, they need to stay involved. If it's product development, they need authority. Lucas: And third — this is the one most people miss — there needs to be a dispute resolution clause upfront. Not just 'we'll figure it out'. Something like: if the earnout calculation is disputed, both sides appoint a neutral accountant to decide. Luna: That saves a lot of headaches. I've seen earnouts where the buyer and seller spent more time arguing over the numbers than actually running the business. Lucas: Let me give you another example. A friend of mine sold a software company a few years ago. The earnout was based on new license sales. Simple, right? Luna: But I bet it wasn't that simple. Lucas: No. The buyer decided to bundle the software with their own products and stopped selling it standalone. So new license sales cratered, and my friend got zero earnout. He sued — and won — but it took two years. Luna: That's brutal. So what could he have done differently? Lucas: He could have defined the earnout metric to exclude the impact of the buyer's decisions. For example, tie it to renewal rates of existing customers, or to revenue from customers that were already in the pipeline. Luna: Or he could have insisted on a minimum period where the buyer couldn't change the go to market strategy. Lucas: Exactly. That's called a 'non-interference' clause. It protects the seller from the buyer making changes that deliberately kill the earnout. Luna: Let's step back. When is an earnout actually a good idea? I mean, why not just adjust the price upfront? Lucas: Sometimes the buyer and seller just can't agree on a single number. The seller thinks the business is worth fifteen million based on future growth. The buyer sees risk and offers ten. An earnout lets them split the difference — the seller gets the upside if the growth happens. Luna: It also reduces the buyer's upfront risk. They only pay more if the business performs. Lucas: Right. But the seller needs to be realistic about the probability. I've seen sellers assume they'll hit every earnout target, but the data says otherwise. According to a study by SRS Acquiom, about 30 percent of earnouts pay out in full. Luna: So most sellers get less than they hoped. That's sobering. Lucas: It is. But if you're a seller and you're considering an earnout, the best advice I can give is to hire an experienced M&A attorney who has seen these disputes. And negotiate the earnout terms like you're going to war, not a partnership. Luna: Because at the end of the day, once you hand over the keys, you lose control. Lucas: Exactly. Now, before we get into another example, I want to mention something quickly. A few listeners have asked how we keep this podcast ad-free and independent. The answer is straightforward — some of you chip in monthly through buy me a coffee dot com slash fexingo. It's a small group, but it literally covers the costs of producing this many episodes. Luna: Yeah, and we really appreciate that. It lets us dig into topics like earnouts without worrying about sponsors or ad reads. Lucas: So if these conversations have been useful to you in your own business journey, that's where you can support us. No pressure at all. Now, back to earnouts — there's another variation I want to talk about: the 'earnout cap'. Luna: Is that where the seller can earn more than the base earnout if they overperform? Lucas: Exactly. Some earnouts have a ceiling, some have a floor. The cap protects the buyer from paying too much if the business suddenly skyrockets due to market conditions. The floor guarantees the seller a minimum even if targets are missed. Luna: I've seen deals where the earnout is uncapped — the seller gets a percentage of every dollar above the target. That can create a huge incentive. Lucas: But it can also create conflict if the buyer thinks the seller is cutting corners to hit numbers. Like deferring maintenance or pushing customers to buy before they need to. Luna: So there's a trade-off between alignment and risk. The key is to be explicit about what each side can and cannot do. Lucas: Right. And one more thing — earnouts aren't just for the full sale price. Sometimes they're used for a portion of the consideration, like 10 or 20 percent. That reduces the risk for both sides. Luna: What about the timeline? I've seen earnouts that last one year, others that last five. Lucas: Typically two to three years. Longer than that, and the seller loses interest or the business changes too much. Shorter than a year, and you might not have enough data to know if the performance is sustainable. Luna: So if you're a seller, what's your takeaway from all this? Lucas: First, assume the earnout will not pay out in full, and negotiate the upfront cash accordingly. Second, define the metric tightly and make sure you can influence it. Third, include a non-interference clause. And fourth, have a dispute resolution process written into the agreement. Luna: That's a solid checklist. And for buyers, I'd add: don't use earnouts as a way to lowball the upfront price. If you genuinely believe the business is worth less, negotiate that. An earnout should be a bridge, not a trap. Lucas: Well said. The deal we started with, the industrial services company — the seller actually got most of the earnout because they had a strong non-interference clause and stayed on as a consultant. But they told me the process was stressful. Luna: I can imagine. Every month, checking whether customers were still billing at the same level. Lucas: Right. So if you're considering an earnout, go in with your eyes open. It's not free money — it's deferred payment with strings attached. And that's not necessarily bad, but you have to know what you're signing up for. Luna: And that's the kind of honest conversation we try to have here. Lucas: Next time, we'll talk about the role of earnout insurance — a relatively new product that can protect sellers if the buyer's actions tank the earnout. It's fascinating. Luna: Looking forward to that. Until then, keep your metrics clean and your clauses tight.