Latest / The Buyer & Seller Podcast with Fexingo: Business Brokers, Exits, and Private Sales Explained / The Earnout Trap What Every Business Seller Needs to Know
Transcript
- Lucas: So you sell your business for what you think is eight million dollars. You sign the papers, shake hands, and a year later you get a check for five point two million. That gap — that missing two point eight million — that is the earnout trap we are about to dig into. Luna: And I know you have a specific story in mind. The software company where the founder walked away with barely half of what he thought he'd get. Lucas: Exactly. I spoke with a business broker who handled a deal for a niche SaaS company — let's call them DataWeave, not the real name — that did about three million in recurring revenue. The buyer offered six million upfront plus a two million earnout tied to hitting a hundred and ten percent of year-one revenue. The founder felt confident. His revenue had been growing thirty percent year-over-year for three years straight. Luna: So what went wrong? Lucas: Six months after closing, DataWeave's biggest client — who represented about twenty percent of total revenue — was acquired by a competitor and terminated the contract. The buyer refused to recalculate the earnout target. The founder missed the revenue target by eight percent. He got zero of that two million earnout. Luna: Ouch. And there's no way to claw that back once you've sold, right? The buyer controls the operations. Lucas: Correct. That's the core problem. The earnout is designed to bridge the gap between what the buyer thinks the business is worth today and what it could be worth if certain milestones are hit. But the seller gives up control the moment the deal closes. The buyer can change strategy, pull resources, or simply run the business differently — and the earnout formula stays static. Luna: I've seen data that says something like forty percent of earnouts never pay out the full amount. Some studies say nearly a quarter pay zero. Lucas: Yeah, the numbers are ugly. A 2023 survey by the International Business Brokers Association found that only about thirty-eight percent of earnouts hit their targets and pay in full. About twenty-two percent pay nothing. So if you're a seller and the earnout is a big chunk of your total price, you are essentially gambling on a future you cannot control. Luna: But it's not all doom and gloom. Some earnouts do work. I mean, I've negotiated a few as a buyer, and when they work, they align incentives. The seller stays motivated to help the business grow post-close. Lucas: Right, in theory. But the devil is in the details. The most successful earnouts are tied to metrics the seller can still influence — like gross margin, customer retention, or even product development milestones — not just top-line revenue. And they often include a 'most favored nation' clause that protects the seller if the buyer changes the business model. Luna: I want to get into those protections. But first, let me ask: what about the buyer's perspective? If I'm buying a business, why would I agree to an earnout at all? Lucas: Because it reduces your risk. You're saying, 'I'll pay you more if the business actually performs the way you say it will.' It's a way to finance part of the acquisition with future cash flows. For the seller, it can justify a higher asking price. But the asymmetry of control is the trap. Luna: Absolutely. And that's something we talk about a lot on this show — the power dynamics in a private sale. If these kinds of conversations have helped you think about your own business exit strategy in a more informed way, I think that's exactly why we keep doing this ad-free. Lucas: Yeah, we deliberately don't run ads on these episodes. If you want to support that choice, the link is buy me a coffee dot com slash fexingo. It's a simple way to keep this resource available without any sponsored interruptions. Luna: Totally. And it's not about big donations — it's just knowing that listeners find real value here. Now, back to the earnout. Lucas, you mentioned 'most favored nation' clauses. Walk me through what that looks like in practice. Lucas: Sure. A 'most favored nation' clause — sometimes called an MFN clause — says that if the buyer changes the business in a way that materially affects the earnout metric, the earnout target gets adjusted fairly. For example, if the buyer decides to pivot from a subscription model to a usage-based model, that could tank year-one recurring revenue. An MFN clause would force renegotiation of the target. Luna: That's smart. But it's hard to get buyers to agree to that. They want flexibility. Lucas: Exactly. So the seller has to negotiate it upfront, before the letter of intent is signed. Once the LOI is signed, the buyer has a lot of leverage. The key is to bring in an experienced business broker or M&A attorney who has seen these traps before. Luna: What about the earnout period itself? How long should it be? Lucas: Typical earnout periods are one to three years. Shorter is better for the seller because the buyer has less time to alter the business trajectory. A one-year earnout tied to a metric the seller can still influence — like ensuring a key client stays — is much safer than a three-year earnout tied to compound annual growth rate. Luna: So what's the best-case scenario for a seller who absolutely must have an earnout to get the deal done? Lucas: I'd say, push for a 'floor and cap' structure. The floor means you get at least some portion of the earnout even if you miss the target by a small amount. The cap means the buyer can't claim unlimited upside if you blow the target out of the water — but honestly, that's usually in their favor anyway. Also, negotiate a 'good leaver/bad leaver' provision: if the buyer fires you without cause, the earnout should accelerate and pay out in full. Luna: And always, always define 'cause' very narrowly. I've seen buyers find a pretext to push the seller out right before the earnout period ends. Lucas: Yes. That's the ultimate nightmare. You stay on as a consultant or employee, and six months in, the buyer says you're not meeting performance expectations — which are subjective — and terminates you. Then they argue the earnout is void because you're no longer employed. So the employment agreement needs to be airtight. Luna: Do you have a recent example where earnouts worked well? Lucas: I do. There was a manufacturing company — let's call it Precision Parts — that sold for ten million with a three million earnout tied to gross margin, not revenue. The founder stayed on as COO. He focused on cost reduction and process improvement. Gross margin went from thirty-two percent to thirty-eight percent in two years. He got the full earnout plus a bonus. The key was that the metric was under his control and the buyer didn't mess with the operations. Luna: So the lesson is: pick a metric you can actually influence, negotiate protections, and get a good lawyer. That sounds like a solid checklist. Lucas: And one more thing: don't let the earnout be more than twenty-five to thirty percent of the total purchase price. Studies show that when the earnout exceeds that threshold, the likelihood of disputes skyrockets. Sellers get desperate to hit targets, buyers get defensive, and relationships sour. Luna: That's a good rule of thumb. I think a lot of sellers get starry-eyed about the upside and ignore the risk. Lucas: Exactly. And that's the trap. When you're negotiating the deal, the earnout feels like free money. But if you're not careful, it can become a source of regret. The best approach is to structure it conservatively, assume you'll get zero, and be pleasantly surprised if you get paid. Luna: So walk away from a deal that leans too heavily on earnout? Or at least demand a higher upfront cash component? Lucas: Right. If a buyer insists on a huge earnout — say fifty percent of the price — that's a red flag. It either means they don't trust your numbers, or they're planning to change the business in ways that will make it hard to hit. A reasonable buyer will accept a modest earnout as a risk-sharing tool, not a crutch to justify a lowball offer. Luna: And if you're on the buyer side, what's your philosophy on earnouts? Lucas: As a buyer, I like earnouts that are tied to specific, verifiable milestones — like retaining a key customer, launching a new product, or hitting a certain EBITDA margin. I also prefer earnouts that are paid in installments, not a lump sum, so I can adjust if things go sideways. But I'm always aware that a poorly designed earnout can create resentment and kill the goodwill I just paid for. Luna: Yeah, the relationship piece is real. An earnout can poison the transition period if both sides aren't aligned. Lucas: Exactly. And that's why I think the best deals are structured with a clean cash exit and maybe a small earnout as a sweetener — not the main event. The DataWeave founder, if he'd taken five million upfront and a one million earnout with strong protections, he'd have walked away with at least five million and maybe an extra million. Instead, he got five point two, and he's still bitter. Luna: Bitter enough to talk about it publicly, which is why we have this episode. So for anyone listening who's considering selling their business: what's the one thing you want them to remember? Lucas: That an earnout is a promise about the future, and the future is not in your hands. So negotiate like the worst case is the base case, and get everything you can upfront. Luna: Good advice. And we'll put some resources in the show notes about earnout clauses and sample language. Lucas: Perfect. Next episode, we're going to talk about seller financing — another tool that sounds great but can backfire. See you then.