Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / How the Earnout Cap Trap Sabotages SaaS Sellers
Transcript
- Lucas: There's a moment in every SaaS earnout negotiation where the buyer's lawyer slides a piece of paper across the table and says, 'We put a small cap in there, just to align incentives.' And a lot of sellers nod and move on. That single word — 'cap' — can cost you more than any other term in the whole deal. Luna: Define 'small.' I've seen caps that look reasonable at first glance but are actually designed to trigger way before the business hits its real potential. Lucas: Exactly. Let's use a real example. Early 2024, a B2B analytics company called — I'll call it DataSeer — got acquired for $40 million upfront with a $12 million earnout tied to recurring revenue growth over two years. The earnout had a $3 million annual cap. Sounded fine in the term sheet. But here's the thing: the earnout formula was written against 'net recurring revenue,' defined as gross recurring minus churn. Luna: So the cap wasn't on growth, it was on the net number after churn. That's a subtle squeeze. Lucas: Right. DataSeer had a 12 percent annual churn rate. So even if they grew gross bookings by 20 percent, net recurring revenue only advanced by about 8 percent. The earnout was designed so the cap would likely bind before they could earn the full $12 million. And in fact, they hit 140 percent of their net revenue target in year one, but the cap limited the payout to $3 million, not the proportional $4.2 million they expected. Luna: That's a $1.2 million haircut on just the first year. And if the same pattern repeated, they'd leave $2.4 million on the table total. But you said $10 million earlier. Lucas: Because in year two, DataSeer's churn actually improved — they got net revenue growth up to 18 percent. But the buyer had structured the earnout with a cumulative cap over the two-year period of $6 million. So even though they earned $4.2 million in year one and $5.4 million in year two — total $9.6 million — the cumulative cap of $6 million swallowed the overage. They got $6 million instead of $9.6 million. That's $3.6 million more lost. And if you factor in the value of the deferred payment and the risk they took, it's effectively a $10 million shortfall. Luna: So the cap doesn't just limit upside — it distorts behavior. If you're a seller still running the company post-close, you know that once you're near the cap, extra effort doesn't pay. Why push for 20 percent growth when you only get paid for 10 percent? Lucas: And that's exactly what happened. DataSeer's CEO told me the team felt demoralized halfway through year two. They'd already hit the cumulative cap, so any additional revenue just made the buyer richer. The earnout stopped being an incentive and became a ceiling. Luna: I want to pause here because I think a lot of listeners are in the middle of earnout negotiations right now, or will be soon. And this kind of episode exists because listeners tell us they need the detail. If today's breakdown was useful to you, the way these stay ad-free is via listener support — you can find that at buy me a coffee dot com slash fexingo. It's a small gesture that keeps these deep dives coming. Lucas: Yeah, exactly. We don't do sponsors, so it's just people who find value chipping in. And it makes a real difference. Now, back to that cap structure. Lucas: The worst part? DataSeer's lawyers didn't catch the cap interplay because the term sheet said 'earnout capped at $6 million cumulative,' but the definition of net recurring revenue was buried in a 40-page disclosure schedule. The cap seemed generous — $6 million on a $12 million potential — but the formula definition was the real trap. Luna: So how do you negotiate a better cap? Or better yet, should you accept a cap at all? Lucas: In an ideal world, an uncapped earnout is best for the seller, but buyers almost never agree. They want to limit their downside if the business explodes. So the compromise is a 'high cap' — set it at 200 percent or 300 percent of the target. That way the seller has genuine upside for outperformance, and the buyer still has a ceiling. For DataSeer, a 200 percent cap would have given them $12 million — exactly the maximum, but they'd have earned it. Instead, the 50 percent cap left them at $6 million. Luna: And the other negotiation lever is the definition of the metric itself. You want the cap to be against a metric you can control, like gross recurring revenue, not net after churn or after cost allocations. Lucas: Absolutely. And if the buyer insists on net revenue, then you push for a churn adjustment or a floor. Say: 'If churn exceeds X percent, the cap lifts proportionally.' That protects you if the buyer's integration team messes up customer retention. Also, watch for annual caps versus cumulative caps. Annual caps are more seller-friendly because if you blow past it in year one, you still get full value. Cumulative caps let the buyer keep overperformance in year one from being compensated in year two. Luna: I once saw a deal where the buyer had an annual cap, but then a 'true-up' clause that clawed back any overpayment if the cumulative didn't hit targets. Basically a cumulative cap disguised as an annual one. Lucas: Right, that's the two-way ratchet. So read every clause carefully. Another tactic: if the buyer insists on a cap, ask for a 'kicker' — if you exceed the cap by a certain percentage, the cap lifts to a higher tier. That aligns incentives again. In DataSeer's case, a kicker at 120 percent of target would have triggered a cap increase to maybe $10 million. Luna: And what about the earnout period? Longer periods with lower caps can actually be better if the business is lumpy. Lucas: That's a good point. A three-year earnout with a $2 million annual cap versus a two-year earnout with a $6 million cumulative cap — the math can favor the longer period if there's seasonality or product cycles. But you have to model it out with your actual projections, not just the buyer's base case. Luna: So the lesson for sellers is: don't just look at the earnout total. Model the cap against your realistic upside, and force every term to be written in plain language with examples. Lucas: Exactly. And one more thing: if you're a seller, have your lawyer attach a simple Excel model to the SPA that shows exactly how the earnout is calculated under different scenarios. If the buyer balks, ask why they're afraid of clarity. That usually reveals the intent. Luna: I think that's a good place to leave it. The earnout cap doesn't have to be a trap — but it will be if you don't read the definitions. Lucas: Next time, I want to talk about the 'earnout waterfall' — what happens when multiple sellers share a single earnout pool and how to avoid internal disputes that kill the value. Until then.