Latest / The Buyer & Seller Podcast with Fexingo: Business Brokers, Exits, and Private Sales Explained / The Earnout Structure That Actually Protects Sellers
Transcript
- Lucas: So there is this idea in private business sales that an earnout is basically a trap. You hear it all the time — 'never take an earnout', 'they'll never pay it', 'it's a way for the buyer to claw back the price.' And look, that can be true. But it's not the whole story. Luna: Right, because a lot of sellers don't have a choice. If the buyer insists on an earnout to bridge a valuation gap, you either figure out how to make it work or you walk. Lucas: Exactly. And walking might be the right call in some cases. But I've seen earnouts actually work — where the seller gets paid in full and the buyer is happy. So the question is: what makes the difference between an earnout that pays out and one that doesn't? Luna: Let me guess — it's in the structure, not just the number. Lucas: It's exactly that. The earnout that fails is usually one where the metric is vague or easily manipulated by the buyer. Revenue, for example — a buyer can push expenses into a different cost center, cut marketing, and revenue might hold up, but the business gets gutted. Or they tie it to EBITDA, which is even more subjective. Luna: So what's the better alternative? I've heard of earnouts tied to gross profit rather than revenue. Does that actually help? Lucas: It helps a lot, actually. Gross margin dollars are harder to manipulate than net income. You'd have to change pricing or product mix in a way that's pretty visible. But even better is when you combine that with a minimum guarantee. Luna: A minimum guarantee — meaning the seller gets a floor no matter what? Lucas: Exactly. Let me give you a concrete example. I spoke with a lower middle market investment banker who represented a specialty-chemicals distributor last year. The deal was around $28 million. The buyer wanted an earnout of up to $4 million based on hitting certain growth targets over three years. The seller was nervous — rightly so. Luna: Because if the buyer doesn't invest, or they change the sales team, the earnout disappears. Lucas: Right. So the banker proposed a structure where the earnout was tied to gross margin dollars — not revenue, not EBITDA — and it had a minimum guarantee of $1.5 million. Meaning, regardless of performance, the seller would get at least that amount. The remaining $2.5 million was contingent on growth. Luna: And the buyer agreed to that? I'd think they'd want all of it to be performance-based. Lucas: Surprisingly, yes. And here's why: the buyer actually preferred it. Because with a minimum guarantee, they could book the liability — it's a fixed obligation. And they could structure the purchase price as a combination of cash and a guaranteed earnout, which made their financing easier. The seller got certainty, the buyer got a cleaner deal. Luna: That's a win-win. So the minimum guarantee isn't just a concession to the seller — it actually serves the buyer's interests too. Lucas: Exactly. And there's another layer: the earnout formula itself. The one they used was based on gross margin dollars above a baseline. The baseline was the trailing twelve months' gross margin at closing. If the business grew gross margin by, say, $500,000 in year one, the seller got a percentage of that. But the minimum guarantee kicked in if growth was below a certain threshold. Luna: So the seller had upside and a floor. That's a lot more balanced than the typical 'all or nothing' earnout. Lucas: Right. And this is where I think a lot of sellers get tripped up — they focus on the total earnout amount, like 'I want $5 million if we hit the plan,' but they don't negotiate the mechanics. What happens if the buyer changes the product line? What if they reassign key salespeople? A good earnout has protections against that. Luna: Like what kind of protections? Lucas: One is called 'most favored nations' — basically, the seller gets the same treatment as the buyer's other portfolio companies. If the buyer gives better support to another division, the seller can claim a loss. Another is 'non-compete carve-outs' — if the seller leaves and the buyer hires a replacement who underperforms, the earnout shouldn't suffer. And a big one is audit rights. Luna: Audit rights meaning the seller can verify the numbers? Lucas: Exactly. At the seller's expense, usually, but if the earnout is underpaid by more than a certain percentage — say 5% — the buyer reimburses the audit cost. That keeps the buyer honest. Luna: So we're talking about a whole negotiation within the negotiation. It's not just 'here's the number, here's the target.' Lucas: Right. And that's why having an advisor who's done this before matters. The banker I mentioned said the biggest mistake he sees is sellers agreeing to an earnout based on a single metric without a floor and without a dispute mechanism. They end up in a fight with the buyer over what the numbers actually are. Luna: And then they spend more on lawyers than the earnout is worth. I've heard that story before. Lucas: You know, this is exactly the kind of practical detail we dig into on this podcast — the stuff that actually changes outcomes for business owners. And 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. Luna: Yeah, it's a small way to keep this resource free and independent. Every bit helps. Lucas: So back to the earnout structure. The other thing that made this chemicals deal work was the duration. The earnout was three years, but with a one-year 'cliff' — meaning no payout in year one unless they hit an aggressive threshold. The idea was that year one was for integration, and the earnout really kicked in years two and three. Luna: So the seller didn't get a check in year one unless the buyer really pushed growth. That seems risky, but the minimum guarantee presumably covered that. Lucas: Exactly. The minimum guarantee was paid out in equal installments over the three years regardless. So the seller got $500,000 per year no matter what. If gross margin grew, they got additional payments on top. In the end, the seller actually earned the full $4 million — the business grew faster than expected. Luna: So the earnout worked exactly as intended. The seller got the upside, the buyer got a motivated seller during the transition, and the business performed. Lucas: Right. But it only worked because the structure was designed from the start to align incentives. The buyer couldn't undermine the earnout by starving the business of resources, because the metric — gross margin dollars — would show that immediately. And the seller had a floor, so they weren't desperate. Luna: I want to ask about something you mentioned earlier — the idea that buyers actually prefer a well-structured earnout. Can you say more about that? Lucas: Sure. A buyer's nightmare is overpaying. If they pay full price upfront and the business underperforms, they've destroyed value. An earnout lets them share the risk. But if the earnout is poorly designed — like tied to revenue with no floor — the buyer might end up paying for growth that isn't profitable. So a good earnout protects the buyer too. Luna: So both sides want the same thing: a formula that rewards real, profitable growth and doesn't create perverse incentives. Lucas: Exactly. And that's why the gross margin dollar earnout with a minimum guarantee is gaining traction in the lower-middle market. It's not perfect for every deal, but it's a much better starting point than the traditional 'earnout based on EBITDA' model. Luna: What about the tax side? Does the structure affect how the earnout is taxed? Lucas: It can. If the earnout is structured as deferred purchase price, it's generally taxed as capital gains when received. But if it's structured as compensation for services — say the seller stays on as a consultant — it's ordinary income. That's a huge difference. So sellers should absolutely have a tax advisor model out the scenarios. Luna: That's a critical point. I've seen sellers accidentally turn a capital gain into ordinary income just by signing the wrong consulting agreement. Lucas: Right. And there's another nuance: the 'earnout period' — how long the earnout lasts. In the chemicals deal, it was three years. I've seen five-year earnouts, but those are harder to enforce because so much can change. The shorter the earnout, the less room for the buyer to manipulate. Luna: So what's the sweet spot? Is two years too short? Lucas: It depends on the business. For a service business with recurring revenue, two years might be enough. For a manufacturing business with long sales cycles, three years is more common. But anything beyond four years starts to feel like a lottery ticket. Luna: And if the buyer doesn't hit the targets, what happens? Does the seller get nothing? Lucas: That's where the minimum guarantee matters. Without it, yes — the seller could get zero. But with a guarantee, they at least get something. And if the buyer deliberately sabotages the earnout, the seller can sue for 'earnout frustration' — but that's expensive and uncertain. Better to have contractual protections upfront. Lucas: One more thing: the 'earnout dispute resolution' clause. In the chemicals deal, they agreed that if the buyer and seller disagreed on the gross margin calculation, they'd go to a neutral accounting firm — not litigation. That saved them time and money. Luna: So the takeaway for sellers is: don't just focus on the earnout amount. Focus on the definition of the metric, the floor, the duration, and the dispute process. Lucas: Exactly. And if a buyer refuses to include a minimum guarantee or audit rights, that's a red flag. It doesn't mean the deal is bad, but it means you need to price that risk into your decision. Luna: Or maybe walk away, as you said earlier. But I think a lot of sellers don't realize they have leverage. If the buyer really wants the business, they'll agree to reasonable protections. Lucas: Right. And that's the bottom line: an earnout can be a tool that bridges a valuation gap and aligns incentives — but only if it's built correctly. Sellers need to treat it as a separate negotiation, not an afterthought.