Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / How Earnouts Drive the Indie M&A Market in 2026
Transcript
- Lucas: If you've been following deal activity this year, you've probably noticed one term popping up in almost every private-company sale under fifty million dollars: earnout. Luna: Yeah — I've seen it in SaaS deals, in consumer brands, even in professional services. It's like earnouts have become the default bridge when buyers and sellers can't agree on value. Lucas: Exactly. And there's a good reason. Interest rates are still elevated relative to 2021, which means leverage is expensive. Buyers want to limit their upfront cash, and sellers want to capture the upside if the business grows. An earnout is supposed to solve both. Lucas: But here's the thing — the structure is deceptively simple on paper and brutally complex in practice. I want to walk through a specific deal from last quarter that really shows how earnouts work when they go right, and then contrast it with a case where the earnout turned into litigation. Luna: Let's start with the good one. What was the deal? Lucas: A mid-market software company — we'll call it DataSync — was acquired by a larger strategic buyer for forty million dollars upfront. The earnout was tied to a revenue target over three years: hit one hundred and twenty million in cumulative revenue, get an additional twelve million. Lucas: The seller stayed on as CEO of the division. Year one, revenue hit forty-five million — above plan. Year two, fifty million. Year three, fifty-five. That's exactly one hundred and fifty million total. The earnout triggered at the maximum payout. The seller walked away with fifty-two million all-in. Luna: That's a 30 percent upside. But that only works if the buyer doesn't screw with the business post-close. That's the classic fear, right? Lucas: Right. And that's where the ugly cases live. There's a documented pattern — call it the 'earnout sabotage' — where the buyer intentionally starves the acquired unit of resources, or reallocates revenue to other divisions, or changes accounting methods to make the earnout harder to hit. Lucas: I looked at a study from a boutique advisory firm that tracks earnout outcomes. They found that of earnouts that were structured as a percentage of revenue or EBITDA, roughly 30 percent paid zero, 40 percent paid partial, and only 30 percent paid the full amount. That's a pretty sobering distribution. Luna: So if you're a seller, you're essentially betting that the buyer will behave in good faith for three years. That's not a great bet. Lucas: It's not. And that's why the best earnout agreements include what are called 'sole efforts' or 'commercially reasonable efforts' clauses — but even those are vague. A better approach is to tie the earnout to metrics the seller can directly control, like product development milestones or customer retention, rather than aggregate revenue that depends on the buyer's overall strategy. Luna: I've also seen earnouts tied to gross margin dollars instead of revenue. That protects against a buyer who slashes prices to boost top-line. Lucas: That's smart. And it points to something broader — the earnout is really a risk-sharing mechanism. In a perfect world, both sides agree on future value and you don't need one. But in practice, it's the tool that gets deals done when there's an information gap. Lucas: And you know, this topic connects to something we hear from listeners all the time — that these conversations have moved their work forward in some small way. We deliberately don't run ads on these shows. If you want to support that choice, the link is buy me a coffee dot com slash fexingo. Any amount helps us keep the entire podcast network ad-free. Luna: Yeah, it's a small way to keep this machine running without interrupting the content. Appreciate everyone who's contributed. Lucas: Alright — back to earnouts. Let's talk about the litigation side. There's a case from 2025 that's making its way through Delaware Chancery — a manufacturing company called Precision Components. The earnout was tied to EBITDA, but the buyer changed the depreciation schedule after closing, which reduced EBITDA by about eight hundred thousand dollars. The seller sued, and the court ultimately ruled in the seller's favor, but it took eighteen months and probably cost both sides half a million in legal fees. Luna: So the earnout destroyed value even when the seller won. That's the real cost — the time and distraction. Lucas: Exactly. And that's why we're seeing more earnout structures that include an independent arbitrator or a 'neutral accountant' provision — a pre-agreed third party who resolves disputes quickly. Some deals even put the earnout amount into an escrow account with a payout schedule, so there's no question about the buyer's ability to pay. Lucas: Another innovation I'm seeing in 2026 deals is the 'earnout swap' — where the seller gets a smaller upfront, but the earnout is paid in buyer stock rather than cash. That aligns incentives better because the seller becomes a shareholder and cares about the combined entity's performance. Luna: But then the seller takes on market risk. If the buyer's stock tanks, the earnout is worth less. Lucas: True. But for founders who believe in the strategic rationale of the deal, it can be a powerful signal. I talked to a founder who sold his cybersecurity startup last fall — thirty million upfront, plus a stock earnout that could be worth ten million in two years. He said he'd have taken a lower upfront for a bigger stock earnout because he genuinely thought the combined company was undervalued. Lucas: And here's the key from that conversation: he insisted on a one-year lockup on the earnout shares, not the standard six months. That gave him negotiating leverage because it showed he was aligned long-term. Luna: So there's a strategic element to earnout design that goes beyond just the numbers. It's about signaling commitment. Lucas: Right. And that's the meta-skill — understanding that the earnout terms themselves communicate how you'll behave post-close. A seller who asks for a one-year lockup signals confidence. A buyer who insists on gaap defined revenue without any flexibility signals they might try to game the calculation. Luna: What about the seller who wants to leave after the earnout period? Should they push for a shorter earnout — say, one year instead of three? Lucas: Depends on the business. If the seller's presence is critical to hitting the target, a three-year earnout forces them to stay engaged — that can be good for the business. But if the seller is burned out or wants to start something new, a shorter earnout with a higher payout percentage can be better. I've seen deals where the seller took a two-year earnout at 25 percent of revenue growth, versus a four-year earnout at 15 percent. They chose the shorter one because they wanted a clean exit. Lucas: And one more thing — we're seeing more 'earnout caps' in 2026. Buyers are putting hard limits on the maximum payout, sometimes as low as 1x the upfront. That's a red flag for sellers, because it means the buyer sees no scenario where the earnout pays off big. If the cap is too low, the earnout doesn't really bridge the valuation gap — it's just a deferred payment. Luna: So the earnout has to be meaningful enough to matter. If the potential upside is trivial, it's not worth the complexity. Lucas: Exactly. And that's the bottom line for any founder listening: if you're considering a deal with an earnout, make sure it's large enough to move the needle, make sure the metrics are under your control, and make sure the dispute resolution is pre-agreed. Otherwise, you might as well take a lower upfront and avoid the headache. Luna: And if you're a buyer, don't design an earnout you plan to sabotage. The reputational damage in a small M&A community is real. Word travels fast. Lucas: It does. And that's actually a healthy constraint — because earnouts work best when both sides treat them as a genuine alignment tool, not a negotiation crutch. Thanks for listening. We'll be back next week with another deep dive into the mechanics of getting deals done.