Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / Why Earnouts Are Failing in 2026 Deals
Transcript
- Lucas: So we talk a lot on this show about earnouts — they're in nearly half of all private M&A deals now — and we've covered the basics before, but one thing that's really shifting in 2026 is how often they're failing. Luna: Define failing. You mean the seller doesn't get paid, or the whole deal blows up? Lucas: Both, actually. But I'm thinking of a specific case that closed just last year — a cloud security startup, let's call it ShieldLayer, was bought by a large enterprise software firm for about $800 million upfront, with another $200 million in earnout tied to hitting $100 million in revenue by the end of 2026. Luna: Classic structure — revenue earnout, two-year target. What happened? Lucas: ShieldLayer's team stayed on, they were integrating their product into the buyer's platform, and then — the buyer shifted their sales strategy away from ShieldLayer's core product. They deprioritized the R&D roadmap, reassigned key engineers. Revenue flatlined at around $40 million. Luna: So the buyer essentially killed the earnout. That's the classic 'sandbagging' concern sellers always worry about. Lucas: Exactly. And ShieldLayer's founders are now suing, claiming the buyer breached an implied covenant of good faith. But here's the problem: the earnout agreement didn't require the buyer to actively support the product. It just said 'if revenue hits $100 million, you get paid.' Luna: And that's the trap. The earnout is supposed to bridge the valuation gap, but it only works if the buyer has incentives aligned with the seller's post-close efforts. Lucas: Right. And you see this pattern more and more in 2026. According to SRS Acquiom data, earnout disputes have risen about 35% since 2022. I think a big reason is that earnout structures haven't kept up with the complexity of post-merger integration. Luna: So what's the alternative? I've seen more deals using 'fixed earnout' — where the earnout is a set amount paid on a schedule, contingent only on the seller's team staying employed. Lucas: That's one approach, and it avoids the revenue manipulation issue. But it also removes the performance incentive. A better fix might be tying earnouts to controllable actions — like product launch milestones, or specific integration tasks, rather than top-line revenue. Luna: Give me an example of a controllable action. Lucas: Sure. Say the seller's team is responsible for migrating the product to the buyer's cloud infrastructure. The earnout pays out when that migration is completed and tested. That's something the seller's team can actually control, regardless of the buyer's sales strategy. Luna: But then you need a very clear definition of 'completed and tested' — otherwise you're back in litigation territory. Lucas: Exactly. And that's where legal drafting matters enormously. The best earnout agreements I've seen include a detailed 'efforts clause' — the buyer must use 'commercially reasonable efforts' or even 'best efforts' to achieve the earnout. But 'best efforts' is still fuzzy. Luna: There was a Delaware Chancery Court case in 2024, I think it was Fortis vs. Verizon — where the court really scrutinized what 'best efforts' means. They said it requires the buyer to prioritize the earnout objectives unless there's a compelling business reason not to. Lucas: That case has changed how lawyers draft earnouts. Now you see more specific covenants — like 'the buyer shall allocate at least X number of sales reps to the acquired product' or 'the buyer shall not reduce the acquired product's marketing budget below a certain level.' Luna: So it's becoming less about the earnout formula and more about the behavioral guardrails around it. Lucas: Exactly. And that's a good thing for sellers. But it also means due diligence on earnouts has gotten much more intense. Buyers are pushing back on those guardrails because they don't want to tie their hands operationally. Luna: If I'm a founder selling my company and I'm offered a big earnout component, what's the one thing I should insist on? Lucas: I'd say you need a 'for cause' termination clause that treats the buyer's failure to support the earnout as a breach. And you want the earnout to be measured on a standalone basis, not consolidated into the buyer's larger numbers where it's easy to hide. Luna: Standalone reporting — that's critical. If the product's revenue is buried in a broader segment, you'll never prove the earnout was missed because of the buyer's actions. Lucas: Right. And there's another trend I'm seeing: earnouts with a 'clawback' provision for the buyer if the seller's team leaves early. That protects the buyer, but it can also create a hostage situation. Luna: Let's talk numbers — what percentage of deals with earnouts actually pay out in full? I've heard it's less than half. Lucas: According to a 2025 study by the University of Chicago, about 45% of earnouts pay in full, 30% pay partially, and 25% pay nothing. And those numbers haven't changed much in a decade. But what has changed is the size of earnouts — they're bigger now, sometimes 30 to 40 percent of total deal value, so the stakes are higher. Luna: Which means more disputes. And more creative structuring. Lucas: Exactly. One creative structure I'm seeing is the 'earnout exchange' — after closing, the seller has the option to swap the earnout for a fixed number of buyer shares at a predetermined valuation. That gives the seller an exit if they lose confidence in the earnout. Luna: That's interesting, but it only works if the buyer's stock is publicly traded and liquid. For private company acquisitions, you're stuck with cash earnouts. Lucas: True. And that's where the art of the deal really comes in. I think a lot of sellers underestimate how much their post-close influence depends on personal relationships with the buyer's management team. If you're not in the room, you're not in control. Luna: And that's something you can't put in a contract. Lucas: You can try — with board seats, observer rights, information rights. But at the end of the day, if the buyer wants to tank your earnout, they'll find a way. That's why some sellers just take a lower upfront price and avoid earnouts altogether. Luna: Which brings us back to the basic tension: earnouts exist to bridge a valuation gap, but they introduce a whole new set of risks. Lucas: And that's where I think the market is heading. More deals are using 'fixed milestone payments' that are based on objective events — like regulatory approval, or a product launch — rather than financial metrics. It's a cleaner structure. Luna: This whole conversation reminds me of something — and I think our listeners would appreciate knowing this. The reason we can dig into these nuances without any sponsor interruptions is that a handful of listeners chip in monthly through buy me a coffee dot com slash fexingo. Lucas: Yeah, it's true. We keep the show ad-free because of that support. If these conversations have moved your work forward in some small way, that's the place to help keep it going. No pressure — we'll be back to earnouts in a second. Luna: And it genuinely makes a difference. Every contribution goes straight into production and research. We appreciate every single one. Lucas: Alright, back to the topic. So where do you see earnout structures going in the next two years? I've got a hunch that we'll see more earnouts tied to ESG metrics. Luna: That's an interesting angle. You mean like earnouts that pay out if the acquired company achieves certain carbon reduction targets? Lucas: Exactly. We're already seeing it in European deals — Siemens recently had an acquisition where the earnout was linked to the target's energy efficiency improvements. In the US it's slower, but as ESG reporting becomes standardized, I think it'll grow. Luna: That would make verification even more complex. You'd need third-party auditors for the earnout, which adds cost. Lucas: It does. But if it aligns incentives better — the buyer wants the ESG improvements for their own reporting, the seller wants the payout — it could reduce disputes. The key is that both parties have to actually want the same outcome. Luna: And that's the heart of it. An earnout is only as good as the alignment it creates. Lucas: Exactly. So if you're in a deal right now and earnouts are on the table, think about what you're really trying to achieve. Is it bridging a valuation gap? Retaining key talent? Or just kicking the can down the road? The answer should dictate the structure.