Latest / The Buyer & Seller Podcast with Fexingo: Business Brokers, Exits, and Private Sales Explained / How to Structure an Earnout That Actually Protects Sellers
Transcript
- Lucas: Last week I sat down with a guy who sold his ad agency for forty million dollars. Thirty million at close, ten million in earnout. And he told me something I still think about — he said the earnout was the only part of the deal that kept him up at night. Luna: Because the earnout is where the buyer's interests and the seller's interests diverge most sharply. Lucas: Exactly. At close, everyone shakes hands. The check clears. But the earnout — that's a performance contract written over the next three years. And if you write it wrong, the buyer has every incentive to make sure you never collect. Luna: And if these conversations have moved your work forward in some small way — if you've ever caught yourself thinking 'I should structure my earnout differently' — a handful of listeners chip in monthly at buy me a coffee dot com slash fexingo. That's literally what keeps this show ad-free and focused on what actually works in the real world. Lucas: It's a small group, but it makes a big difference. And honestly, it's what lets us spend a full episode on something like earnout mechanics — which most business shows would gloss over in thirty seconds. Luna: Yeah. Okay — back to the agency deal. What was the earnout structure? Lucas: So this agency had about twenty-two million in revenue, twelve million in gross profit, and four million in EBITDA. The buyer was a larger holding company. They agreed on a forty million valuation — roughly ten times EBITDA — but the buyer wanted to protect against client attrition post-sale. Luna: Classic earnout rationale. The buyer says 'we're paying for your key clients, and if they leave, we overpaid.' Lucas: Right. But the seller was smart. He said 'I'll take an earnout, but only if it's tied to gross profit retention, not revenue.' That was the first critical move. Luna: Why gross profit over revenue? Seems like revenue would be simpler. Lucas: Simpler, yes. But revenue can be inflated by pass-through costs — media buying, production, third-party services. If the buyer loads the agency with more pass-through work, revenue looks fine but margins compress. The seller's earnout gets killed even though the agency is actually healthier. Luna: Ah — so gross profit is a cleaner measure of the agency's real earning power. Lucas: Exactly. So the earnout was split: sixty percent based on maintaining gross profit at or above twelve million, and forty percent based on new client revenue generated in the first two years. The seller wanted a growth incentive, not just a maintenance incentive. Luna: That's interesting — most earnouts only have one metric. Splitting it into two creates a balanced scorecard. Lucas: It does. But here's the detail that made it work: the measurement window was three years, with annual lookbacks. If gross profit dipped below twelve million in year one, the seller could make it up in year two before any payout was clawed back. Luna: A cumulative measurement period instead of annual hurdles. That's huge — because a bad year can happen for reasons unrelated to the seller's performance. Lucas: Exactly. And the second thing he negotiated was a 'most favored nation' clause — meaning if the buyer changed the agency's business model, like shifting from full-service to a la carte, the earnout targets would be renegotiated. Luna: I've seen deals where the buyer pivots the business model post-close and the earnout becomes impossible. That clause is rare but powerful. Lucas: Rare, but he got it. And then there was the no-cap upside. The earnout was structured as a percentage of gross profit above twelve million, with no ceiling. So if the agency grew to fifteen million in gross profit, he'd share in that upside. Luna: That's aggressive. Most buyers insist on a cap. How did he sell them on unlimited upside? Lucas: He agreed to a lower base valuation. He took thirty million instead of thirty-three at close, but the earnout potential was ten million-ish. The buyer saw it as paying for performance, and the seller was confident he could over-deliver. Luna: So he traded certainty for upside. That only works if you genuinely believe you can grow the business post-sale. Lucas: Right. And he structured the earnout so it wasn't tied to his personal employment. A lot of sellers make the mistake of tying earnout to them staying on as CEO. If you leave or get fired, you lose the earnout. Luna: That's the 'earnout trap' we've talked about before. The buyer fires you six months in and the earnout disappears. Lucas: Exactly. So he carved himself out. The earnout was tied to the agency's performance, not his employment. He agreed to a twelve-month transition period, but after that, the earnout ran independently. Luna: Did it pay out? How did it end? Lucas: The agency hit twelve million gross profit in year one, thirteen point five in year two, and fifteen point two in year three. He collected the full ten million — plus an additional one point eight from the upside sharing. Eleven point eight total. Luna: So he ended up at forty-one point eight million on a forty million valuation. That's a rare outcome. Most earnouts underperform. Lucas: Most do underperform — studies show about forty percent of earnouts pay less than fifty percent of the target. But this seller designed the earnout to work for him, not just the buyer. Luna: What would you say is the single most important takeaway for a seller listening? Lucas: Don't let the earnout be a simple revenue target. Tie it to gross profit or EBITDA. Use cumulative measurement. Get a most favored nation clause. And decouple it from your employment. If you give away those four points, you're leaving the door open for the buyer to structure your earnout into failure. Luna: And if you're a buyer listening, the reverse is true — you want simple revenue targets, annual hurdles, no model-change protections, and employment linkage. It's a negotiation, but understanding the mechanics levels the playing field. Lucas: Exactly. Earnouts aren't inherently bad. They're a tool. But like any tool, you have to know how to use it — or it'll be used on you.