Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The Earnout Trap How Buyers and Sellers Split the Risk
Transcript
- Lucas: You buy a business, you write a check, you own it. That's the simple story. But a lot of middle-market deals don't work that way — there's a second check hiding in the fine print, and it's called an earnout. Luna: An earnout — where the seller gets more money only if the business hits certain targets after the sale. It sounds fair, but I've heard it can get messy. Lucas: It's one of the most misunderstood tools in M&A. So let's anchor with a real deal. In early 2025, a private equity-backed rollup called ServiceRocket acquired Growsari — a Philippines-based HubSpot CRM reseller and consulting shop — for about one point three billion dollars. Luna: That's a big number for a HubSpot partner. What was the earnout piece? Lucas: Roughly three hundred and fifty million of that was structured as an earnout — about 27 percent of the total consideration. The sellers — the founding team — had to hit specific revenue and EBITDA targets over the next two years to collect the full amount. And the targets were aggressive: 25 percent year-over-year revenue growth and EBITDA margins above 18 percent. Luna: Oof. So they sold their company, but their payout depends on hitting numbers they no longer control. Lucas: Exactly. And that's the tension. Earnouts are meant to bridge the valuation gap — the buyer thinks the business is worth X, the seller thinks it's worth X plus something. The earnout gives the seller a chance to earn that something if performance continues. But post-close, the buyer is running the show. They might change the sales comp plan, pull investment dollars, or shift strategy — all of which can torpedo those earnout targets. Luna: So the seller is betting on their own performance, but the buyer controls the playbook. That seems like a recipe for conflict. Lucas: It is. A 2023 study by the M&A advisory firm SRS Acquiom found that over 40 percent of earnouts never pay out in full. And about 15 percent pay out nothing at all. The ones that fail usually do so because of what I'd call the 'earnout gap' — the operational decisions the buyer makes after closing that the seller didn't anticipate. Luna: Give me an example. What does that gap look like in practice? Lucas: Say the earnout is tied to revenue. The buyer decides to raise prices across the board to improve margin. That might hurt volume — revenue dips, and the seller misses their target. Or the earnout is tied to EBITDA, and the buyer invests heavily in R&D or marketing, which depresses short-term profit. The seller sees their earnout shrink because of decisions they had no part in. Luna: That sounds like the classic alignment problem. But earnouts must work sometimes, or they wouldn't be so common. Lucas: They do work — when the terms are tight and the buyer is disciplined about not meddling. The typical earnout structure falls into three categories. The most common is revenue-based: the seller gets a percentage of revenue above a baseline, usually for one to three years. Second is ebitda based: tied to profit milestones. Third is product or milestone-based: the seller gets paid if a new product launches or a regulatory approval comes through. Luna: And which one is least likely to cause a fight? Lucas: Revenue-based, by a mile. Because revenue is harder for the buyer to manipulate in the short term. If the buyer fires the sales team, revenue drops — and everyone can see that. EBITDA, on the other hand, can be cratered by a single discretionary expense like a consulting engagement or a bonus program. There's more gray area. Luna: So if I'm a seller, I want a revenue earnout. But what about the length? Two years? Three? Lucas: Longer isn't always better. The industry sweet spot is 18 to 24 months. Anything longer than three years and the seller's influence on the business is basically zero — you're just hoping the buyer doesn't screw it up. And the buyer has to carry a liability on their books the whole time, which they don't love either. Luna: Right — because earnouts are contingent consideration. The buyer has to estimate the fair value at close and adjust it each quarter. Lucas: Exactly. Under ASC 805, the buyer must record the earnout's fair value as a liability at close — and then mark it to market every quarter. If the earnout looks less likely to pay out, the liability shrinks and the buyer books a gain. If it looks more likely, the liability grows and they take a charge. That volatility can mess with reported earnings, especially for public buyers. Luna: So the buyer has an accounting incentive to lowball the earnout probability at close, then manage operations to avoid paying it. That's a perverse incentive. Lucas: It is. And sophisticated sellers know that. That's why we're seeing more deals with 'earnout protection' clauses — things like a guaranteed minimum payment regardless of performance, or a cap on how much the buyer can change the business model during the earnout period. Luna: Before we go deeper — and I know this is a tangent — I want to flag something for listeners. If today's episode was useful to you and you want to keep it ad-free, buy me a coffee dot com slash fexingo helps. That's literally what keeps these conversations going. Lucas: Yeah, and we mean it — no ads, no sponsors, just the content. So if it's worth that to you, that's the link. Luna: Alright, back to earnouts. You mentioned protection clauses — what does that look like in a term sheet? Lucas: One common one is the 'most favored nation' clause — the buyer can't change the compensation plan for the earnout team without the seller's consent. Another is the 'operating budget' clause: the buyer agrees to maintain at least the same level of investment in sales and marketing during the earnout period as the seller had before the deal. Luna: That seems reasonable. But does the buyer ever agree to that? Lucas: They do — if the seller has leverage. In a competitive auction with multiple bidders, a seller can push for those protections. In a one-on-one negotiation, less so. The key is for the seller to get those protections in writing before signing. Once you close, your bargaining power is gone. Luna: Let's talk about the Growsari case specifically. Did they end up collecting the full earnout? Lucas: As of our recording date — May 2026 — the earnout period is still ongoing. The first year targets were reportedly met, but the second year targets are proving tougher because ServiceRocket has been integrating Growsari's operations into its own platform, which has caused some customer churn. The founders are watching closely. Luna: So that's the earnout gap in real time. The buyer's integration decisions are directly affecting the seller's payout. Lucas: Right. And the founders don't have a seat at the table anymore. They may have negotiated some protections, but ultimately the buyer owns the business. That's the trade-off: you get a higher headline price, but you give up control over whether you actually collect it. Luna: What about the buyer's perspective? Why would a buyer want an earnout instead of just paying a lower price upfront? Lucas: Two reasons. First, it reduces their risk. If the business underperforms, they don't pay as much. Second, it helps with financing. In a leveraged buyout, the debt providers are more comfortable if a chunk of the purchase price is contingent — it means less debt needed at close. And the seller gets a higher potential price. Luna: So it's a risk-sharing mechanism. But it only works if both sides are realistic about the targets. Lucas: That's the hard part. Too many sellers get seduced by the upside. They hear 'you could earn an extra fifty million' and they ignore the probability. A good advisor will run a Monte Carlo simulation showing the range of outcomes based on different growth rates and cost scenarios. Most sellers don't do that math. Luna: Walk me through what that simulation would look like for a typical earnout. Lucas: Sure. Say the earnout is 40 percent of the total price, tied to hitting $100 million in revenue in year two. You model three scenarios: base case — 15 percent growth, you hit $95 million and get, say, 20 percent of the earnout. Bull case — 25 percent growth, you hit $105 million and collect it all. Bear case — flat revenue, you get nothing. Weight those by your estimate of probability, and you get an expected earnout value. If that expected value is significantly less than what the buyer is offering as a lower upfront price, you're better off taking the cash. Luna: So the seller should discount the earnout by the probability of failure. And most sellers don't. Lucas: They don't. They anchor on the maximum payout. And then they're disappointed when reality hits. The best sellers negotiate a 'floor' — a minimum earnout payment even if targets are missed — and a 'cap' on how much the buyer can change operations. Luna: Are there any structures where the earnout actually works as intended? Where both sides feel good about it? Lucas: Yes — when the earnout is based on a metric the seller can still influence after close, and the buyer agrees to let the seller stay on as a manager during the earnout period. That way the seller has some operational control. I've seen deals where the seller stays as a division head with P&L responsibility, and the earnout is tied to that division's performance. Those tend to pay out more often. Luna: So the seller has skin in the game and the levers to pull. That makes sense. Lucas: Exactly. The earnout is most effective when it's a retention tool, not just a valuation bridge. The buyer wants the seller to stick around and drive growth. The seller wants to be rewarded for that growth. Aligned incentives, clear metrics, and a defined period — that's the formula. Luna: Let's zoom out. Are earnouts becoming more or less common? Lucas: More common. In 2025, about 35 percent of middle-market deals included an earnout, up from 25 percent five years earlier. The trend is driven by higher valuation multiples and more private equity capital chasing deals. When prices are high, buyers use earnouts to justify the multiple — 'we'll pay 12 times EBITDA, but only if you hit these numbers.' It's a way to make the math work. Luna: That makes sense in a frothy market. But what about when valuations cool — do earnouts fade? Lucas: They might shrink in size, but I think they're here to stay. The logic is too powerful: buyers get downside protection, sellers get upside potential. The key is managing the conflict. And that comes down to one thing — a well-written contract. Luna: So for an operator listening who might sell in the next few years, what's your number one piece of advice on earnouts? Lucas: Negotiate your earnout terms as if the buyer will change their mind six months in. Because they probably will. Get the measurement period, the definition of the target metric, and the protection clauses in writing. And run the numbers — don't just hope for the best. Luna: That's the kind of concrete advice that can save someone millions. Thanks, Lucas. Lucas: Sure thing. And if you want to keep hearing conversations like this — ad-free, no sponsors — you know the link. Buy me a coffee dot com slash fexingo. Luna: We'll be back next week with another angle on the deal world. Until then, take care.