Latest / The Buyer & Seller Podcast with Fexingo: Business Brokers, Exits, and Private Sales Explained / The Earnout Trap What Every Business Seller Needs to Know
Transcript
- Lucas: You're negotiating the sale of your company. You've agreed on a $50 million valuation. You're about to sign. Then the buyer says: we'll pay $30 million upfront, and the other $20 million is tied to hitting revenue targets over the next three years. Luna: Right, that's the earnout. And I bet a lot of sellers hear that and think, okay, I just need to keep growing the business. What's the catch? Lucas: The catch is that you're giving up control. You're betting your payout on someone else playing fair with the playbook. And in practice, earnouts go sideways more often than they work out. A 2023 survey by SRS Acquiom found that about 30 percent of private acquisitions under $100 million include an earnout component. But nearly half of those end up in some kind of dispute. Luna: So nearly half the time, sellers don't get the full earnout they thought they were signing up for. That's brutal. Lucas: It is. And the problem isn't necessarily bad faith on the buyer's part. It's structural. Once you sell, the buyer controls the resources, the strategy, even the compensation of the team that's supposed to hit those targets. You're a former owner now, possibly still running the business day-to-day, but you're reporting to someone who can change the rules. Luna: Give me a concrete example. I want to see how this actually plays out. Lucas: Sure. Let's take a real-ish case. A SaaS company called CloudMetrics—fictional name, but the dynamics are real. They were doing about $8 million in annual recurring revenue, growing 40 percent year-over-year. A larger tech firm offers $50 million: $30 million cash at close, $20 million earnout based on hitting $12 million in ARR by year two. Luna: That sounds achievable if growth continues. Lucas: Except the buyer immediately integrates CloudMetrics into its own sales team. They reassign the founder's best account executives to other product lines. They change the pricing model, which slows new customer acquisition. And in year two, CloudMetrics hits $10.5 million. The earnout pays zero. The founder walks away with $30 million instead of $50 million. And there's no recourse because the earnout contract only specified the target, not how the buyer would operate the business. Luna: So the founder lost $20 million because the buyer changed the game. And presumably the earnout contract was written by the buyer's lawyers. Lucas: Exactly. And that's the thing—earnouts are a tool for buyers to shift risk onto sellers while keeping the headline price high. They say, 'We're paying $50 million,' but really they're paying $30 million plus a lottery ticket. The seller doesn't realize they're taking on almost all the execution risk. Luna: I've heard that earnouts can also be useful when there's a valuation gap—the buyer thinks it's worth $40 million, the seller thinks $60 million, and the earnout bridges that difference. Is that ever a good idea? Lucas: It can be, but only if it's structured fairly. The key is specificity. The seller needs to negotiate exactly what resources the buyer must provide—a dedicated sales team, a certain marketing budget, no price changes without consent. And the earnout should be measured on metrics the seller can still influence, like gross profit or customer retention, not just top-line revenue that the buyer can manipulate by cutting prices. Luna: You're saying a good earnout contract is basically a detailed operational plan. Most sellers aren't thinking like that. Lucas: They're not. And that's why business brokers and M&A advisors earn their fees here. A good broker will tell you: if you must do an earnout, cap the term at two years, not three. Base it on EBITDA or gross profit, not revenue. And include a clause that if the buyer materially changes the business, the earnout accelerates or is paid out in full. That's called a 'change of control' or 'adverse action' clause. Luna: What about the alternative—a seller note? I've heard that's more seller-friendly. Lucas: It can be. A seller note is basically the seller lending the buyer part of the purchase price. The buyer pays you over time with interest. The difference is that the note is a fixed obligation—it doesn't depend on performance. The buyer has to pay you regardless. So the risk is credit risk: if the buyer goes bankrupt, you're an unsecured creditor. But in a solid transaction, the seller note is much safer than an earnout. Luna: So you'd rather have a note with a 6 percent interest rate than an earnout with a potential 50 percent upside? Lucas: For most sellers, yes. Because the earnout upside is often illusory. The data backs this up. A study of earnout outcomes by the University of Chicago found that only about one in five sellers actually receive the full earnout amount. The median payout is about 60 percent of the stated max. So on that $20 million earnout, the average seller gets $12 million. Meanwhile, a seller note would pay the full $20 million plus interest, as long as the buyer doesn't default. Luna: Okay, but let's say you're set on an earnout. What's the single most important thing to get in the contract? Lucas: The most important thing is 'seller control over key inputs.' That means you get to approve the budget for the business unit, you have a say in hiring and firing the team, and the buyer cannot integrate the business into their own operations without your consent. If you don't have that, you're just hoping they play nice. And hope is not a strategy. Luna: And if the buyer refuses those terms? Lucas: Then you should push for a higher upfront payment and reduce the earnout. Or walk. There are plenty of buyers who will pay all cash without an earnout. You just have to find them. A good business broker can help you identify which buyers are serious and which ones use earnouts as a way to lowball you. Luna: So the takeaway for sellers is: earnouts are risky, and if you do one, negotiate hard on the operational terms. Don't just accept a boilerplate clause. Lucas: Exactly. And if you're a buyer listening, remember that a fair earnout structure actually aligns incentives. If you screw the seller on the earnout, you get a reputation. The private M&A world is small. People talk. So the best outcome is a deal where both sides feel they got a fair shake. That starts with understanding exactly what you're signing. Luna: I think the biggest mistake sellers make is focusing only on the headline number. The earnout structure can turn a $50 million deal into a $30 million deal. So read the fine print. Lucas: And have a lawyer who specializes in M&A, not a general practitioner. This is not the time to save on legal fees. A good lawyer will cost you $50,000 to $100,000 on a $50 million deal, but they could save you millions in a bad earnout. Luna: Alright, so next time someone says 'earnout,' you'll know exactly what questions to ask. Thanks Lucas. Lucas: Thanks Luna. And to our listeners—whether you're buying or selling, the best deal is the one you understand completely. Happy negotiating.