Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The Earnout Milestone Definition Trap That Cost a Seller 25 Million
Transcript
- Lucas: So you sell your company for a hundred million, with twenty-five million of that tied to an earnout. And the buyer manages to miss the milestone by twelve thousand dollars. Twelve thousand. And you end up with nothing. Luna: Twelve thousand dollars. That's brutal. How does that even happen? Lucas: It's a classic definitional trap. The earnout was tied to hitting a specific EBITDA number in the year after closing. And the buyer's finance team, quite legally, applied a set of accounting policies that shaved off just enough to fall below the threshold. Luna: And the seller had no recourse? Lucas: Well, there was a dispute resolution clause, but it said any disagreement would go to a mutually agreed independent accountant. The seller thought that was protection. The problem was the earnout language didn't specify which accounting principles would apply. Luna: So the buyer just used their own policies and the accountant... what, rubber-stamped it? Lucas: The accountant actually sided with the buyer because the contract said 'in accordance with the buyer's accounting policies, consistently applied.' And the buyer's policies were aggressive, but they were consistent. So the earnout failed. Luna: Consistently applied. That's the killer phrase. Lucas: Exactly. And this isn't some obscure corner of M&A. This is the kind of thing that happens in deals worth hundreds of millions. The earnout is supposed to bridge the valuation gap, but if the definition is loose, it's just a lottery ticket. Luna: So what should the seller have done? I mean, you can't predict every accounting trick. Lucas: You can't, but you can anchor the definition. The best practice is to define EBITDA as 'calculated in a manner consistent with the historical financial statements of the company, prepared under GAAP, with no adjustments except for those explicitly listed.' Luna: So you're locking in the seller's own accounting history. That makes sense. Lucas: Right. And then you list the specific adjustments, like one-time transaction costs, or non-recurring legal fees. Anything not on that list is off the table. The buyer can't just invent a new policy post-closing. Luna: And what about the dispute resolution? Would an independent arbitrator have helped here? Lucas: It can, but only if the standard is clear. The clause in this deal said 'independent accountant,' but it didn't say what standard they should apply. So the accountant just deferred to the buyer's policy. If the clause had said 'the accountant shall determine EBITDA in accordance with the definition in this agreement, using the seller's historical accounting principles,' the outcome could have been different. Luna: So the lesson is: define everything, and make the dispute resolver follow your definition, not the buyer's. Lucas: Exactly. And it's not just about EBITDA. You see this with revenue-based earnouts too. If the earnout is tied to net revenue, you need to define what 'net' means. Returns, discounts, co-op marketing deductions — those can all be used to chip away at the number. Luna: Yeah, I've seen a case where a seller's earnout was based on gross profit, and the buyer allocated overhead costs to the product line that were never allocated before. The gross margin dropped like a stone. Lucas: That's the same pattern. The buyer has every incentive to minimize the earnout, and if the contract doesn't lock down the accounting, they will. You have to think like a buyer. What could they do to make this number smaller? And then close every loophole. Luna: But how do you do that without turning the earnout into a fifty-page appendix? Lucas: You don't need fifty pages. You need a few crisp sentences that reference the historical financials and list the allowable adjustments. And you need to specify that any changes to accounting policies require mutual consent. That's the key. Luna: Mutual consent. So if the buyer wants to change how they account for revenue recognition, they have to ask the seller first. Lucas: Exactly. And that's what changes the negotiation dynamics. The buyer can't just unilaterally adjust the numbers. They have to come to the table and discuss it, which gives the seller leverage. Luna: So, look, this episode is exactly the kind of thing that could save someone a lot of money. If this was useful, you know, the reason we can keep doing this without ads is listener support. Buy me a coffee dot com slash fexingo helps keep the lights on. Lucas: Yeah, and honestly, if you've ever learned one thing from this show that helped you in a deal, that's the way to pay it forward. We appreciate it. Luna: Alright, back to the story. So the seller lost the earnout. What did they do next? Lucas: They sued. But here's the thing — the contract had a limitation of liability clause that capped damages at the earnout amount itself. So even if they won, they'd only get the twenty-five million, minus legal fees. Luna: So the buyer had basically nothing to lose. The worst case was they paid what they owed anyway. Lucas: And that's why the buyer was so aggressive. They had a free option. If the earnout paid, great. If it didn't, they'd just fight it, and the seller would have to spend hundreds of thousands in legal fees to get what they were owed. Luna: So what's the takeaway for sellers? Besides the definition stuff, and the mutual consent on accounting policies — what else? Lucas: I'd say, fight for an independent arbitrator rather than an accountant. An arbitrator with M&A experience will understand the commercial context and won't just defer to the buyer's accounting policies. They'll look at the intent of the parties. Luna: And make sure the standard is 'commercially reasonable,' not just 'in accordance with the buyer's policies.' Lucas: Precisely. 'Commercially reasonable' gives the arbitrator a benchmark. It says, you can't just do something that's technically allowed but commercially absurd. Luna: So, in this case, if the arbitrator had been able to weigh commercial reasonableness, the buyer's aggressive revenue recognition might have been rejected. Lucas: It's possible. And the seller had a decent argument. The buyer had, for example, started deferring revenue on some annual maintenance contracts, which was a change from the seller's historical practice. That alone accounted for about a million dollars of the shortfall. Luna: A million dollars. And the threshold was missed by twelve thousand. So that single change alone would have pushed them over. Lucas: Exactly. And the seller's lawyers argued that the buyer's policy change was designed to push the earnout down. But the accountant said 'consistent application' trumped the seller's history, and the judge agreed. Luna: So the seller lost the whole earnout because the contract didn't say 'consistent with historical practice.' Lucas: That's the whole story in a nutshell. The earnout is only as good as its definition. And the definition has to be anchored to something the seller controls — their own historical financials. Luna: And for buyers, I guess the lesson is: a sloppy earnout definition is a litigation magnet. You might win the accounting argument, but you'll spend years in court, and you'll never get the seller's full cooperation post-closing. Lucas: That's a great point. A fair, clearly defined earnout actually benefits the buyer too. It keeps the seller motivated and focused on growth, not on looking for ways to sue. If the earnout is a trap, the seller will spend their time trying to escape it, not building the business. Luna: So, in the end, a good earnout is one where both sides feel they got a fair deal. Lucas: And that's the goal. It's not about tricking the other side. It's about aligning incentives. When the earnout is structured with clear definitions, mutual consent on accounting changes, and a fair dispute resolution mechanism, it works. When it's not, it's a ticking time bomb.