Latest / The Startup Exit Podcast with Fexingo: IPOs, Acquisitions, and Founder Liquidity Events / Earnout Accounting Traps That Sink Founder Payouts
Transcript
- Lucas: So there's this moment in basically every earnout deal — you've signed, you've gotten your upfront check, and then the buyer's finance team starts reporting revenue. And founders discover that the number they thought they were measured against is not the number that's actually being reported. Luna: You mean like, the definition of revenue changes after the fact? Lucas: Exactly. And it's not always malicious — sometimes it's just a different accounting framework. But the effect is the same: your earnout payout shrinks, or disappears, because the metric got redefined under you. This is such a common source of post-deal litigation that I'm surprised more founders don't dig into it before they sign. Luna: Give me a concrete example. What does this actually look like in practice? Lucas: Let's say you run a SaaS company and your earnout is tied to gross revenue. You've been booking subscription fees as revenue, straightforward. But the buyer consolidates your financials into their own, and they recognize revenue on a net basis — they back out the payment processing fees, or the sales commissions, because their accounting policy treats those as contra-revenue. Suddenly your reported revenue is 15 percent lower than what you were tracking internally. And your earnout is based on that lower number. Luna: Wait, that seems like something you'd catch in diligence. How do founders miss that? Lucas: A lot of times the earnout metric is defined vaguely — 'revenue' or 'net revenue' — without specifying which accounting framework. And in private companies, you might not have audited financials, so the buyer gets to apply their own policies after close. It's a recipe for disputes. Luna: So what's the fix? Do you actually define revenue in the contract down to the line item? Lucas: You should. The best earnout agreements define the metric with precision — whether it's gross or net revenue, which costs get deducted, how to account for multi-year contracts, even how to treat refunds and chargebacks. I've seen deals where the earnout was tied to 'net revenue' and the buyer started deducting customer acquisition costs because those were 'direct costs of revenue' for them. That's a huge swing. Luna: And that's not just SaaS. I'm thinking of a recent AI infrastructure deal where the earnout was tied to a specific product's sales — the buyer redefined the product line to include only certain SKUs, and the founder's payout got cut in half. Lucas: Right, that's the other trap — the scope of what counts. If you're selling a product or service, you need to enumerate exactly what's included. Otherwise, you're leaving the definition open to interpretation. Luna: And the buyer's CFO will always interpret it in a way that makes their numbers look better. Because your earnout is their expense. Lucas: Exactly. So the first thing founders should do is look at the buyer's public financials — if the company is public, you can often see their revenue recognition policy in the 10-K. And you want to make sure your earnout metric aligns with how they'll actually report. Luna: But what if the buyer is private? That's harder to research. Lucas: Then you ask for their accounting policies in the diligence phase. And you get it in writing. If they won't share, that's a red flag. Luna: You know, this reminds me — and I know we don't usually do this, but a quick honest thing. A handful of listeners chip in monthly through buy me a coffee dot com slash fexingo, and that's literally what keeps this show ad-free and lets us do deep dives like this. Lucas: Yeah, it's a small group but it makes a real difference. We appreciate everyone who does that. So, back to the earnout — another layer is the earnout period itself. Even if the metric is well-defined, the buyer's business decisions during that period can affect your payout. Luna: Like what? You mean they could stop selling your product on purpose? Lucas: That's the extreme case, but yes. More common is they change the sales strategy — they bundle your product with something else, so revenue gets allocated differently. Or they shift the sales team's focus to another product line. Your earnout was based on standalone sales, but the buyer reports it as part of a bundle. Luna: So founders need to protect against that, too. How? Lucas: You can include provisions in the earnout agreement that require the buyer to use 'commercially reasonable efforts' to sell the product. But that phrase is notoriously weak in court. The better approach is to define what happens if the buyer makes changes that materially affect the metric — like a floor, or a renegotiation trigger. Luna: And I've seen deals where the founder stayed on as a consultant during the earnout period specifically to watch over this. Lucas: Staying involved helps, but it doesn't give you control. The buyer still makes the final calls on accounting and strategy. So the real protection is in the contract language. Luna: What about earnouts tied to EBITDA? I feel like that's even more prone to manipulation. Lucas: Oh, for sure. EBITDA can be adjusted with a lot of discretion — what counts as an add-back, how you treat stock-based compensation, whether you capitalize or expense certain costs. I've seen earnouts where the definition of EBITDA in the contract was a page long, but there was still a dispute. Luna: So what's the one clause founders should absolutely ask for in an earnout? Lucas: I'd say a clear dispute resolution mechanism. Not just arbitration, but a process for how disagreements over the metric get resolved. Who's the accountant? What standards do they use? And make sure the contract says that any ambiguity in the definition is resolved in favor of the seller — that's a big one. Luna: That last part, is that actually enforceable? Lucas: Courts will enforce a clear contractual provision that says ambiguities are resolved against the drafter. It's a common rule in contract law. So if the buyer wrote the definition, having the tie go to the seller is a powerful tool. Luna: I think there's also an emotional side to this that founders don't anticipate. You've already sold your company, you're supposed to be celebrating, and instead you're fighting over numbers for two years. Lucas: That's a really good point. The earnout period can be draining. That's why some founders choose a lower upfront but walk away clean, because they don't want the overhang. Luna: And that's a legitimate choice. But if you do take an earnout, you have to treat it like a business negotiation, not a handshake. Lucas: Absolutely. And I'll say this — in the current market, we're seeing more earnouts as a way to bridge valuation gaps. So getting the accounting right is more important than ever. Luna: I noticed a bunch of tech stocks were down this week — Apple, Amazon, Alphabet all lost a couple percent. Do you think that's making buyers more conservative with upfront cash? Lucas: It can. When valuations get wobbly, buyers lean harder on earnouts to protect themselves on the downside. But founders can use that to their advantage — if you're willing to take more earnout, you can sometimes push for a higher total price. Luna: But only if the earnout is actually likely to pay out. Otherwise you're trading real dollars for paper. Lucas: Exactly. So the key is to do your homework on how the buyer will account for your business post-close. Talk to their finance team, not just their M&A team. Ask for the actual accounting policies that will apply. Luna: And get a lawyer who's done earnouts before, not just your regular corporate counsel. Lucas: That's a great final point. Earnouts are a specialized area, and a generalist might miss these traps. So find someone who's seen a dispute play out. Luna: So, rough rule of thumb — if you're a founder about to sign an earnout, what are the top three things to check? Lucas: One, define the metric precisely — gross or net, and what's included. Two, include a change of control or change of strategy provision so the buyer can't tank your payout by shifting focus. Three, get a clear dispute resolution process and ambiguity in your favor. Luna: That's a solid checklist. And honestly, if you can't get those, maybe you need to walk away. Lucas: Or at least be prepared to fight for it. Earnouts can work — they bridge gaps and let deals get done. But they only work if the contract actually protects the founder's upside.