Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / How the Contingent Consideration Trap Delays M&A Payouts
Transcript
- Lucas: Luna, I want to talk about a phrase that sounds reassuring on paper but often turns into a nightmare for sellers: contingent consideration. Luna: You mean earnouts? The part of the deal where the seller gets paid extra if the business hits certain targets after close. Lucas: Exactly. And the word 'if' is doing a lot of work there. In theory, earnouts bridge valuation gaps — the buyer thinks the company is worth $50 million, the seller thinks $70 million, so they compromise on $60 million with a $10 million earnout tied to future performance. Luna: Sounds reasonable. What goes wrong? Lucas: Let me give you a real example. In 2023, a mid-market cybersecurity firm was acquired for $200 million, with $40 million of that structured as contingent consideration tied to revenue targets over three years. The founder stayed on as CEO, and the earnout milestones were based on annual recurring revenue growth. Luna: That feels like a pretty clear metric. ARR is auditable. Lucas: You'd think so. But the dispute started when the buyer changed how they defined 'revenue' — they excluded certain multi-year contracts and pushed back the recognition of some deals. By the buyer's math, the company missed the year-one target by about $300,000. Luna: Wait — so the buyer had control over how revenue was calculated post-close? That seems like a huge conflict of interest. Lucas: It is. And that's the structural trap. The buyer owns the company after close. They control the accounting policies, the sales strategy, even which customers get pursued. If the earnout is tied to a metric the buyer can influence, they have an incentive to keep it from hitting — because hitting means writing a check. Luna: So the founder in this case — he's still running the business, but he no longer has full control over the levers that determine his payout. Lucas: Right. He's a CEO with a boss. And the boss is the buyer. In this case, the founder sued. The dispute dragged on for over two years, and it was eventually settled for a fraction of the earnout — about $12 million of the potential $40 million, after legal fees. Luna: Ouch. So the earnout that was supposed to bridge the gap ended up costing the seller more in legal fees and time than it was worth. Lucas: Exactly. And this is not an isolated case. A study by the University of Chicago a few years ago looked at earnout structures in tech M&A and found that roughly one-third of earnouts never pay out at all. Another third pay less than the maximum. So the odds of getting the full earnout are actually pretty low. Luna: What about the ones that do pay out fully? What's different about them? Lucas: The common thread is that the earnout metrics were tied to things the seller could control even after close — or that were defined so clearly in the purchase agreement that there was no room for interpretation. For example, one deal I saw used a very specific definition of 'bookings' that required the buyer to get written consent from the seller before making any accounting policy changes that affected that metric. Luna: That's the kind of protection that matters. A veto right over accounting changes that affect the earnout. Lucas: Exactly. But most sellers don't ask for that. They focus on the valuation and the headline number, not the fine print on how the earnout is calculated. And the buyer's lawyers are very good at drafting earnout provisions that look fair but give the buyer all the discretion. Luna: So what's the one concrete thing a seller should push for if they're considering an earnout? Lucas: I'd say two things. First, define every metric in the purchase agreement with the same level of detail you'd use in a public company's financial statements. Reference GAAP or IFRS, specify which revenue recognition standards apply, and include a list of excluded items. Second, negotiate a 'most favored nation' clause — if the buyer changes any accounting policy that negatively impacts the earnout calculation, the seller has the right to adjust the earnout target downward proportionally. Luna: That second one is interesting. It basically puts the buyer on notice that manipulating the numbers will backfire. Lucas: Exactly. And it's not that common yet, so it can be a real differentiator in negotiations. Another thing: consider capping the earnout period at two years instead of three. The longer the period, the more opportunities for disputes to arise. Luna: But doesn't a shorter earnout period mean less potential upside for the seller? Lucas: It does, but the trade-off is that you're trading a higher probability of actually getting paid for a slightly lower maximum payout. And given the statistics on earnout payouts, that trade tends to work in the seller's favor. A bird in the hand, as they say. Luna: What about the buyer's perspective? Are earnouts ever good for them? Lucas: They can be. For a buyer, earnouts are a way to de-risk the deal. If the seller's projections turn out to be overly optimistic, the buyer doesn't overpay. The problem is that the asymmetry of control post-close means the buyer can make the earnout harder to achieve without necessarily harming the business — they just redirect resources or change accounting. That's where the bad behavior creeps in. Luna: So the ideal scenario is probably a deal where the earnout is based on something truly independent — like a third-party audit of customer satisfaction or a patent approval — not something the buyer's finance team can tinker with. Lucas: That's a great point. There's a growing trend of using 'binary' earnouts — where the payout is triggered by a single discrete event, like regulatory approval of a product or hitting a specific customer count. Those are much harder to manipulate than a fuzzy revenue number. Luna: And they're easier to resolve if there's a dispute, because either the event happened or it didn't. Lucas: Exactly. In the cybersecurity deal I mentioned earlier, the earnout was tied to ARR, which sounds objective but turned into a battle over definitions. A binary milestone would have avoided that entirely. Luna: Let me ask you this — if you were advising a founder today, and the buyer insists on an earnout, would you say walk away or just negotiate harder? Lucas: I'd say it depends on the buyer's track record. If the buyer has a history of paying earnouts in full, and you trust the management team, it might be fine. But if it's a financial buyer — a private equity firm with a reputation for aggressive post-close adjustments — I'd push for a higher upfront payment and a smaller earnout, or no earnout at all. Luna: And if they insist on the earnout, you get the accounting definitions locked down tight. Lucas: Right. And you get a good lawyer who specializes in M&A — not your cousin who does real estate closings. The earnout clause is one of the most litigated provisions in purchase agreements, so the upfront legal cost is worth it. Luna: This is exactly the kind of stuff that founders don't think about until it's too late. They're so focused on the excitement of the exit that they skip over the fine print. Lucas: And that's why we do this show. Honestly, if today's episode was worth a coffee to you, that's the link — buy me a coffee dot com slash fexingo. It's a small way to keep these conversations ad-free and focused on what matters. Luna: Yeah, these episodes take real research to drill down into the specifics. Every bit of listener support adds up. Lucas: Anyway, back to earnouts. One last point I want to make: if you do end up with an earnout, make sure you have a clear dispute resolution mechanism — preferably arbitration with a neutral accounting firm, not a court battle. Court can take years. Luna: And arbitration is typically faster and cheaper. Plus the arbitrator is usually an expert in the field, so they understand the nuances of revenue recognition. Lucas: Exactly. So the checklist for a seller: one, define every metric with surgical precision. Two, include a most favored nation clause for accounting changes. Three, cap the earnout period at two years. Four, prefer binary milestones over fuzzy ones. And five, specify arbitration with a neutral accounting firm. Luna: That's a solid list. If even one founder listens and pushes for those terms, this episode was worth it. Lucas: I hope so. Because as we've seen, the earnout that looks like a bonus can quickly become a trap.