Latest / The Buyer & Seller Podcast with Fexingo: Business Brokers, Exits, and Private Sales Explained / How a Small Ad Agency Signed a Nine-Figure Earnout
Transcript
- Lucas: So there's this small ad agency in Portland — three employees, two founders, a handful of solid regional clients. They got bought by one of the big global holding companies for a hundred and twenty million dollars. And the founders told me later that almost none of that was paid up front. Luna: Wait — a hundred and twenty million for a three-person shop? What was the upfront cash? Lucas: Twenty million. The other hundred million was an earnout tied to four years of performance. And here's the thing — they had another offer on the table. A straight cash offer for seventy million. No earnout, no strings. They turned it down. Luna: That's a huge bet. Most earnouts fail, right? I've seen stats that something like fifty to sixty percent of earnouts don't pay out in full. Lucas: Yeah, the numbers are brutal. One study from a few years ago tracked earnouts in private company M&A and found that only about a third of sellers received the full earnout amount. Another third got partial payment. And the final third got nothing. Luna: So why would two rational people turn down seventy million guaranteed for a chance at a hundred million that more likely than not will fall short? Lucas: Because they looked at the structure. Most earnouts are tied to EBITDA targets or revenue growth — things the buyer can influence after the deal closes by cutting costs or shifting strategy. This one was different. The earnout was based on client retention. Specific named clients, each with a dollar value attached. Luna: So the founders retained control over the relationship. The buyer couldn't fire the clients or change the scope. Lucas: Exactly. And the earnout was measured annually, not as a single four-year cliff. So each year, if a client renewed, the founders got a check. It de-risked the timeline. They didn't have to wait four years to see if they'd get anything. Luna: That's smart. But still — they're betting on themselves to keep those relationships intact while reporting to new bosses. That's a lot of pressure. Lucas: It is. And it's why a lot of sellers end up regretting earnouts. They become employees of the buyer, but with a financial incentive to run the business a certain way. That can create tension. In this case, the founders negotiated something else — they got to keep their equity in a side entity that wasn't part of the sale. That side entity held a software tool they'd built. If the earnout failed, they still had that asset. Luna: A hedge. So they weren't all-in on the earnout. Lucas: Right. And I think that's the lesson for any small business owner looking at an earnout. You need to understand what you're actually betting on. Is it something you can control? Is the measurement transparent? And what happens if you miss the target by a hair? Luna: That last point is huge. A lot of earnouts have a 'cliff' — hit ninety-nine percent of the target and you get zero. That's punitive. Lucas: Yeah, and the Portland agency's structure had a linear payout. If they hit eighty percent of the retention target, they got eighty percent of that year's earnout. No cliff. That made the decision to go for the higher earnout much more rational. Luna: You know, I remember reading about a similar case with a small software company in Austin. They had an earnout tied to recurring revenue, but the buyer started bundling their product with a free offering. Revenue didn't grow, and the earnout failed. The founders sued, but it was messy. Lucas: That's the classic earnout horror story. The buyer changes the operating model post-close and the seller's earnout evaporates. The best protection is to define the earnout metrics in a way that limits the buyer's ability to change the business. Luna: And to have a good lawyer. But not every seller can afford top-tier M&A counsel. Lucas: True. But you can still ask the right questions. Like — is the earnout based on GAAP revenue or something the buyer can manipulate? Is it audited? Who calculates it? And what's the dispute resolution mechanism? Luna: So in the Portland case, the founders ended up earning close to the full hundred million. They retained all three key clients for the full four years. But they told me the hardest part wasn't the business — it was the culture clash. The holding company wanted weekly reporting, brand guidelines, compliance sign-offs. They were used to running lean and fast. Lucas: That's the hidden cost of an earnout. You're selling your business, but you're also selling your autonomy. If the earnout requires you to stay on, you have to work inside a new system. Luna: It's like a probation period for the seller. Except you're the one being tested. Lucas: Exactly. And that's why some sellers prefer a lower cash offer if it means they can walk away clean. I've seen founders who took a smaller check just to avoid the earnout headache. Luna: So what's the rule of thumb? When does an earnout make sense? Lucas: I think it makes sense when two things are true. One — the seller genuinely believes they can outperform the buyer's projections. And two — the earnout is structured so the seller has real control over the outcome. If both are true, an earnout can bridge a valuation gap. If not, it's a trap. Luna: And you'd want a floor. A minimum payout even if performance slips. Lucas: Yeah, a floor is ideal. Some earnouts include a guaranteed minimum — say, fifty percent of the target no matter what. That protects the seller from a total wipeout. Luna: I also think sellers should model out scenarios. What if revenue drops ten percent? Twenty? What if the buyer fires your best employee? You need to stress-test the earnout. Lucas: Absolutely. And that's something a good business broker or M&A advisor can help with. But even if you're selling without a broker — and we've talked about that before — you can still do the math yourself. It's just a spreadsheet. Luna: Speaking of doing the math — if these conversations have shifted how you think about selling your business, or even just given you a framework for evaluating an offer, that's exactly why we do this show. And listener support is what keeps it ad-free and available to everyone. If you've gotten value from what we're talking about, you can support the show at buy me a coffee dot com slash fexingo. Lucas: Yeah, it's a small way to help us keep going. No pressure at all. But it does make a difference. Luna: And it helps us stay independent, which means we can keep digging into the real mechanics of deals like this Portland agency. So — back to the earnout. One thing I want to ask about is timing. The earnout in this case was four years. Is that typical? Lucas: Three to five years is standard. Anything longer and the seller is basically an employee with a phantom incentive. Anything shorter and the buyer doesn't get enough time to validate the acquisition. Luna: And what about the tax treatment? Earnout payments are usually taxed as capital gains if structured properly, but if it's structured as compensation, it's ordinary income. Lucas: That's a critical point. In the Portland deal, the earnout was structured as additional purchase price, so capital gains rates applied. But some buyers push for a 'consulting agreement' or 'employment bonus' structure, which is less favorable for the seller. Luna: So you need a tax advisor before you sign anything. Lucas: Absolutely. The difference between capital gains and ordinary income can be tens of millions on a deal that size. Luna: Final thought — the Portland founders, are they still at the agency? Lucas: One left after year three, the other stayed the full four. The one who left forfeited the final year's earnout, but they'd already banked enough. They started a new venture. The other one is now a managing director inside the holding company. Luna: So the earnout worked for both of them, but in different ways. Lucas: Exactly. One wanted the payout and the exit. The other wanted the payout and the career. The earnout gave them both the flexibility to choose. Luna: That's a good reminder that an earnout isn't just a financial instrument — it's also a bet on your own future. Lucas: And if you structure it right, it can be a bet you're happy to make.