Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / How Earnout Antifraud Provisions Work in M&A Deals
Transcript
- Lucas: It was a $200 million med-tech acquisition in 2023. The buyer agreed to a $50 million earnout tied to hitting three years of revenue and EBITDA targets. By the end of year one they suspected the seller had deferred R&D—pushed it into the next fiscal year—to inflate EBITDA by about $47 million. Luna: Forty-seven million is actual fraud territory. Not just aggressive accounting. Lucas: Right. The buyer sued and the case settled late last year. What came out in the deposition was that the earnout agreement had exactly zero antifraud provisions. No specific indemnity for earnout misrepresentations, no post-closing true-up mechanism, no clawback. The buyer was basically relying on the general representations in the purchase agreement, which the seller argued were superseded by the earnout formula. Luna: So the judge had to decide—do the reps survive the earnout clause? That's a gamble most buyers don't want to take. Lucas: Exactly. And in that case the court said the reps were still valid, but you don't want to test that in litigation. The smarter move is to build three specific provisions into the deal. First, a specific indemnity clause for any earnout-related misrepresentation—meaning if the seller's calculation of the earnout metric is later found to be wrong, the buyer gets indemnified dollar for dollar. Luna: That's different from the general indemnity basket. It usually has a lower threshold—sometimes zero deductible. Lucas: Right. Second, a post-closing true-up mechanism. That means the buyer gets to audit the financials used to calculate the earnout for, say, 18 months after each measurement period. If the audit finds manipulation, the earnout payment is adjusted retroactively. Luna: And the third one is the clawback—allowing the buyer to recoup earnout payments already made if the true-up reveals fraud. Lucas: Exactly. The clawback matters because earnouts are often paid in installments. If the first year's payment was based on inflated numbers, you want a way to get that money back without having to file a new lawsuit. Luna: You see these provisions in larger private equity deals, but in the lower middle market—deals under $100 million—they're rare. I've seen earnout agreements that are literally a page and a half. Lucas: Right. And that's where the danger is. The seller's incentive is to maximize the earnout. If the agreement is vague about how EBITDA is calculated—what gets included, what gets excluded—there's room to game it. We're talking about things like capitalizing expenses that should be operating costs, accelerating revenue recognition, or deferring maintenance. Luna: There's also the classic 'stuff the channel' move—shipping extra product to distributors at the end of the period with the right to return it later. Lucas: Right. And those are the obvious ones. The more sophisticated fraud involves manipulating the timing of M&A-related costs. If the acquisition is a platform deal with add-ons, the seller might allocate more integration costs to periods outside the earnout window. Luna: So the buyer is essentially paying a premium for performance that isn't real. And by the time they find out, the seller is already out the door. Lucas: That's the structural problem. Earnouts are supposed to align incentives. But if the buyer doesn't have the right safeguards, they actually create a perverse incentive. The seller has one shot at the payout, and they can disappear once the earnout period ends. Luna: I want to talk about something you mentioned earlier—the FTC advisory opinion from mid-2024. Can you unpack that? Lucas: Sure. In August 2024, the FTC issued an advisory opinion on earnout accounting in the context of healthcare transactions. It said that earnout payments tied to the seller's continued employment could be considered disguised compensation, not purchase price. That has implications for how the earnout is treated for tax purposes and, more importantly, for fraud liability. Luna: So if the earnout is compensation, it falls under employment law—which has different fraud standards than contract law. Lucas: Right. And the opinion also suggested that earnouts tied to EBITDA that include the seller's own salary can be problematic. If the seller is the CEO post-close and the earnout metric includes their compensation, they have an incentive to keep their salary low to boost EBITDA. That's not fraud—it's just bad structuring. But it shows how the details matter. Luna: So the lesson is: if you're a buyer, define the earnout metrics in excruciating detail. Spell out exactly which expenses are excluded, how adjustments are calculated, and who gets to audit. Lucas: And include those three provisions—specific indemnity, true-up, and clawback. I'd also add a provision requiring the seller to maintain GAAP accounting throughout the earnout period, and maybe even require the seller to use the same accounting firm they used pre-deal. Luna: On the seller side, you'd want to push back. Sellers argue that antifraud provisions are insulting—they say, 'I'd never cheat, trust me.' But a professional buyer should insist anyway. Lucas: Exactly. And look, I know this kind of contract talk can feel dry. But if you're an operator selling your business, understanding these clauses can mean the difference between getting your full payout and leaving millions on the table. And if you're buying, it can protect you from a very expensive mistake. Luna: It's also worth noting that earnout fraud isn't just a buyer problem. Sometimes sellers genuinely hit their numbers only to have the buyer manipulate the post-close financials to avoid paying. The same provisions work both ways. Lucas: That's a great point. The true-up should be bilateral. And the clawback should apply to both sides—if the buyer deliberately understates the metric, the seller should get compensation. Luna: We've covered a lot of ground. Let me ask you this—where do you see the earnout market going in the next couple of years? Lucas: I think we'll see more standardization. The FTC opinion and the med-tech case are pushing buyers to demand stronger language. I also think we'll see more use of independent auditors to certify earnout calculations, maybe even third-party earnout administrators. Luna: And we haven't even talked about R&W insurance. Some policies now offer coverage for earnout misrepresentations. Lucas: That's a relatively new product. But it's not a substitute for good contract design. Insurance is only as good as the coverage language, and carriers are starting to exclude fraud. Luna: So the bottom line: don't leave your earnout to chance. Write the rules clearly, build in safeguards, and get professional help. Lucas: And if you're listening and thinking about negotiating an earnout, the best time to add these provisions is before the letter of intent gets signed. Once the LOI is out, the buyer has leverage to say no. Luna: Agreed. And on that note, I'd like to take a quick moment to mention something about this show. Lucas and I pour a lot of research into these episodes, and we deliberately keep them ad-free. If you find value in these conversations—maybe they've helped you negotiate a better deal or avoid a bad one—consider supporting the show. Lucas: Yeah, it's a small way to keep this independent. If that's something you want to do, the link is buy me a coffee dot com slash fexingo. No pressure, just a way to say 'this matters.' Luna: Exactly. And it helps us keep doing deep dives like this one. So, back to earnouts—one more practical tip. If you're a seller and you're worried about the buyer gaming you, ask for a 'most favored nation' clause in the earnout definition. Lucas: Great idea. That means if the buyer changes accounting policies or adds a new expense line, the seller gets the benefit of the more favorable treatment. It's a fairness hedge. Luna: Right. And it's a simple line that can save a lot of headaches. Lucas: Alright, that's a solid place to wrap. Thanks for listening, and we'll be back with another episode soon. Luna: Take care, everyone.