Aug 22 • General discussion
The Earnout Neither Side Should Have Accepted
The buyer and seller had spent weeks trying to close a valuation gap. The seller believed the company's recent growth justified a higher price, while the buyer wasn't comfortable paying today for earnings that had yet to materialize. Neither wanted to lose the transaction over a disagreement about the future, so their advisors proposed what seemed like an elegant solution.
They would use an earnout.
The seller would receive additional consideration if the business reached certain performance targets after closing. The buyer would pay the higher valuation only if the results actually appeared. On paper, it seemed to give both sides exactly what they wanted.
The problem was that everyone focused on the amount of the earnout and not enough on how it would be measured.
The agreement referenced revenue and profitability targets, but left important questions unresolved. How would unusual expenses be treated? Could the buyer increase staffing or marketing after closing? What happened if an investment reduced short-term profit but strengthened the company long term? Who controlled pricing, and how would revenue from new products be allocated?
Those questions seemed manageable while everyone was trying to close.
A year later, they weren't.
The business had grown, but the buyer had also invested heavily in people, systems, and equipment. The seller believed the earnout had been achieved based on the company's underlying performance. The buyer's calculations showed otherwise.
Neither side believed they were being unreasonable. They were simply interpreting an ambiguous agreement in the way that supported their own position.
The earnout hadn't resolved their valuation disagreement. It had postponed it.
Eventually, attorneys became involved, and a provision designed to save the transaction became one of its most expensive sources of friction. Looking back, both sides realized they had spent more time negotiating the potential payout than defining the rules that would determine whether it was earned.
Earnouts can be useful when buyers and sellers genuinely disagree about future performance, but ambiguity isn't compromise. If the measurement period, accounting treatment, operational control, calculation methodology, and dispute process aren't clearly understood before closing, the parties may simply be moving today's disagreement into tomorrow's operating relationship.
A creative structure can bridge a valuation gap, but only if both sides know exactly where the bridge ends.
Sometimes the most dangerous deal term isn't the one you disagree about.
It's the one both sides think they understand differently.
If these are the kinds of acquisition conversations that interest you, we'd love to have you join us
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The Earnout Neither Side Should Have Accepted
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