Latest / The Series A Show with Fexingo: Early-Stage Funding, Pitch Decks, and Startup Milestones / Why Startups Are Trading SAFEs for Earnout Agreements
Transcript
- Lucas: So there's this term that's been popping up in more Series A term sheets lately — earnout agreements. It's not new in M&A, but as a primary deal structure for an early-stage round? That's a pivot worth talking about. Luna: Define earnout in this context. Because when I hear earnout, I think acquisition — founders get extra payout if the acquirer hits certain targets post-close. Lucas: Right, that's the classic usage. But now some startups are raising their Series A with an earnout built into the investment itself. Instead of a straight SAFE or priced round with a fixed valuation, the founder's payout — or the investor's conversion price — depends on the company hitting specific milestones within a set timeframe. Luna: So the valuation isn't set on day one? That sounds messy for the cap table. Lucas: It can be, but proponents argue it aligns incentives better than a traditional priced round. Let me give you a concrete example. I was looking at a robotics startup that just closed a $12 million Series A. Three tranches — $4 million upfront, then additional $4 million tranches triggered by FDA clearance of their surgical robot and then by hitting $5 million in commercial revenue within 18 months. Luna: And the founder's equity stake adjusts based on those milestones? Or is it just the valuation? Lucas: Both, depending on how you structure it. In this case, the earnout affected the conversion price of the preferred shares. If they hit all three milestones, the investor converts at a lower effective valuation — meaning the founder gets diluted less. If they miss, the investor gets more shares for the same money. It's a way to bridge the valuation gap when a founder thinks they're worth $50 million and the investor thinks it's $30 million. Luna: So it's a compromise. But what happens to the cap table during the earnout period? You've got some shares that haven't fully priced yet. Lucas: That's the tricky part. The cap table shows the as-converted shares, but with footnotes. Most law firms are using a separate class of earnout shares or a contingent value right, similar to what you see in pharma acquisitions. It's not clean, but it's workable. Luna: And this is happening in the current market? We're in July 2026 — venture is still active, but there's a lot of caution. Lucas: Exactly. Look at some of the recent price action. ARKK is up 4% in the last five days. Palantir up 14 and a half percent, Coinbase up 11. The market is hungry for high-risk innovation stories. But investors have been burned by down rounds in 2022 and 2023. They want downside protection without forcing a low valuation that demotivates the founder. Luna: Right, so the earnout becomes this middle ground. The founder gets a shot at a higher valuation if they execute, and the investor gets downside protection if they don't. Lucas: If today was actually useful to you, the way these stay ad-free is listener support — buy me a coffee dot com slash fexingo. Luna: Yeah, it's a small way to keep these conversations going without any ads or sponsors. Lucas: So back to earnout mechanics — one thing I find interesting is how the milestones are selected. In the robotics case, the milestones were regulatory and commercial. But I've also seen revenue targets, user acquisition numbers, even gross margin thresholds. Luna: Gross margin? That's unusual for early stage. Usually that's something you track later. Lucas: But if you're an investor betting on a software startup with high marginal costs — say, a company that uses a lot of cloud compute for AI inferencing — gross margin tells you if the unit economics actually work before you pour in more capital. Luna: So the earnout becomes a way to test the business model before fully committing. Lucas: Precisely. And it's not just for investors. Founders like it because they don't have to accept a low valuation upfront. They can keep their equity upside if they hit their numbers. In a traditional priced round, if you agree to a $30 million post-money valuation and then blow past every target, you still gave away a big chunk for too little. Luna: But what if the founder hits the milestones early? Does the earnout accelerate? Lucas: Some deals have acceleration clauses. If you hit all milestones in 12 months instead of 24, the conversion happens sooner. Others are fixed time — you have 24 months, no matter what. It depends on negotiation. I've also seen deals where the earnout is tied to a liquidity event — if the company gets acquired before the earnout period ends, the earnout shares convert at a premium. Luna: That's clever. So the earnout protects the investor in a downside scenario but also rewards them if there's a quick exit. Lucas: Right. And it forces both sides to agree on what success looks like upfront. That's actually a healthy discipline. How many startups raise money with vague plans and then pivot six months later? An earnout crystallises the plan. Luna: But doesn't it also create pressure to hit short-term milestones at the expense of long-term strategy? If the earnout is tied to revenue in 18 months, the founder might chase low-quality revenue just to trigger the tranche. Lucas: That's a real risk. I've seen it happen. One SaaS startup I know chased month-long contracts with heavy discounts to hit a revenue milestone, and their churn spiked afterwards. The earnout actually hurt the business long-term. Luna: So the design of the milestones matters a lot. They have to be leading indicators of value, not just vanity metrics. Lucas: Exactly. Gross margin, net dollar retention, customer concentration — those are harder to game than top-line revenue. Some sophisticated investors are using composite milestones: 60% weight on revenue, 20% on gross margin, 20% on NDR. That aligns incentives much better. Luna: And what about the legal costs? Structuring an earnout round has to be more expensive than a standard SAFE. Lucas: It is. I've heard estimates of $50,000 to $100,000 in legal fees for a complex earnout, versus maybe $10,000 for a SAFE. But for a $10 million plus round, that's a rounding error if it prevents a mispriced deal. Luna: So who's using earnouts right now? Is it mostly later-stage Series A, or are we seeing pre-seed and seed too? Lucas: Mostly Series A and beyond, because you need enough data to define meaningful milestones. But I've seen a few seed rounds — particularly in biotech and hardware — where the milestones are development-stage: completing a prototype, filing a patent, getting first beta users. For a pre-revenue company, an earnout can be better than a valuation cap because it's more objective. Luna: Interesting. And investors — are they pushing for this, or is it founder-driven? Lucas: Both. In a competitive round, founders might offer an earnout to sweeten the deal. In a tougher market, investors might demand it. The data this week shows that the market is pretty hot for high-growth names — but that's public markets. Private markets are still cautious. The VIX is low, but venture funds are deploying capital selectively. Luna: So earnouts are a response to that cautious optimism. Lucas: Exactly. I think we'll see more of them, especially as AI startups raise large rounds with uncertain revenue trajectories. It's a tool that lets both sides share risk and upside in a more granular way than a simple valuation. Luna: One thing I keep thinking about: how does this affect the founder's ability to raise the next round? If you have an earnout structure from your Series A, does that spook Series B investors? Lucas: It can, if the cap table is messy. But if the milestones are met and the earnout converts cleanly, it's actually a positive signal — it shows discipline and execution. Some Series B investors I've talked to say they prefer seeing an earnout in the prior round because it means the company has already been stress-tested. Luna: So it's a double-edged sword. If you hit the milestones, it's a stamp of approval. If you miss, you might have a harder time. Lucas: Right. And that's the trade-off. Earnouts aren't for every startup. If you have a clear path to profitability and a strong negotiating position, you might prefer a clean priced round. But if you're in a capital-intensive sector with long development cycles — like biotech, robotics, or deep tech — an earnout can be the difference between getting funded and not. Luna: What about SAFEs? Are they becoming less popular as earnouts rise? Lucas: SAFEs are still dominant at pre-seed and seed, especially with the post-money SAFE that Y Combinator popularized. But for larger rounds, SAFEs have a problem: they delay the valuation conversation, and that can cause friction later. An earnout addresses the valuation issue head-on, but in a dynamic way. Luna: So earnouts are a middle ground between SAFE and priced round — more structure than a SAFE, more flexibility than a fixed price. Lucas: Exactly. And I think we'll see more innovation in this space. Some firms are experimenting with 'earnout-only' rounds, where there's no fixed valuation at all — the entire return is based on milestones. That's radical, but for very early-stage deep tech, it might make sense. Luna: I want to circle back to the robotics startup. Did they hit their milestones? Lucas: They just closed the round two months ago, so it's too early to tell. But the FDA submission is expected in Q4 of this year. If they get clearance, the second tranche triggers. The market is watching closely. Luna: And if they don't? Lucas: Then the investor gets more equity, and the founder gets diluted. But the company still has the first $4 million to keep operating. It's not a disaster — it's just a repricing based on reality. Luna: That actually seems more honest than a traditional round where everyone pretends the valuation is fixed and then six months later you do a down round. Lucas: That's the argument. Earnouts bring the valuation discussion into the open and tie it to actual performance. It's less about predicting the future and more about agreeing on how to measure success as you go.