Latest / The Startup Exit Podcast with Fexingo: IPOs, Acquisitions, and Founder Liquidity Events / How Founders Use Earnout Milestones to Avoid Post-Deal Value Pitfalls
Transcript
- Lucas: So Luna, we keep talking about earnouts as this bridge over a valuation gap, but here's the thing I keep coming back to: the data says nearly half of all earnouts fail to pay out in full. That's not a bridge, that's a trapdoor. Luna: That's a brutal stat. Where are you seeing that from? Lucas: There's a study from a few years back that tracked earnout performance across a few hundred tech deals, and it found that around forty-seven percent of earnouts paid out less than the maximum. And more than a quarter paid out nothing at all. So when a founder brags about their earnout, I always wonder if they've actually read the fine print. Luna: And that's the thing, right? The earnout sounds great in the headline — you know, 'I got two hundred million dollars' — but the reality is often tied to metrics that the acquirer controls. Lucas: Exactly. And that's what we need to drill into today. Because earnouts have been around forever, but they've become way more common in the last few years as the market's gotten choppier. You look at your screen today, August first, 2026, and you see the five-day moves — Apple down eight percent, Microsoft up nineteen, Coinbase down almost thirteen. That kind of dispersion makes acquirers nervous, so they lean on earnouts to protect themselves. But founders need to understand that the structure of the earnout is just as important as the size. Luna: So what are the specific clauses that turn a earnout from a trap into a fair deal? Lucas: First, the metrics themselves. The classic earnout is tied to revenue or EBITDA targets, right? But the smartest founders are pushing for metrics tied to things they still control after the deal. Like product development milestones or customer retention targets. If you're an AI startup and your earnout is tied to revenue, but the acquirer decides to pull your sales team and integrate your product into their stack, you have zero control over that revenue number. Luna: Right, and that brings up the change of control issue. If the acquirer gets bought themselves, what happens to your earnout? Lucas: That's the second clause. Most earnouts have what's called a change of control provision, but they vary wildly. Some say the earnout accelerates in full if the acquirer is acquired. Others say it just converts into the acquirer's stock, which could be worthless. You want to negotiate for partial acceleration — at least a percentage of the earnout paying out immediately if the acquirer is taken over. Luna: And what about the time horizon? I've seen earnouts stretch for three years, which is a long time to be handcuffed. Lucas: Three years is pretty standard now, but some are stretching to four or five. The longer the earnout, the more likely something goes wrong — either the acquirer changes strategy or the market shifts. One founder I know negotiated a two-year earnout instead of three, and that single year difference probably saved them millions because the business hit a rough patch in year three. Luna: That's a concrete example. But I want to push back on the idea that earnouts are inherently bad. If you're a founder who really believes in the business and you're willing to stay on, an earnout can actually increase your total payout. It lets the acquirer pay a higher purchase price because they're de-risking the deal. Lucas: That's true, and I don't want to dismiss earnouts entirely. They can be a useful tool, especially when there's a genuine difference of opinion about future performance. But the key is that founders need to approach them with eyes open. You can't just sign on the dotted line and assume you'll get that full payout. Luna: So what's the first thing a founder should ask their lawyer when they see an earnout in a term sheet? Lucas: Well, I'd ask: 'What happens if the acquirer changes the business model?' Because that's the number one way earnouts get killed. The acquirer buys your software product, then decides to sunset it and fold the team into a different project. Your revenue target becomes impossible. So you want language that says the earnout must be measured against the business as it exists at the closing date, not as it might be changed. Luna: And that's where disputes come in, right? The earnout period ends, the acquirer says you missed the target, and the founder says, 'You moved the goalposts.' Lucas: Absolutely. That's probably the most common source of post-deal litigation. So another clause to negotiate is dispute resolution — maybe an independent arbitrator to decide if the earnout was achieved, rather than leaving it up to the acquirer's CFO to interpret the numbers. Luna: Let's bring in a real example that's not in tech. Remember the electronics retailer that acquired a smaller competitor a few years back? The earnout was tied to the acquired company's online sales, but the acquirer immediately centralized all e-commerce on their own platform. The acquiree's site was shut down, and surprise, surprise, the online sales target was missed. Lucas: That's the classic case. And it's a perfect illustration of why founders need to protect themselves. Now, I want to talk about one more angle that often gets overlooked: tax treatment. The way an earnout is structured can have a big impact on how much you actually keep. Luna: How so? Lucas: If your earnout is structured as additional purchase price, it's usually taxed as capital gains, which is great. But if it's structured as compensation for your continued services, it's taxed as ordinary income, which can be as high as thirty-seven percent. The difference is massive. So you want to make sure your deal attorney and your tax advisor are on the same page about how the earnout is characterized. Luna: And you also have to think about the time value of money. A dollar three years from now isn't worth the same as a dollar today. Even if you do hit every earnout target, you're waiting three years to get that money. Lucas: Right, so some founders try to negotiate a discount rate on the earnout — like, if you hit the target in year two instead of year three, you get a premium. Or even better, they push for a structure where a portion of the earnout is paid upfront, with a smaller earnout on top. That way you have some cash in hand and you're not betting everything on future performance. Luna: That seems like the smartest approach, honestly. Take less risk, still get some upside. Lucas: Exactly. And if you're a founder listening to this and you're in the middle of a deal right now, the takeaway is: don't be afraid to push back on the earnout terms. The acquirer expects you to negotiate. They've built in some flexibility. The worst thing you can do is resign yourself to whatever outline they offer. Luna: Yeah, and I think a lot of founders feel like they're in a weak position because they're the one selling. But the acquirer wants the deal to close just as much as you do. They're not going to walk away over a reasonable ask about change of control or dispute resolution. Lucas: Exactly. So, before we move on, I want to say something. If this conversation has been helpful to you as you think about your own exit, that's exactly why we keep these episodes ad-free. The way that stays possible is listener support. If you've gotten something useful today, consider buying me a coffee at buy me a coffee dot com slash fexingo. It's a small gesture that keeps this going. Luna: And honestly, every little bit helps. We're just two people trying to make sense of this stuff and share it with you. Lucas: Alright, back to the numbers. Let's talk about how earnouts are being used in the current market. With all the volatility we're seeing — I mean, look at Roblox down twenty-six percent in the last five days — acquirers are even more cautious. So earnouts are becoming the norm in deals that would have been all-cash a few years ago. Luna: And that means founders need to be even more prepared. So what's a realistic expectation for the size of an earnout relative to the total deal value? Lucas: It varies a lot by sector. In software, earnouts typically range from ten to thirty percent of the total consideration. In biotech, where milestones are common, they can be much higher — sometimes the earnout can equal the upfront payment. But the point is, you need to model out the best and worst case scenarios. What's your payout if you hit all the targets? What's your payout if you miss by a little? By a lot? Luna: And if the earnout is the majority of the deal, that's a red flag. You're basically selling your company for a lottery ticket. Lucas: Exactly. I would never advise a founder to accept a deal where the earnout is more than half the deal value. That's too much risk. The whole point of selling is to de-risk your financial life, not to create a new dependency on the acquirer's execution. Luna: So let's wrap this up with a concrete checklist. What are the three or four things you'd tell a founder to insist on before signing an earnout? Lucas: First, make sure the metrics are within your control and clearly defined. Second, negotiate a change of control clause that at least partially accelerates the earnout. Third, get an independent dispute resolution mechanism. And fourth, consider the tax characterization and the time value of money. If you've got those four, you're in a much better position than most. Luna: I'd add a fifth: don't be afraid to walk away. If the earnout is too one-sided, there will be other buyers. Lucas: That's the bottom line. The best negotiator is someone who's willing to walk. And with that, we'll leave it here. Next time, we're going to dig into how the recent volatility is affecting IPO pricing — but for now, keep your eyes open and your earnout clauses even more open. Luna: Thanks for joining us, and we'll see you next time.