Latest / The Startup Exit Podcast with Fexingo: IPOs, Acquisitions, and Founder Liquidity Events / The Earnout Trap What Every Founder Needs to Know Before Signing
Transcript
- Lucas: So we talk a lot on this show about the headline numbers of an exit — the billion-dollar valuation, the IPO pop, the liquidity event that changes a founder's life. But there's this one mechanism that shows up in maybe a third of all tech acquisitions, and it almost never works out the way founders think it will. Luna: I'm guessing you mean earnouts? Lucas: Exactly. The earnout clause. It's a classic valuation bridge. The buyer says, 'We'll pay you $200 million upfront, and another $50 million if you hit these performance milestones over the next two years.' It sounds like a win-win. But the data tells a different story. Luna: What's the failure rate? Lucas: Depending on the study you look at, between 30 and 40 percent of earnouts never pay out in full. And a significant chunk — maybe 15 to 20 percent — pay out zero. Zero. The founder walks away with only the upfront money, having stayed on for two years chasing a phantom bonus. Luna: That's brutal. Why does it happen so often? Lucas: A few reasons. First, the milestones are often tied to metrics the founder no longer fully controls — things like revenue targets that depend on the buyer's own sales team, or integration timelines that get deprioritized. Second, post-close, the buyer's incentives shift. They've already got the asset. The earnout is a cost center for them, not a priority. So they might underinvest in the very division that's supposed to hit those numbers. Luna: Right. So the founder is grinding for a bonus that the buyer has no real reason to help them achieve. Lucas: Precisely. And you see this pattern across industries. Take the current market, for instance. Look at Palantir — down 16.5 percent this week. Or Coinbase, down 12.7 percent. If you're a founder who signed an earnout tied to revenue or stock performance and the market turns, you're doubly exposed. The buyer's stock drops, the earnout becomes even less of a priority, and the milestones get harder to hit. Luna: So if you're a founder negotiating an exit right now, what do you actually do? Walk away from earnouts entirely? Lucas: Not necessarily. Earnouts can make sense when there's a genuine disagreement about future growth. But you have to structure them defensively. First, push for milestones that are directly within your control — product development milestones, not revenue targets that depend on the buyer's sales engine. Second, negotiate for acceleration clauses: if the buyer fires you or materially changes your role, the earnout vests immediately. Luna: That's key. I've seen deals where the founder gets pushed out six months in and the earnout just vanishes. Lucas: Third, put a cap on the buyer's ability to change the business model. Some buyers will shut down a product line and then claim the earnout target wasn't met. You want language that says if the buyer makes changes that materially impact the earnout, it's treated as if the target was achieved. And fourth, shorten the earnout period. Two years is standard, but one year is a lot safer. The longer the period, the more things can go wrong. Luna: What about the tax angle? Deferred earnout payments get taxed as ordinary income when they hit, right? Lucas: That's right. And that's another reason they're less attractive than upfront cash. If you get $50 million upfront, it's likely a capital gain — lower rate. If you get $50 million spread over earnouts, each payment is ordinary income. So you're paying more tax on money you're less sure you'll even receive. Luna: So the math really works against you. Lower probability, higher tax rate. Lucas: Exactly. There is one scenario where earnouts can be smart though — if the buyer's stock is volatile and you believe in the combined company. If you take earnout in stock, and the stock appreciates, you can come out ahead. But that's a bet, not a guarantee. Luna: And right now, with stocks like Palantir and Coinbase swinging 10-15 percent in a week, that's a risky bet. Lucas: It is. So the core advice: treat an earnout as a bonus, never as a certainty. Budget your exit assuming you get only the upfront cash. If the earnout pays out, great. If not, you're not disappointed. Luna: That's probably the healthiest mindset. And speaking of things that aren't certain, but that we appreciate — I want to mention something real quick. You know how we keep this show ad-free? That's not an accident. Lucas: It's not. A small group of listeners chips in monthly through buy me a coffee dot com slash fexingo, and that's literally what makes it possible to produce this many episodes — going deep on topics like this without any sponsor interruptions. Luna: Yeah. If you find these conversations useful for what you're building or running, that's the only way we keep going. No pressure, just putting it out there. Lucas: And we mean that. Now, back to earnouts — one more thing I want to flag. The earnout clause often includes something called 'earnout accounting,' where the buyer can use accounting methods that reduce the apparent achievement of the milestone. For example, they might defer revenue recognition or allocate more costs to your division, making it look like you missed the target. Luna: So you need to specify the accounting principles in the contract. Lucas: Yes. You want to lock in GAAP as of the signing date, and require that the buyer doesn't change accounting policies without your consent — at least for the earnout period. Otherwise, they can shift the goalposts. Luna: That reminds me of a case where a founder had an earnout tied to EBITDA, and the buyer started allocating corporate overhead to the acquired unit — completely wiping out the EBITDA target. Lucas: Classic move. So if you're negotiating an earnout, you need to define not just the metric, but how it's calculated, who controls the inputs, and what happens if the buyer restructures. It's a minefield. Luna: Alright, so bottom line: earnouts are a tool, but they're a tool that cuts both ways. Use them carefully, or skip them if you can. Lucas: Yeah. And if you're in the middle of a negotiation right now, talk to a lawyer who's seen a hundred earnout disputes. The upfront cost of that legal advice is tiny compared to what you'd lose if the earnout fails. Luna: Good advice. And on that note, thanks for listening. We'll be back next week with another angle on founder liquidity. Lucas: Take care, everyone.