Latest / The Series A Show with Fexingo: Early-Stage Funding, Pitch Decks, and Startup Milestones / How Startups Use Earnouts to Bridge Valuation Gaps
Transcript
- Lucas: Palantir is up more than 17 percent in the last five days. That's not just a tech rally—it's a signal that the market is pricing in a certain kind of future for data-intensive startups. And that has a direct effect on how early-stage deals get structured. Luna: Because if public comps are surging, private valuations get harder to pin down. Founders see Palantir at a hundred thirty-seven and think, 'My AI startup should be worth more.' VCs push back. So what's the workaround? Lucas: The workaround that's quietly becoming standard in seed and Series A rounds is the earnout agreement. You've probably heard the term, but let's be specific. An earnout ties part of the purchase price—or in a financing context, part of the founder's equity—to hitting certain milestones post-close. It's a way to bridge the valuation gap without either side walking away. Luna: Right. So instead of arguing over whether the company is worth ten million or twelve million today, you agree on ten million upfront, with another two million in contingent consideration if revenue hits a target in eighteen months. Lucas: Exactly. And it's not just for M&A anymore. We're seeing earnout-like provisions in priced equity rounds, especially for pre-revenue startups where the only real asset is the team's execution risk. Speaking of teams—did you catch the Figma news today? Luna: Figma acquired the team behind a vibe-coding app. That's interesting because vibe-coding is essentially ai generated front-end from natural language prompts. It's a hot space, but still very early. What's the deal structure? Lucas: We don't have the full terms, but acquisitions of early-stage teams like this almost always involve earnouts. Figma isn't buying a product with proven revenue—they're buying talent and a prototype. So you structure it so the team gets a base payout, then additional equity or cash if they ship certain features or hit user milestones within two years. Luna: That protects the acquirer from overpaying for potential that never materializes. And it aligns the team to stay and execute, rather than cashing out and leaving. Lucas: Exactly. And this same logic applies to early-stage financing rounds. I've been talking to founders who are using earnout structures with their angel investors and micro-VCs. The typical setup: the investor puts in, say, five hundred thousand dollars at a five-million-dollar cap on a SAFE, but with an earnout clause that gives them an extra percentage point of equity if the startup hits a million in annual recurring revenue within twelve months. Luna: That changes the risk profile. It's almost like a performance-based warrant. The investor gets upside for taking the risk of a lower valuation upfront, and the founder gives up less dilution if they miss the target. Lucas: Right. And if these conversations are useful for what you're building or running, consider supporting the show. It keeps us ad-free and focused on the mechanics that actually matter for founders. You can do that at buy me a coffee dot com slash fexingo. Luna: Yeah, that direct support makes a real difference. We hear from listeners who use these episodes in their board meetings. Lucas: Back to earnouts. One nuance that trips up founders: earnout milestones need to be objective and verifiable. Not 'we'll work hard to grow.' It has to be something like 'achieve two hundred thousand dollars in GAAP revenue from new customers within eighteen months.' Otherwise you get disputes. Luna: And disputes can kill the relationship. I've seen earnout clauses that led to litigation because the acquirer or investor claimed the milestone wasn't met due to accounting changes. So the contract language is critical. Lucas: Absolutely. A well-structured earnout defines the metric, the measurement period, the payment mechanism, and what happens if the company is sold again before the earnout period ends. That last one is huge—if you're a founder and your startup gets acquired during the earnout period, the earnout from the financing round might trigger, and you could end up with two layers of contingent consideration. Luna: It becomes a waterfall within a waterfall. So how do founders protect themselves? Is there a standard playbook? Lucas: There's no standard, but there are patterns. One common protection is to cap the earnout at a certain percentage of the overall round—say, no more than twenty percent of the investment amount. Another is to allow the founder to buy out the earnout at a predetermined price if they want to clean up the cap table before a Series A. Luna: That makes sense. Clean cap tables are more attractive to later-stage investors. A messy earnout clause can spook a lead investor. Lucas: Exactly. And here's where the Palantir surge connects back. When public markets are pricing growth companies at a premium, it trickles down to private markets. Founders feel more emboldened to push for higher valuations. But VCs, especially at the seed stage, are still cautious. They don't want to overpay for a company that hasn't proven product-market fit. So earnouts become a compromise that lets both sides claim a win. Luna: The founder gets a higher headline valuation because the earnout creates potential upside, and the VC gets downside protection because the earnout only pays out if targets are hit. Lucas: And it's not just for cash-strapped startups. I've seen well-capitalized companies use earnouts to attract top-tier investors who normally wouldn't write a check at a lower valuation. The earnout sweetens the deal without blowing up the cap table. Luna: Are there industries where earnouts are more common? I'm thinking about biotech, where milestones are very clear—phase one trials, FDA approvals. Lucas: Biotech is the classic example. But we're also seeing it in hardware and deep tech, where you have tangible milestones like 'ship first production unit' or 'achieve a certain error rate in the model.' The clearer the milestone, the easier the earnout. Luna: What about the downside for the investor? If the earnout is too generous, the founder might sandbag—deliberately delay hitting the milestone to avoid giving up more equity. Lucas: That's a real risk. Good earnout clauses include 'best efforts' language and sometimes a negative covenant that prevents the founder from taking actions that would impede the milestone. But enforcement is tricky. It's a relationship contract at the end of the day. If you have to litigate, you've already lost. Luna: So the earnout works best when both parties trust each other and the milestones are genuinely aligned with value creation. Lucas: Exactly. And I think that's why we're seeing more earnouts in pre-seed and seed rounds, where the relationship between founder and investor is still being built. It's a way to commit to each other without having to agree on every assumption today. Luna: Let's talk about the recent M&A uptick. With Figma acquiring that vibe-coding team, and the broader tech M&A market picking up—do you see earnouts becoming the default for acqui-hires? Lucas: I do. Acqui-hires are inherently risky for the buyer. You're paying for a team that may not integrate well or may not produce the same magic in a new environment. An earnout tied to retention and output—like 'team stays for two years and delivers three features'—protects the buyer and motivates the team. I expect that to become standard. Luna: And for founders, what's your advice? Should they proactively propose an earnout structure in their fundraising? Lucas: It depends on the leverage. If you have multiple term sheets, you don't need to propose an earnout—you can just take the best valuation. But if you're in a situation where the investor is balking at your number, offering an earnout can be a smart negotiation tactic. It shows you're confident in your ability to hit milestones, and it gives the investor a reason to say yes. Luna: Right, it's a signal of confidence. 'I'm so sure we'll hit that revenue number that I'm willing to put extra equity on the line.' Lucas: Exactly. But don't over-optimize. An earnout adds complexity to the cap table, and every extra clause is something a future investor will have to diligence. Keep it simple: one or two milestones, tied to the most critical value driver for the next twelve to eighteen months. Luna: Good rule of thumb. So for a pre-revenue SaaS startup, the milestone might be first paying customer or first $10K MRR. For a biotech, it's IND filing or Phase 1 data. Lucas: Right. And if you're the investor, push for milestones that are within the founder's control. Market-based milestones like 'achieve $1M revenue' can be affected by macro factors. Better to use operational milestones like 'ship version 2.0' or 'sign five enterprise pilots.' The founder can control that. Luna: That's a good distinction. One thing I want to clarify: earnouts in financing rounds are different from earnouts in M&A. In M&A, the earnout is typically paid by the acquirer to the seller. In financing, it's the investor getting additional equity from the company or founder. Lucas: Important point. In a financing earnout, the founder is essentially giving away more equity if they hit the milestone. That can be dilutive, so founders need to model the fully diluted cap table under different scenarios. Make sure you can live with the outcome if you blow the milestone out of the water. Luna: Because if you triple your revenue, you might end up giving away more equity than if you'd just negotiated a higher valuation upfront. Lucas: Exactly. That's the trade-off. The earnout is insurance for the investor and a bet on yourself for the founder. Use it wisely. Luna: Before we wrap, I want to check: with Palantir up 17 percent, are we seeing any ripple effects in private AI startup valuations? Lucas: Anecdotally, yes. Founders are showing up to meetings with public comps and saying, 'Palantir trades at 20x revenue, why should I take a 10x cap?' VCs are pushing back by pointing out that Palantir has been public for years and has proven scale. But the gap is narrowing, and earnouts are one way to bridge it. Luna: So the earnout is becoming the valve that releases pressure in a heated market. It lets both sides move forward without a perfect meeting of the minds. Lucas: Exactly. And I think that's a healthy development. Startups are inherently uncertain. Pretending you know the exact valuation today is often fiction. An earnout acknowledges that uncertainty and builds a mechanism to adjust as reality unfolds. Luna: That's a good note to end on. Next episode, I want to dig into the mechanics of earnout waterfalls in multi-investor rounds. It gets complicated quickly. Lucas: It does. We'll map it out. Thanks for listening, and if you want to support the show, you know where to find us.