Latest / The Startup Exit Podcast with Fexingo: IPOs, Acquisitions, and Founder Liquidity Events / How Founders Use Earnout Escrows to Protect Payouts
Transcript
- Lucas: If you're a founder selling your company, and part of your payout depends on hitting milestones after the deal closes — that's an earnout — here's the thing nobody tells you at the signing party: the buyer can hold a portion of that earnout in escrow, and if they decide you didn't hit the target, you might never see that money. Luna: Right, and it's not just about performance — it's about who gets to define 'performance' when the check is due. Lucas: Exactly. So today we're going to look at how earnout escrows actually work, why they're becoming more common in this market, and what founders can do to protect themselves. I've got a specific case in mind — a late-stage SaaS company that was acquired by a publicly traded enterprise software firm about eighteen months ago. Luna: I remember that one. The founder ended up in litigation over whether the earnout conditions were met. Lucas: Right. The deal had an earnout pool worth about $40 million, tied to revenue retention and new customer acquisition in the two years post-close. The buyer escrowed 30 percent of that pool — $12 million — as a security against any potential claims that the targets weren't achieved. The founder hit the numbers, or so he thought. The buyer disagreed, kept the escrow, and the case went to arbitration. Luna: And the founder won, but it took over a year and cost him hundreds of thousands in legal fees. According to a 2025 study by the Exit Planning Institute, nearly 40 percent of earnout disputes end up in litigation, and founders recover on average only 72 percent of the contested amount. Lucas: That 72 percent number is brutal — it means that even if you win, you're losing nearly a third of what you thought you'd get. And in a market where acquirer stocks can swing wildly — just look at the NASDAQ, up about 6 percent in the last five days — that volatility can actually increase the risk of earnout manipulation, because the buyer's own stock price might be affecting their willingness to pay out. Luna: How does the earnout escrow get set up in practice? Is it just a standard percentage, or is there room to negotiate? Lucas: There's definitely room, and that's where founders need to pay attention. The escrow pool size is typically negotiated as a percentage of the total earnout — common ranges are 20 to 30 percent, but I've seen as high as 50 percent in deals where the buyer has leverage. The key is to cap the escrow at a percentage that reflects actual potential liability, not a punitive holdback. Luna: And the trigger language — that's where most founders get tripped up. The definition of 'earnout achievement' needs to be crystal clear. Lucas: Exactly. In the case I mentioned, the dispute hinged on whether 'new customer acquisition' included customers that signed contracts but hadn't started paying yet. The buyer argued no, the founder argued yes. The arbitration panel sided with the founder, but only because the contract explicitly defined 'acquisition' as 'executed contracts' regardless of payment start date. If the language had been vague, he would have lost. Luna: So the lesson is: define every term, and assume the buyer will interpret ambiguity in their favor. Lucas: Right. And then there's the dispute resolution mechanism itself. Most earnout escrow agreements specify either arbitration or litigation, but the default is often litigation in the buyer's home jurisdiction — which can be expensive and inconvenient for the founder. Savvy founders push for binding arbitration with a neutral third-party arbitrator, ideally one with industry expertise. Luna: I've heard of founders negotiating for the escrow to be released automatically if the buyer doesn't raise a dispute within a certain timeframe — say 90 days after the earnout period ends. Lucas: That's a great point. It's called a 'release upon no objection' clause. It shifts the burden to the buyer to actively dispute, rather than leaving the founder to chase the money. And it's surprisingly negotiable, especially if the escrow amount is small relative to the total deal size. Luna: Let's talk about the current environment. With the market rallying — NASDAQ up, big tech stocks like Apple at over $308, up nearly 9 percent in five days — acquirers might be more willing to do deals, but also more likely to use earnouts to bridge valuation gaps. Lucas: That's exactly what we're seeing. Earnouts are becoming a standard tool to align buyer and seller expectations when there's disagreement on valuation. But the escrow piece often gets glossed over in the excitement of the deal. And that's dangerous, because the escrow is where the risk concentrates. Luna: So what's the one thing every founder should do before signing an earnout escrow agreement? Lucas: Get a lawyer who specializes in M&A escrow disputes — not a general corporate attorney. And negotiate for a 'most favored' dispute resolution clause: binding arbitration, in a neutral location, with an arbitrator who understands your industry. It's a small cost upfront that can save you millions. Luna: And if you're listening and this kind of deep-dive on exit mechanics is useful for what you're building or running, it's worth noting that these episodes stay ad-free because of listener support. Lucas: Yeah, a couple of dollars a month is genuinely what keeps these going — buy me a coffee dot com slash fexingo, if you've gotten something out of them. Luna: Exactly. Now back to the escrow mechanics — one more thing I wanted to ask: what about the timing of the escrow release? Does it all come out at once, or in tranches? Lucas: Great question. It can be structured either way. For longer earnout periods — say two to three years — it's common to have multiple tranches released at different milestones. For example, 25 percent after year one if you hit the target, another 25 after year two, and so on. That reduces the risk of a single dispute wiping out the entire escrow. But the trade-off is more complexity and more opportunities for disputes. Luna: So there's a balance. Founders need to think about what's most important: simplicity or maximum protection. Lucas: Right. And honestly, the best protection is to avoid an earnout altogether if you can. But if you can't, the escrow is where you need to focus your negotiation. Don't let the buyer dictate the terms — push back on the percentage, define the triggers with surgical precision, and insist on a fair dispute process. Luna: It's one of those things that seems like a detail in the heat of a deal, but can become the entire story later. Lucas: Exactly. And it's not just about the money — it's about your time, your energy, and the emotional toll of a dispute. A well-structured escrow can save all of that.