Latest / The Startup Exit Podcast with Fexingo: IPOs, Acquisitions, and Founder Liquidity Events / How Earnout Agreements Bridge Valuation Gaps in Acquisitions
Transcript
- Lucas: So let's talk about earnout agreements. You've probably heard the term — it's that chunk of an acquisition price that's contingent on the startup hitting certain targets after the deal closes. And they are everywhere right now. Luna: Everywhere? I looked at some recent data from Shareworks — they tracked private tech acquisitions in the first half of this year and found that 42% included earnouts. That's up from about 28% five years ago. Lucas: And that number makes sense when you look at the market environment. Tech stocks have been volatile — NVIDIA, for example, is trading around $207 as of this week, down significantly from its highs. When the public market is shaky, buyers and founders have a harder time agreeing on what a company is worth today, let alone what it'll be worth in two years. Luna: Right — earnouts exist to bridge that gap. The buyer says, 'I'll pay you X now, and if you hit Y in revenue by the end of next year, you get another Z.' It's a way to bet on future performance together. Lucas: Exactly. And if you're finding these conversations useful for something you're building or running, it's worth mentioning that listener support is what keeps this show ad-free. A small contribution at buy me a coffee dot com slash fexingo goes a long way. Luna: Yeah, it's a simple way to keep the lights on and the content coming. Lucas: So back to earnouts — let's get into the mechanics. An earnout is essentially a contingent consideration. It's typically tied to a financial metric like revenue, EBITDA, or sometimes a product milestone like hitting a certain user count or launching a feature. The period is usually one to three years. Luna: One to three years — that's short enough to keep the founder incentivized, but long enough for integration risks to surface. And that's where things can get messy. Imagine you're a founder who sold your company to a big tech firm, and your earnout is based on revenue from your product. Then the acquirer decides to rebrand it, fold it into another division, or change the sales strategy. Suddenly hitting that target becomes really hard. Lucas: That's the classic 'operational interference' problem. I've seen deals where the earnout metric was tied to gross profit, and the acquirer shifted the startup's customers to a lower-margin bundle. The founders missed their target through no fault of their own. Luna: So how do you protect against that? I've heard of founders negotiating 'most favored nation' clauses or specifically defining how the product will be sold post-close. Lucas: Yes, or including a 'best efforts' covenant that obligates the buyer to use commercially reasonable efforts to hit the earnout targets. But those are hard to enforce. The stronger protection is to tie the earnout to metrics the founder still controls — like new customer acquisition, if the founder stays on as a product lead, or a pure revenue number that's insulated from pricing changes. Luna: What about the flip side? When do earnouts benefit the buyer more than the seller? Lucas: Great question. Buyers love earnouts because they defer risk and often keep the founder engaged during the critical integration period. But if the earnout is too aggressive — say, 50% of total consideration tied to doubling revenue in a year — the founder might walk away with far less than they expected. And that can create bad blood and even litigation. Luna: Speaking of litigation — I read a stat that nearly a third of earnout-related deals end up in some form of dispute. That's a huge number. So getting the terms right upfront is critical. Lucas: Absolutely. One thing that helps is defining the earnout metric as clearly as possible. For example, if it's based on 'net revenue,' spell out what counts — subscription revenue, professional services, hardware? And define what doesn't — returns, chargebacks, intercompany sales. Luna: And include a dispute resolution mechanism. I've seen arbitrations over something as simple as how to calculate recurring revenue when the buyer changes the accounting method. Lucas: Right. Another tactic is to structure the earnout as a mix of cash and stock. That way, if the acquirer's stock price drops, the founder isn't doubly hit — they still get some cash. But if the stock goes up, they share in the upside. Luna: That's a good point, especially with the volatility we're seeing. Microsoft, for instance, is around $382, down from its 52-week high. If you took all stock, you might be sitting on a loss before the earnout even vests. Lucas: Exactly. And some founders negotiate a collar or a floor on the stock component to limit downside. But of course, the buyer will push back — it's a negotiation. Luna: So for founders listening who are thinking about an acquisition, what's your single best piece of advice on earnouts? Lucas: Assume that the earnout won't pay out fully — and negotiate a higher upfront payment accordingly. Earnouts are often treated as a sweetener, but statistically, only about half pay out the maximum. So push for as much cash at close as you can, then treat the earnout as a bonus. Luna: That's sobering but practical. Also, get everything in writing — the metric, the period, the accounting rules, the dispute process. And don't rely on handshake promises from the board. Lucas: Handshake promises get forgotten the minute the deal closes. If the CEO who wooed you leaves six months later, you're dealing with a whole new team. Luna: So what's the future of earnouts? With the IPO market still relatively cool and acquisitions being the primary exit for most startups, I think we'll see even more creative structures — maybe earnouts tied to ESG targets or AI adoption metrics. Lucas: That's a good callout. We're already seeing some deals where earnouts are linked to carbon reduction goals or diversity hiring milestones. It's a way to align financial incentives with mission-driven outcomes. Luna: And as the market evolves, earnouts will likely become more standardized — maybe templates will emerge that reduce the back and forth. But for now, every deal is still bespoke. Lucas: And that's why understanding the nuances matters. Whether you're a first-time founder or a serial entrepreneur, getting earnout right can mean millions of dollars in difference. Luna: Absolutely. And on that note, we'll keep watching the market and bring you more practical insights. Thanks for listening — and if you found this useful, you know what to do. Lucas: Buy me a coffee dot com slash fexingo. We'll be back next time with another deep dive into startup exits. Luna: Take care, everyone.