Latest / The Startup Exit Podcast with Fexingo: IPOs, Acquisitions, and Founder Liquidity Events / How Founders Use Earnout Caps to Avoid Leaving Money on the Table
Transcript
- Lucas: So there's a phrase that makes every founder's stomach drop when they read it in an acquisition term sheet: 'earnout capped at two times revenue.' And it's buried in a paragraph that nobody reads until it's too late. Luna: Two times revenue — that sounds like it could be generous or a trap, depending on the numbers. What's the actual story? Lucas: The story is the cautionary tale playing out right now between Runlayer and Rippling. They just dropped their lawsuits, but the whole mess started because of an earnout that was capped. Runlayer's founders thought they were getting a certain payout if they hit growth targets. Rippling interpreted the cap differently. The result? A public fight, legal fees, and probably a settlement that neither side loves. Luna: And this is the kind of thing that doesn't just hurt the founders' bank accounts — it burns the relationship they need with the acquirer to actually hit those earnout targets. Lucas: Exactly. And that's why we're drilling into earnout caps today. Because most founders focus on the earnout multiple — like 'I get three times revenue if I hit my numbers' — but they ignore the cap on top of it. A cap is essentially the maximum amount the acquirer will pay, no matter how well you perform. And it's often written as a fixed dollar amount or a multiple of the initial payment. Luna: So you could blow past every target and still hit a ceiling. How common is that? Lucas: It's incredibly common, especially in deals where the acquirer wants to protect themselves from overpaying if the startup's growth is just a fluke. For example, say a founder negotiates a $50 million earnout based on hitting $25 million in revenue. The acquirer might cap it at $40 million. So even if you double your revenue, you only get $40 million. That's a $10 million gap that nobody talks about at the signing table. Luna: And that gap is exactly what leads to lawsuits. So what's the smart way to handle a cap before you sign? Lucas: First, understand what the cap is actually based on. Some caps are tied to a multiple of the initial payment — like 'earnout cannot exceed two times the upfront cash.' Others are tied to revenue or EBITDA. Each has different implications. A revenue-based cap might seem generous, but if your margins are thin, you could be doing all that work for a cap that doesn't reflect the value you're creating. Luna: So the cap should be tied to the same metric you're being measured on, right? Lucas: Ideally, yes. But the real pro move is to argue for an uncapped earnout, or at least a cap that's so high it's practically a non-issue. The justification is simple: if you're willing to put a significant portion of your payout at risk based on performance, the acquirer should be willing to share the upside if you outperform. That's the whole point of an earnout — aligning incentives. Luna: But I imagine acquirers push back hard on that. They want certainty. Lucas: They do. And that's where you need to get creative. You can propose a tiered cap — like a base cap, but if you exceed the target by a certain percentage, the cap rises. Or you can cap it based on a multiple of EBITDA rather than revenue, because EBITDA reflects actual profitability. If you're growing efficiently, that's a stronger argument for a higher cap. Luna: That makes sense. But what about the timing? Earnouts typically run one to three years. Does the cap apply to the entire period or each year separately? Lucas: Great question. Some caps apply annually, others apply to the cumulative total. An annual cap might be lower, but it resets each year, so you could earn more over the whole period. A cumulative cap is simpler but can be a real ceiling. Founders should map out their best-case and worst-case scenarios to see which structure actually pays them more. Luna: And this is all happening against a backdrop where the IPO market is choppy. I'm looking at META down seven and a half percent over the past week. That kind of volatility makes private exits look more attractive, and earnouts become a bigger part of the conversation. Lucas: You're spot on. When public markets get shaky, acquirers get more conservative, and they lean on earnouts to bridge valuation gaps. But that also means founders need to be even more careful about caps, because the acquirer is looking to protect themselves. In a market like today, August 2026, every percentage point of a cap matters. Luna: So what's a concrete example of a cap that looked good on paper but ended up being a problem? Lucas: Let's use a hypothetical, but based on real deal patterns. Say you're a SaaS founder and you negotiate an earnout of three times annual recurring revenue, capped at $60 million. Your ARR at signing is $15 million, so you think the cap isn't a constraint. But then you land two enterprise contracts and your ARR jumps to $30 million within the earnout period. Three times that is $90 million, but you're capped at $60 million. You just left $30 million on the table for doing exactly what you promised. Luna: Ouch. And the acquirer is probably thrilled-because they got a bargain for your outperformance. Lucas: Exactly. That's the asymmetry. The cap protects the acquirer from overpaying if you miss targets, but it also protects them from paying you what your success is actually worth. So the negotiation should be about removing that asymmetry, or at least making the cap high enough that it only kicks in for truly extraordinary outcomes. Luna: And what about the legal side? The Runlayer-Rippling dispute shows that vague language can be a landmine. What should founders insist on in the contract? Lucas: Clarity on what exactly triggers the cap and how it's calculated. Is it based on GAAP revenue or billings? Does it include acquisitions the startup makes during the earnout period? What happens if the acquirer changes the product or sales strategy mid-way? All of that needs to be spelled out. The more definitions you can pin down, the fewer surprises later. Luna: That sounds like it's worth the legal fees upfront. Lucas: It absolutely is. And honestly, that's a good place to pause and mention something. We're able to do deep dives like this because of listeners who support the show. If today's episode saves you from a painful surprise at closing, that's the kind of value worth a coffee. The link is buy me a coffee dot com slash fexingo. Every bit keeps us going. Luna: Yeah, it's a small way to keep these conversations free and ad-free. We appreciate everyone who does. Lucas: So back to caps. The other angle founders often miss is how the cap interacts with an earnout escrow. Some deals put the earnout in escrow, which can be good because it protects the money if the acquirer tries to renege. But if the cap is structured poorly, the escrow might not be enough to cover the full payout you're owed. Founders should check that the escrow amount matches the maximum earnout, not just the initial estimate. Luna: That's a subtle but important point. So what's your advice for founders who are already in an earnout and realize the cap is hurting them? Lucas: First, don't panic. Read the contract carefully and see if there's any room for interpretation. Sometimes the cap is based on a formula that can be negotiated if you can show that the acquirer's actions affected your ability to hit targets. For example, if they cut your marketing budget or reassigned your sales team, that could be a material change that allows you to renegotiate. But you need to document everything. Luna: And if it's too late to negotiate, what's the fallback? Lucas: You can still protect yourself by making sure you're hitting the targets as efficiently as possible. If the cap is $60 million and you're only on track for $55 million, it's worth pushing hard to close that last stretch. But if you're already way above the cap, the incentive to keep pushing drops off a cliff. That's actually a design flaw of caps — they can kill motivation. Luna: So in a way, caps can work against the acquirer's own interest if they want you to stay motivated. Lucas: Exactly. That's why some sophisticated acquirers prefer no cap, or a cap that's so high it's irrelevant. They want founders to keep building value without a ceiling. But in a tough market, they default to caps. So founders need to push back with data showing why uncapped or high-cap structures are better for both sides. Luna: And speaking of data, we've got COIN up sixteen percent over the past week. That kind of volatility in a single stock shows how unpredictable this market is. It reinforces that earnouts are risky because the broader economy can shift under your feet. Lucas: Right. And that's another reason to negotiate a floor on your earnout, not just a cap. Some deals have a minimum payout regardless of performance, which helps protect you if the market turns. But that's rare. Usually, the earnout is all-or-nothing based on hitting targets. So you want to build in as many protections as possible. Luna: So what's the one thing you want listeners to take away from this episode? Lucas: The takeaway is simple: the earnout cap is the most important number in your acquisition agreement after the purchase price. Spend as much time on that one line as you do on the headline number, because it determines what you actually walk away with. And don't be afraid to ask for the cap to be removed entirely — the worst they can say is no. Luna: And if they say no, at least you know what you're signing up for. That's power.