Latest / The Series A Show with Fexingo: Early-Stage Funding, Pitch Decks, and Startup Milestones / Why Startups Are Using Earnouts to Bridge Valuation Gaps
Transcript
- Lucas: If you're a founder raising a Series A right now — and I've talked to a few this week — you're probably running into a wall. The investor loves your traction, but they want a lower valuation. You think you're worth more. And neither side wants to walk away. So what do you do? More and more startups are using a tool that used to be reserved for M&A: earnouts. Luna: Earnouts in a Series A? That feels new. I've seen earnouts in acquisitions — like, 'if you hit this revenue target in two years, we'll pay you an extra $5 million.' But in a fundraising round? Lucas: Right. Traditionally, earnouts were for when a big company bought a startup and wanted to bridge a valuation gap. But in the last year or so — and especially in the first half of 2026 — I'm seeing them appear in priced equity rounds. Founders and investors agree on a base valuation, say $40 million, but then add a contingent payout if the company hits certain milestones. It's a way to get the deal done without either side feeling ripped off. Luna: And those milestones — are they usually revenue-based? Or something else? Lucas: Revenue is the most common. But I've also seen user growth, gross margin targets, or even product launch dates. The key is that the milestone has to be objective and verifiable. If the company hits the target within 12 to 18 months, the investor issues additional shares or a cash payment to the founders. If they miss, the investor gets the lower valuation. It's a hedge. Luna: So the investor gets downside protection, and the founder gets a shot at a higher valuation if they deliver. That seems fair. But is it actually becoming common? Lucas: It's still niche, but it's growing. I looked at some data from a few law firms that track Series A terms. In 2024, earnout clauses showed up in maybe 2 percent of priced rounds. By Q2 of this year, we're seeing closer to 8 or 9 percent. And it's not just late-stage — it's happening at the Series A and even seed. The dynamic is: markets are choppy. Valuations are under pressure. But good companies are still raising. So both sides are getting creative. Luna: And when you say choppy — look at the ARK Innovation ETF, ARKK, it's down over 2 percent in the last five days. ARKW is down a bit too. So there's definitely nervousness in growth stocks. That trickles down to private valuations. Lucas: Exactly. And then you have outliers like Palantir, up over 5 percent in the same period, and Apple up 6.5 percent. So the market is rewarding some companies, but punishing others. That uncertainty makes valuation negotiation harder. Founders look at Palantir and think, 'Why can't I get a higher valuation?' Investors look at ARKK and say, 'I need protection.' Earnouts are the middle ground. Luna: Let's get specific. Can you give an example of how an earnout might be structured in a Series A? Lucas: Sure. Let's say a startup — call it CloudThread — is raising a $10 million Series A. The founder wants a $50 million post-money valuation. The investor thinks $40 million is fair. So they agree on a $45 million base valuation, but with an earnout: if CloudThread hits $5 million in annual recurring revenue within 18 months of closing, the valuation automatically adjusts to $50 million. The investor issues additional shares worth the difference. If CloudThread falls short, the valuation stays at $45 million. Both sides sign off. Luna: And the founder doesn't get diluted if they hit the target. That's powerful. But what happens if the company blows past the target? Like, hits $10 million ARR? Lucas: Most earnouts are capped. The investor won't let the valuation run indefinitely. They'll say, 'If you exceed the target by more than 20 percent, we'll renegotiate the next round, but the earnout is fixed.' So the founder gets the bump, but the investor doesn't get unlimited dilution. It's a compromise. Luna: I've also heard that some investors are using earnouts as a way to test founder conviction. If the founder is confident they can hit the milestone, they'll agree. If they hedge, maybe the investor walks. Lucas: That's a great point. It's a signal. A founder who pushes back on an earnout might be signaling that they don't believe their own projections. So in a weird way, the earnout can actually speed up negotiations. Both sides put their cards on the table. Luna: But there's a downside, right? If the milestone is tied to something the founder can't fully control — like a product launch that depends on a third-party API — the earnout could become a source of tension. Lucas: Absolutely. That's why lawyers I've talked to emphasize that the milestone needs to be within the founder's control. Revenue is good because it's a direct result of the team's execution. But something like 'FDA approval' or 'partnership with a specific company' is risky. What if the FDA delays? What if the partner backs out? The founder shouldn't be penalized for things outside their control. Luna: So earnouts work best when the milestone is a leading indicator of value, not a binary event. Revenue growth. User engagement. Maybe gross margin. Lucas: Right. And the other risk is complexity. Term sheets are already dense. Adding an earnout clause means defining the metric, the measurement period, the adjustment mechanism, and what happens if the company gets acquired before the earnout vests. That can add weeks to legal negotiations. Luna: But for founders who are confident in their trajectory, it's worth it. You give up a little downside protection in exchange for a higher ceiling. Lucas: Exactly. And I think this is part of a larger shift. The old model was: you pitch, you get a valuation, you close. Now, with rolling funds, SAFEs with valuation caps, and earnouts, the terms are becoming more dynamic. Investors and founders are treating valuation as a range, not a fixed number. Luna: And that's healthier. It acknowledges that early-stage companies are inherently uncertain. No one knows what they're worth. So why pretend? Lucas: Exactly. The earnout is basically saying, 'We'll figure it out together as we go.' That's the spirit of partnership. Lucas: If today's episode gave you a useful framework for thinking about valuation gaps, that's exactly why we make this show ad-free. Listener support is what keeps it that way — buy me a coffee dot com slash fexingo. Luna: Yeah, it's a small way to make sure we can keep digging into these topics without commercial interruptions. Appreciate anyone who chips in. Lucas: So back to earnouts — one thing I haven't mentioned is that they're not just for the founder. Some investors are also using earnouts to align with their LPs. If the fund's mandate is to invest at a certain valuation range, an earnout lets them stay within that range while still giving the founder upside. It's a fund-level tool too. Luna: Interesting. So the earnout is a way to satisfy both the founder and the limited partners. Everyone gets what they need. Lucas: Right. And I think we'll see more of this as the market normalizes. The days of easy money are over. But good deals are still getting done — just with more creativity. Luna: And more paperwork. But you know, if it means founders and investors can actually close, maybe it's worth it. Lucas: I think so. So if you're a founder about to start a Series A negotiation, ask your lawyer about earnouts. It might just save the deal.