Latest / The Startup Exit Podcast with Fexingo: IPOs, Acquisitions, and Founder Liquidity Events / How Founders Use Milestone-Driven Earnouts to Protect Exit Value
Transcript
- Lucas: So OpenAI's acquisition of NextSlide this week got me thinking about earnouts again. Not the standard 'hit revenue by year two' kind, but the milestone-driven ones where payments are tied to specific operational achievements. That's a different beast. Luna: Milestone earnouts. We've touched on earnouts in general before, but not this specific structure. What's the real difference? Lucas: A classic earnout is usually about financial metrics like revenue or EBITDA targets over a period. Milestone-driven earnouts are more binary or stage-gated: you get paid when the product reaches a certain user count, or when a regulatory approval lands, or when a specific integration goes live. Investors often hate them because they're harder to predict, but for founders they can be a tool to capture value that's hard to price today. Luna: And in the case of NextSlide, OpenAI is buying a presentation tool. What milestones would make sense there? Lucas: Probably integration milestones, like embedding the tech into their existing products, or user adoption thresholds within a certain period. But here's the thing: the headline numbers in tech M&A often hide how much of the deal is actually contingent. I've seen deals where half the purchase price is earnout, and that changes the founder's real liquidity. Luna: Half the deal? That sounds like a lot of risk for the founder. Let's break that down with a concrete example. Lucas: Sure. Think of a software company I've consulted with: a founder selling a niche SaaS product to a larger player. The buyer was skeptical about future growth, so they structured a $40 million total deal, $20 million upfront, and $20 million tied to milestones. The milestones were specific: double the customer base within eighteen months, and launch a mobile version within twelve. If those hit, the founder got the full $20 million. If not, he'd get a fraction. Luna: And what happened? Did they hit them? Lucas: They did, but only because the founder negotiated hard on two things: control and definition. He made sure the buyer couldn't arbitrarily change the product roadmap, and he got the milestones tied to objective, verifiable metrics that the buyer couldn't game. That's the key. Luna: So the real risk isn't just missing the metric, it's that the buyer controls whether you even get a shot at it. That's something I'd never thought about. Lucas: Exactly. And you see this in deals across the board. With the market volatility we're seeing — Palantir up nearly 37 percent this week, Shopify up almost 30 — acquirers are more nervous about paying full price upfront. Earnouts, especially milestone-driven ones, shift some of that risk to the founder. That's a trade-off worth understanding. Luna: So the current environment is making earnouts more common, but also more complex. How do founders protect themselves? Let's dig into that. Before we do, I want to mention something that's been on my mind. We get a lot of messages from listeners who say these episodes have helped them think about their own exits, and honestly, that's why we keep making them. This show is ad-free, and it stays that way because a handful of listeners chip in a few bucks a month. If these conversations have given you a useful framework, you can support the show at buy me a coffee dot com slash fexingo. Every little bit genuinely helps keep the lights on. Lucas: Yeah, and it's not about big pledges. It's the small, steady support that makes a difference. That's what keeps this going. So back to the earnout structure — what are the common pitfalls founders hit? Luna: I guess the first pitfall is not defining the milestones clearly enough. If it's 'improve customer satisfaction,' that's a recipe for dispute. It needs to be something like 'Net Promoter Score increases by 15 points within nine months.' Lucas: Right, and even then, you need to think about who's measuring it and how. But another big one is the buyer's ability to interfere. We touched on this: if the buyer pulls resources or changes priorities, the founder has no chance. That's why good-faith clauses and 'best efforts' language are crucial. They're not just boilerplate. Luna: And what about the timeline? I imagine milestones spread over two to three years are more common than a quick hit. Lucas: Typically, you'll see earnout periods of one to three years. Longer than that and the founder is basically tied to the business without full control, which is a recipe for frustration. Some founders I know have pushed back and said, 'If you want me to hit these milestones, I need to stay in a role that gives me the authority to make it happen.' That's a legitimate ask. Luna: So the founder's involvement post-deal is a huge factor. But what if the milestones are tied to things outside the founder's control, like a regulatory approval? How do you handle that? Lucas: That's a great question. You can structure those as 'milestone payments' that are triggered by the approval itself, but you also need to consider what happens if the approval never comes. Some deals include a 'most favored nation' clause or a partial payment for partial achievement. It's about anticipating the squeaky scenarios. Luna: And that's where legal counsel really earns their keep. On the flip side, I've heard that some founders actually prefer milestone earnouts because they can lead to a higher total payout than a straight upfront offer. Lucas: Absolutely. If you're confident in your business and your ability to execute, a milestone earnout can be a way to bridge a valuation gap that would otherwise kill the deal. It's a bet on yourself. But it's not for everyone. If you're looking for a clean exit, or you're not sure about the buyer's commitment, it might be better to take a lower upfront number and walk away. Luna: So how does a founder decide? What's the mental framework? Lucas: I like to think of it in terms of risk tolerance and conviction. Ask yourself: do you believe the milestones are achievable with the resources you'll have? Can you live with the uncertainty of not knowing your final payout for a year or two? And honestly, how much do you trust the buyer? If you have any doubt, you need to price that risk into the deal. Some founders demand a higher earnout multiple to compensate for the risk. Luna: And that's where the negotiation gets really interesting. You're not just arguing over the total number; you're arguing over the risk premium embedded in the earnout. Lucas: Exactly. And a good negotiator will also push for the earnout to be paid in stock rather than cash, or vice versa, depending on their tax situation and their view on the acquirer's stock. That's another layer. It gets complicated, but that's why founders hire good advisors. Luna: Let's talk about the tax side for a second, since we've touched on QSBS in the past. Does the structure of the earnout affect the tax treatment? Lucas: It can. Earnouts are often treated as contingent payments, and the tax treatment can be tricky. You might be taxed at ordinary income rates if it's considered compensation, especially if you're staying on as an employee. Structuring it as a capital gain, tied to the sale of the business, is usually more favorable. But the IRS has rules, and you need to structure the deal carefully with your accountant to avoid surprises. Luna: Yeah, I've heard horror stories about founders getting hit with a huge tax bill on earnout payments. That's a real risk if you're not careful. Lucas: It's a classic trap. You think you're getting a windfall, and then a third of it goes to taxes. That's why you need to model the tax implications before you sign. But if you do it right, an earnout can be a powerful tool. I've seen founders use it to get a deal done that would have fallen apart otherwise, and in some cases, they ended up with more than the initial offer. Luna: So what's the bottom line for a founder considering a milestone earnout? What should they walk into the negotiation with? Lucas: First, know exactly what your milestones are and how they'll be measured. Second, have a clear plan for what happens if the buyer interferes. Third, get professional tax advice. And fourth, be honest with yourself about your own risk tolerance. If you're not comfortable with uncertainty, a milestone earnout might not be for you. But if you're confident and you trust the buyer, it can be a real win-win. Luna: And I guess that's why we're seeing more of these structures in the current M&A environment. As stock prices swing and buyers get cautious, they're looking for ways to share risk. For founders, that means more opportunities to get creative, but also more pitfalls to navigate. Lucas: Right. And the NextSlide deal is a good reminder that even in a hot market, buyers are thinking about how to protect themselves. Founder-friendly or not, these structures are here to stay. The savvy founders will be the ones who understand them and use them to their advantage. Luna: So if you're a founder facing a potential exit, what's your first step? I'm guessing it's not just 'get a lawyer.' Lucas: I'd say start by building a financial model that projects your business under different scenarios. That gives you a sense of what a fair earnout might look like. Then, talk to other founders who've been through it. They'll tell you the practical pitfalls. Finally, bring in advisors who specialize in M&A tax and deal structuring. It's worth the investment. Luna: That's solid advice. And on that note, I think we're at a natural close. Thanks for joining us on this milestone episode. If you're a founder thinking about an exit, we hope this gave you a new lens. And as always, if this show has been valuable, you know where to find us. Lucas: Buy me a coffee dot com slash fexingo, if you're so inclined. Otherwise, we'll be back next week with another angle on startup exits. Until then.