Latest / The Startup Exit Podcast with Fexingo: IPOs, Acquisitions, and Founder Liquidity Events / How Founders Use Structured Earnouts to Close Valuation Gaps
Transcript
- Lucas: If you've ever tried to sell a company, you know the hardest part isn't finding a buyer—it's agreeing on price. Luna: Yeah, that valuation gap. The buyer sees risk, the seller sees potential. Lucas: Exactly. And one of the most common tools to bridge that gap is the earnout. A structured payout contingent on hitting certain milestones after the deal closes. Luna: It's like the seller gets to bet on their own future performance. Lucas: Right. And when done right, it can unlock a deal that otherwise would have died. This is a show where operators meet builders, and if these conversations are useful for what you're building or running, we hope you find value in them. Luna: We keep the show ad-free because we think that's better for you. If you want to support that choice, the link is buy me a coffee dot com slash fexingo. Lucas: Now, let's look at a real example. Yesterday, TechCrunch reported that video-generation startup PixVerse raised $439 million at a valuation north of $2 billion. Luna: That's a big round. But how does that relate to earnouts? Lucas: Great question. So, PixVerse is private, but the structure of that deal likely includes some contingent elements. Investors are putting in $439 million now, but the final valuation might depend on hitting user growth or revenue targets. That's effectively an earnout. Luna: So the founders only get the full $2 billion valuation if they deliver. Lucas: Exactly. And in M&A, earnouts work the same way. Say a buyer offers $100 million upfront, plus another $50 million if the startup hits $20 million in revenue in year two. That's an earnout. Luna: What kind of milestones are we talking about? Revenue? Users? Lucas: Common ones include revenue, EBITDA, product launch dates, or customer retention rates. The key is that they're measurable and verifiable. If the milestone is subjective, you're asking for trouble. Luna: I've heard horror stories where buyers change the accounting methods to avoid paying out. Lucas: That's a real risk. Founders need to negotiate protections—like having the earnout calculated using the same accounting principles as the base business. Also, a timeline: typical earnout periods are one to three years. Luna: And what about taxes? Is the earnout taxed as a capital gain or ordinary income? Lucas: That depends. If it's structured as additional purchase price, it's usually capital gains. But sometimes the IRS recharacterizes it as compensation, especially if the founder stays on as an employee. That's a big discussion to have with your tax advisor. Luna: So the takeaway: earnouts can close the gap, but they add complexity. Lucas: Right. And today's market conditions make them more relevant. Look at the tech stock moves this week: Meta up nearly 7% in five days, NVIDIA up 3.4%, but ARKK down 3.6%. There's a divergence—some buyers are bullish, others cautious. Luna: So in a market where valuations are uncertain, earnouts become a hedge. Lucas: Exactly. The buyer hedges against overpaying; the seller gets a chance to prove worth. But founders should remember: an earnout is a loan on future performance. If you miss milestones, you get nothing. Luna: What about the 'grinding winners' article from TechCrunch today? It said many successful founders are staying at their companies longer because they can structure earnouts to keep upside. Lucas: That's a great point. The article noted that even after exits, founders are grinding because they have earnout targets. It's not just a payout—it's a motivation tool. Luna: Or a golden handcuff. Lucas: Exactly. So if you're a founder considering an earnout, think about: are the targets realistic? Do I have control over the outcomes? And what happens if the buyer doesn't support the business? Luna: One more thing: in the PixVerse deal, the $439 million is a mix of primary and secondary capital. That secondary portion is an early liquidity event for existing investors. Lucas: Right. And that's another way to think about earnouts—they're not just for M&A. In private rounds, contingent value rights are essentially earnouts. So the concept is broader. Luna: I think the key is: don't rely on an earnout to make up for a low base price. If the base is too low, the earnout won't save you. Lucas: That's a perfect way to put it. The earnout is a bridge, not a foundation. Founders should negotiate the best upfront price they can, then use earnouts only to close the remaining gap. Luna: And always, always have a lawyer who specializes in M&A review the earnout language. Lucas: Absolutely. So next time you're at the table and the buyer says 'we're $10 million apart,' an earnout might be the answer. Just make sure it's structured on your terms. Luna: And that you can actually hit those milestones. Lucas: Right. Thanks for listening—we'll be back with another episode soon.