Latest / The Startup Exit Podcast with Fexingo: IPOs, Acquisitions, and Founder Liquidity Events / How Founders Use Earnouts to Bridge Valuation Gaps in Exits
Transcript
- Lucas: If you're a founder sitting across from an acquirer and the number they offer is 80 cents on the dollar of what you think the company is worth, you have two choices: walk away, or get creative with the structure. That's where earnouts come in. Luna: And they're becoming more common. We saw a data point earlier this week — earnout deals are up about 30 percent year-over-year in 2026. Lucas: Yeah. And it's not just small companies. A mid-cap private AI firm was acquired for two point three billion dollars last month. Roughly 40 percent of the total consideration was structured as an earnout tied to hitting revenue milestones over the next three years. Luna: So the founders get, say, one point four billion at close, and the remaining nine hundred million only pays out if they hit certain numbers. Lucas: Exactly. And that creates this interesting tension. On one hand, the earnout can bridge the valuation gap — the acquirer gets protection against overpaying, and the founder gets a shot at the higher number. On the other hand, the founder is now effectively working for that earnout, which might not be under their control if they get absorbed into a larger organization. Luna: Right. So the classic risk is that the acquirer doesn't invest in the product post-close, or redirects sales efforts, and the target is missed. Then the founder gets nothing. Lucas: That's called 'sandbagging' in deal circles. It's why earnout protection clauses exist. A well-negotiated earnout will include things like 'best efforts' language or a requirement that the acquirer provide certain resources. Some founders even negotiate for a guaranteed minimum payout. Luna: I've also seen earnouts tied not just to revenue but to user growth or product milestones. It depends on what the acquirer values most. Lucas: Yeah. The key is that the metric can be objectively measured and audited. You don't want it to be subjective, like 'strategic value' or 'synergy realization'. Luna: So what's the current typical earnout duration? I've seen two to three years mostly. Lucas: Three years is pretty standard. Sometimes it's a single cliff at the end, but more often it's a series of annual or quarterly targets. That way the payout is spread out, and the founder has ongoing incentive. Luna: But it also means the founder is locked in. They can't just sell their shares and leave. Lucas: Exactly. So it's a retention tool as much as a valuation bridge. The acquirer wants the key people to stay and execute. The founder wants the full price. The earnout aligns those interests — in theory. Luna: In practice, it often creates friction. I know a founder who missed his earnout because the acquirer changed the sales compensation plan six months in. His team lost momentum, and the target was missed. Lucas: That's exactly the kind of thing you want to guard against in the agreement. You can negotiate for the earnout to be based on the business unit's standalone financials, not the merged entity's overall numbers. Also, if the acquirer makes changes that materially affect performance, the earnout should be adjusted. Luna: So it's really about control. How much control does the founder retain over the factors that drive the earnout? Lucas: Right. And that's where the negotiation gets nuanced. A savvy founder will ask for a separate P&L for their unit, and maybe even a seat on the integration committee. Luna: Let's talk about the tax implications. Earnout payments are typically treated as contingent consideration, which means they might be taxed as ordinary income if they're structured as compensation, or as capital gains if they're part of the purchase price. Lucas: That's a huge point. If the earnout is structured as compensation for services — like staying with the company — it's ordinary income. But if it's additional purchase price for the shares, it's capital gains. The difference can be tens of millions. Luna: And the IRS looks closely at how it's labelled. So founders need good tax advisors early in the process. Lucas: Absolutely. You can't fix the structure after the fact. One thing I've seen work is to split the earnout: part as a guaranteed minimum that's treated as purchase price, and part as a bonus for hitting stretch goals. Luna: That's a creative approach. It gives the founder some certainty while still offering upside. Lucas: And it signals to the acquirer that you're serious about the business's potential. You're putting your money where your mouth is. Luna: Now, there's also the question of earnout financing. Some acquirers set aside funds in escrow to cover potential earnout payments. That protects the founder if the acquirer runs into financial trouble. Lucas: Yeah, that's a good point. Earnout escrows are becoming standard in larger deals. The acquirer puts, say, 20 percent of the earnout amount into an interest-bearing account, and it releases as milestones are hit. Luna: Let's shift to a specific example. You mentioned that AI deal earlier. Do you know how the earnout was structured? Lucas: From what I've read, it's a three-year earnout with annual revenue targets. Year one is sixty million, year two eighty, year three one hundred million. If they hit all three, the full nine hundred million pays out. If they miss one, they get a proportional reduction. Luna: That's a lot of pressure. Especially in AI where revenue can be lumpy. Lucas: It is. But the founders were confident. They had a pipeline of enterprise deals already signed. The risk was more about integration than demand. Luna: And if they hit the targets, they end up with a total of two point three billion, which is probably above what any other buyer was offering. Lucas: Exactly. That's the trade-off. You take a lower upfront payment but potentially much higher total value. Luna: It's a bet on yourself. And in a market where valuations are compressed — we saw the S&P 500 down a bit last week, tech stocks mixed — earnouts are a way to get a deal done despite uncertainty. Lucas: Right. When public markets are choppy, acquirers are more risk-averse. They don't want to overpay upfront. Earnouts let them share the risk. Luna: And founders who are confident in their growth can actually come out ahead. Lucas: That's the upside. But it requires discipline in negotiation. You need to know what you're willing to accept, and what protections you need. Luna: This is exactly the kind of practical insight that makes this show useful for founders and operators. If today's episode helped you think about your own exit strategy, the best way to keep these conversations going is listener support. Lucas: Yeah, it's what keeps the show ad-free. If you found value here, you can toss a coffee our way at buy me a coffee dot com slash fexingo. Luna: Every bit helps us keep bringing you detailed breakdowns like this one. Lucas: Alright, back to earnouts. One more thing I want to touch on: the earnout as a signaling mechanism. When you agree to a large earnout, you're telling the acquirer, 'I believe in this so much that I'll tie my payout to performance.' That can actually increase trust. Luna: It's a powerful signal. But it only works if the earnout is well-designed. A poorly structured earnout can backfire. Lucas: For sure. The worst case is when a founder leaves before the earnout period ends, forfeiting the remaining payments. That's why many earnouts include clawback provisions or forfeiture clauses tied to employment. Luna: So the founder is essentially a key employee for the earnout duration. That can be a hard pill to swallow for someone used to being CEO. Lucas: It is. But it's also an opportunity to learn from the acquirer's resources and build something bigger. Some founders actually enjoy the integration phase. Luna: Fair point. It's situational. But the key is to go in with eyes open. Lucas: Right. And to negotiate the contract as if the acquirer will act in their own self-interest — because they will. Luna: So final thought: if you're a founder heading into M&A talks, get an experienced M&A attorney and a tax advisor before you sign anything. And think hard about whether an earnout is right for you. Lucas: And if you can, talk to other founders who've been through it. Their war stories are worth more than any template.