Latest / The Startup Exit Podcast with Fexingo: IPOs, Acquisitions, and Founder Liquidity Events / How Founders Use Structured Earnouts to Close Valuation Gaps
Transcript
- Lucas: So it's July 2026, and we're seeing this fascinating headline: an OpenAI researcher, Miles Wang, is in talks to launch an AI drug discovery startup valued at two billion dollars. But here's the thing — that valuation almost certainly isn't all cash upfront. There's going to be a big earnout component. Luna: Right, because no buyer is going to write a two-billion-dollar check for a pre-revenue biotech AI play without some performance strings attached. Lucas: Exactly. And that's what we're talking about today — structured earnouts. How founders use them to close valuation gaps when the buyer and seller see different futures for the business. Luna: Before we dive deep — Lucas, I've got to say, if conversations like this are useful for what you're building or running, it's worth mentioning that listener support is what keeps this show ad-free. If today's episode was worth a coffee to you, you know the link — buy me a coffee dot com slash fexingo. Lucas: Yeah, it's a small thing that makes a big difference for us. And honestly, it keeps us independent, which is how we want to stay. Luna: Totally. So back to earnouts — what does a typical structure look like? Lucas: Standard earnout works like this: the buyer pays a base price at closing, say one point five billion in Wang's case. The remaining five hundred million is tied to hitting milestones — revenue targets, FDA approvals, user growth, whatever. Luna: So the founder gets paid only if the business performs. That aligns incentives, but it also shifts risk back to the seller. Lucas: Exactly. And the devil is in the details. How are the milestones defined? Over what time period? What happens if the buyer changes strategy? I've seen earnouts blow up because the acquiring company reassigned the team or cut the budget. Luna: So how do founders protect themselves? I know some negotiate for 'sole discretion' or 'best efforts' language, but that's vague. Lucas: The best practice is to tie earnouts to objective, verifiable metrics that the founder still has control over. For a drug discovery startup, that might be the number of targets validated or patents filed, not revenue — because revenue takes years. Luna: And what about the time horizon? I've seen earnouts that stretch three to five years. That's a long time to stay motivated. Lucas: It is. But the trade-off is a higher total payout. And some founders structure it with accelerating cliffs — if you hit the first milestone early, the remaining milestones pay out faster. Luna: So it's like a earnout with a bonus for speed. That's clever. Lucas: Right. And we're seeing this more in 2026 because the IPO market has been choppy. M&A is becoming the primary exit route, and earnouts are the bridge when valuations are uncertain. Luna: Speaking of choppy markets, look at the big tech names this week: Meta up nearly ten percent in five days, while Apple and Microsoft are flat. That volatility makes buyers cautious. Lucas: Exactly. When the public markets are swinging, private valuations become harder to anchor. Earnouts let both parties bet on the future without betting the whole farm on day one. Luna: So what's the biggest mistake founders make when negotiating an earnout? Lucas: Not thinking about what happens if the buyer gets acquired themselves. A change of control can kill an earnout unless there's a clause that accelerates it. Luna: Right, the 'double trigger' — if the acquirer is bought, the earnout pays out immediately. Lucas: Exactly. And another mistake is agreeing to earnouts that are tied to metrics the founder can't influence after the deal — like stock price or overall company revenue. Luna: That's a common one. The founder's team gets absorbed, they lose control, and the earnout becomes a lottery ticket. Lucas: Yeah. So the best earnouts are tightly scoped, short duration, and based on metrics the founder can still drive. And they should include dispute resolution mechanisms — arbitration or a neutral third party. Luna: What about the tax implications? Earnout payments are usually treated as part of the purchase price, so they're capital gains, not ordinary income — but only if structured correctly. Lucas: That's a huge point. If the earnout is classified as 'compensation for services,' it's ordinary income. Founders need to work with tax advisors to make sure it's structured as an installment sale or contingent payment. Luna: So it's not just a negotiation lever — it's a tax strategy too. Lucas: Absolutely. And we've talked about contingent value rights in past episodes, which are similar but tradeable. Earnouts are typically non-transferable and tied to the founder staying on. Luna: Right, CVRs can be sold to investors, while earnouts are personal. That's a key difference. Lucas: So for a founder like Miles Wang looking at that two billion figure, the earnout structure will determine how much he actually walks away with. If the milestones are realistic and well-defined, it's a great tool. If not, it could be a trap. Luna: And given the AI hype cycle, there's pressure to over-promise. Founders need to be realistic. Lucas: Exactly. The market is watching. In 2026, earnouts are becoming standard in tech M&A — but only the well-structured ones actually pay out. Luna: So if you're a founder heading into a deal, what's your one piece of advice? Lucas: Hire a lawyer who has done earnout deals before. And model out the scenarios — what happens if you hit 80 percent of the target? 120 percent? Make sure the earnout isn't binary. Luna: Great advice. And I'd add: talk to other founders who've been through it. There's nothing like real-world experience. Lucas: Yeah. Earnouts are a tool, not a solution. Used right, they can make a deal happen. Used wrong, they can leave founders bitter. Luna: Alright, that's a wrap on earnouts. Next time, we'll look at another way founders bridge gaps — maybe earnout alternatives. Lucas: Sounds good. Until then, keep building.