The upside of taking the deal, even a bad one
The real economics behind an exit and the trade-offs between holding onto the business compared to selling the company. From earnouts to tax, to compounding interest, it's all on the table.
What do you define a successful exit? Or better yet, how do you define an 'exit' by itself? The importance of this article will probably apply to first-time founders and the young guns of tomorrow more so than the vets, so if you've been through the process before, this'll probably sound a little familiar.
In the real-world, not the 'LinkedIn World' where everyone's made out to be Gordon Gekko, the process of an exit has a lot of variables to consider (for both sides), though broadly it's a fairly similar process across the board. In its simplest form, an exit either happens for good reasons or bad reasons. Good being you've likely built a good company, and someone's willing to give you money for it. Bad being you've either had to leave, been asked to leave, or the company's going through a hard time and in that case there's lots of things that could happen. For the purpose of this article, we'll talk a bit about the 'good' reason, and the most common exit scenario for founders who've built a 'good' business.
A realistic offering scenario
Take Company X for example, as a placeholder for context. Company X is a service business in a particular industry that does approximately $2M in revenue, and has an EBITDA of $500K (25%), with a track record of 3 years of decent profitability. Broadly we'll consider Company X a good business.
As a founder of Company X, investors who are interested in buying your company will value your business on a multiple of EBITDA (revenue multiples are rare but possible). Realistic expectations at this size are probably 3-5x depending on how generous Mr Investor's feeling or their model. So you're looking at say $2M to pick a middle ground. Only once a business exceeds $1M in profit (or EBITDA) do multiples start to climb north of 7-8x.
Now once you have an offer to have your company sold, this is where things get a little more complicated and also, where you start to weigh your options.
What's being left on the table?
Almost all offers will come with conditions, and these conditions are all part of what's called an 'earn-out' which as you can tell quite literally means what you're going to 'earn' on your way 'out' the door. Unless the offer is 100% cash, and they want you off-boarded as part of the offer, which is very rare, you as a founder will be asked to stick around for a while and lead the charge, meaning you're going to have to leave something on the table. Investors don't always like risk unless they're gamblers, and if you're not looking to trade a company inside a couple years, they're normally risk-averse. So their conditions may look something like this:
'The founder is required to stick around and run the company for 3-years after the deal closes. The founder is eligible for 60% of the buy-out value upon closing, with 20% being conditional on the end of Y1 Performance, and another 20% conditional on the end of Y2 performance. Year 3 is just another salaried year.' To de-risk their investment in you, you'll likely have to cooperate.
BUT, what if you're paying yourself dividends? A lot of businesses (especially in the service sector) have the freedom of being cash flow positive and keeping their fixed costs fairly low (typically staff being the big one). Keeping 1-2 months payroll on the books is fairly standard. Now say the founder's the sole operator drawing dividends of $400K p/year. They're keeping the lights on. This is going to have to be deducted from the valuation, because to an investor they're otherwise getting Profit minus Dividends to founders. If you kept yourself paid at $400K, you're looking at an actual adjusted EBITDA of $100K, changing your valuation greatly.
So what do you do with your salary?
This is almost a game of chicken, because you could say to the investor, if they're still interested in the business 'I'd like to keep my salary of $400K' and take the lower multiple, or drop your salary considerably, to add more money onto the multiple. If you drop too far they'll think you're unmotivated to keep running the brand, the same way if you're after too much in salary they're getting less value from the business and may not want to move forward. So oftentimes, there's a phase in which you negotiate and meet somewhere in the middle, for example: $150K in salary for 3 years, and an adjusted EBITDA of ($500K − $150K salary) = $350K. So where do you stand now?
Year 1: $2M initial offer minus salary adjustment ($350K × 4x = $1.4M revised valuation). Minus 40% for earnout, you're now looking at $840K upfront. Plus the $150K salary, your total compensation for Y1 would be $990K, with $560K on the table.
This is where things start to get interesting. Your tax structure is one of the largest components of the deal. Oftentimes, if a company's under your control, you can structure your dividends to be paid into a separate LLC, or a company where you can defer expenses and make 401K contributions. What if your VC wants to make you an employee (e.g a W2 in the US) post-exit? Suddenly your tax exposure could change. What about healthcare? There's a lot of components that come into play, and leaving 40% on the table is a good chunk of change.
What's your alternative to selling?
What if you considered not selling the company? At best, your scenario improves from $990K in Y1 (pre-tax), to $1.85M across 3-years, if both salary and earn-out compensation hits. That's 4.6x your prior annual salary, so you'd have to retain the business and operate under the same compensation structure for that long in order for yourself to benefit equally. If the business struggles post exit, and you only get your $990K + 2 more years salary that's $1.29M compensation over 3 years, $90K greater than if you'd held the business for 3 years and it performed equally the same and you kept your salary the same.
But here's the way I look at an exit and the way I'll always look at an exit ever since we sold our company. The value of the money in an exit is not the value today, it's value when you actually need the money.
If your dividends were $400K prior, and you only need $150K to fund your lifestyle, everything above that is being saved and invested after-tax. Roughly $132K goes to tax (33%), you spend $150K, and invest $118K. That's $118K being invested every year, spread monthly. At a 10% annual return over 6 years, that compounds to roughly $945K. That's your no-exit baseline.
The value in compounding interest is where it works
This is where the exit opportunities actually get very attractive. Let's say under the same circumstances your lifestyle costs $150K. Let's also assume in the worst case you do not achieve your earn-outs and after 2 years your ass is on the street. Y1 you have a total compensation of $990K. Minus 33% tax, gets you to roughly $660K. Deduct your $150K, and your Y1 savings to invest are $510K, deposited as a lump sum at deal close. Now remember, Y2 and Y3 you're actually breaking even with a $150K salary and no additional savings. In fact after tax your salary is actually taking a hit of approx -$50K p/year.
So what does your total look like after 6 years at 10% invested? Year 1 you deposit $510K at close. Years 2 and 3 you're running a -$50K shortfall against your lifestyle, so we'll draw that down from the invested pot. From Year 4 onwards, let's assume you're back in market at something close to your pre-exit earnings, which means you're depositing $118K back into the pot annually, spread monthly.
By the end of Year 1 your pot sits at roughly $561K (the $510K deposited at close, compounded through the year at 10%). After Year 2 you're at $568K. End of Year 3, $570K. From Year 4 your back-to-market contributions start showing up, pushing you to $750K by the end of Year 4, $948K by the end of Year 5, and roughly $1.16M by the end of Year 6.
So the worst-case exit, where neither earnout triggers, has you sitting at roughly $1.16M after 6 years. The no-exit scenario, where you keep your $400K and stay running the business, lands you at $945K over the same period. The exit, even in its worst case, comes out roughly $215K ahead.
Best case is the version where both earnouts trigger. Year 1 still gives you the same $510K invested upfront. But Years 2 and 3 are different now, because on top of the $150K salary, you also receive a $280K earnout payment in each year (20% of the $1.4M valuation). That's $430K of gross compensation per year, which after 33% tax leaves you with roughly $288K. Take $150K out for lifestyle and you're investing $138K each year in Years 2 and 3 on top of the original $510K. From Year 4 onwards, you're back in market and depositing $118K a year like before.
Run that forward at 10% compounded over the same six years and your pot ends Year 6 at roughly $1.7M. Compared to the no-exit baseline of $945K, that's still almost double the money. Same six years, same lifestyle, same investment return assumption. The only thing that changed is the timing of when the cash hit your account, and what version of you was free to invest it.
The point isn't the absolute dollar figure. It's the front-loading. The exit takes future earnings and crystallises them into today's money, which then has six years to do the compounding work for you. That head start is the part most founders underestimate when they look at an offer and think, 'the multiple isn't high enough.'
And there's a second layer to this most founders don't fully internalise. Once you've signed, the operational risk isn't yours anymore. The market shifts, the category compresses, a bigger player parachutes in, your top hire walks, a recession lands. None of that lives on your balance sheet now. You've sold the upside of a few good years, but you've also sold the downside of every bad one. For a lot of founders, that swap is the actual win.
So my lesson? Take the deal (probably).
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A few important caveats worth flagging on this model:
* The 10% return assumption is roughly the long-run S&P 500 nominal return. Real-world returns vary year-to-year, fees and taxes erode it, and personal portfolios rarely match the index.
* The "back to market at $400K in Year 4" assumption is the single biggest swing factor in this model. If you take a year off, the gap closes. If you never get back to that number, the no-exit scenario can beat the worst-case exit. Be honest with yourself about what your post-exit earning power actually looks like.
* The buyout proceeds and your salary are likely taxed differently in reality. Long-term capital gains on the equity portion of the buyout is typically lower than the 33% ordinary income rate used here, which means your real after-tax position from the exit is probably better than the model shows. The 33% blended rate is conservative.
* The model assumes a US tax structure at a blended 33%. State taxes vary widely (CA, NY add over 10%, FL and TX add zero). Adjust accordingly.
* Inflation isn't modelled. All figures are nominal. $150K of lifestyle today buys closer to $124K of stuff in six years at 3.5% annual inflation.
* Healthcare costs shift post-exit. Losing the ability to expense health insurance through the company can add $15-30K/year in unrecoverable expense. Sits on top of the $150K lifestyle, not inside it.