#221: Earnouts, Ratchets and Consent Rights: The Exit Terms Founders Miss - Jesse Welch

Greg Head introduces Jesse Welch, a MidCap Global partner who advises companies across industries on acquisitions, capital raises, minority investments, and exits. Welch began in film production and raised money for Sino-U.S. co-productions in mainland China, then worked with AI startups before moving into finance in 2019. He later co-founded a real-estate private equity firm and helped launch a cryptocurrency hedge fund that was sold in 2021 after a nine-month, “balls to the wall” run. MidCap Global now focuses on companies with roughly $1 million to $50 million of EBITDA. Welch also publishes Capital Love Letters about M&A traps.

Welch’s central warning is that the announced purchase price is rarely what founders actually take home. The terms determine who gets paid, how much, and when, but founders are usually experts at operating products and companies rather than structuring finance transactions. A founder may negotiate once in a lifetime against a buyer supported by lawyers and deal professionals who do these transactions repeatedly. Greg describes a founder offered more than $100 million who discovered that preferences, ratcheting dividends, and participating preferred terms could leave him with little control or ownership despite the attractive headline. Welch recommends treating the terms, not the headline, as the real deal.

Welch says about 25% of lower-middle-market deals in SRS’s data include an earnout. The usual pitch is that a seller wanting $200 million and a buyer offering $190 million can bridge the $10 million gap by having the founder work for two years and receive $5 million per year if profit targets are met. Welch calls this betting on the same horse with a different jockey: the buyer can cut marketing, add monitoring fees, or allocate overhead until a $10 million target becomes $9.9 million. The founder may receive no partial credit after two years of work; SRS data says just under half pay zero, while earnouts overall pay about 21 cents per dollar.

Welch has a more favorable view of rollover equity, in which a founder sells, for example, 70% of the company and retains 30% in the new entity. If the buyer grows the company or uses it as a platform for acquisitions, the retained stake can produce a second successful liquidity event; Greg cites founders who benefited when a company grew from $20 million to $60 million before a recapitalization. Welch warns that buyers always present a company as the platform rather than a bolt-on. Founders must examine vesting, what happens if the company is sold or folded into another entity, asset-sale treatment, dilution, and whether they could be stranded in a worthless shell.

Welch explains that an escrow or holdback is usually easier to understand than an earnout: a buyer may agree to pay $100 million but hold $5 million for a year. If a pre-sale problem later costs the buyer $2 million, the buyer can use the escrow and release only the remaining $3 million. The holdback effectively sets a timer for a suspected liability; if the buyer expects an issue to emerge in two years, it may seek a two-year holdback. Welch says holdbacks can also protect a buyer if the seller leaves and the buyer discovers that the founder had been holding the business together. Founders should identify exactly which risks the escrow covers and for how long.

Consent rights give an investor veto power over specified company decisions. Welch says approving new debt is a normal protection, but rights can extend to changing vendors, increasing executive salaries, paying bonuses, or selling the company. A minority investor may therefore control the business without controlling the board. Welch advises founders to assume clauses can be weaponized; based on his experience, he estimates that happens 40% to 50% of the time. He compares consent rights to asking “daddy” for permission: they may be reasonable guardrails when interests remain aligned, but combined with other provisions they can gradually transfer control.

Welch says institutional investors generally receive preferred equity rather than common stock. A 1x liquidation preference is common: an investor who put in $30 million receives that $30 million before common holders in a sale, while higher multiples provide more protection. Payment-in-kind, or PIK, interest lets an investor receive part of an 8% return in additional equity rather than cash; over several years, that extra preferred equity can itself receive the agreed liquidation multiple. Participating preferred lets an investor take its preference and then share in the remaining proceeds as common. Welch says investors choose whichever option pays them more, potentially leaving less for founders, employees, and friends.

Welch describes ratchets as protections against dilution or downside, especially in a down round. A weighted-average ratchet is more founder-friendly, while performance ratchets can attach ownership increases to a metric the investor selects. He recounts a 1999 case involving Warburg Pincus, where a founder rolling up technology companies lost 2% for every quarter in which he failed to hit an accounts-receivable target for four consecutive quarters. The business was growing, but the ratchet forced management to prioritize an unusual metric; after enough quarters, the investor gained control, the board removed the founder, and he worked for ten years yet received zero. His later company sold for $151 million.

Welch says annual prepaid contracts can create a negotiation after signing an LOI. If a customer pays $120,000 up front and the company is sold halfway through the service year, a buyer may demand that $60,000 remain in the business to fund the remaining service. A software seller should negotiate from the actual cost of delivery instead: with 80% margins, the required reserve may be closer to 20% of the unfulfilled contract, or roughly $6,000 to $12,000 in this example. Welch also recommends that larger sellers obtain their own quality-of-earnings report, typically costing about $50,000, so they know which revenue and EBITDA issues a buyer will challenge.

Welch recommends a three-person transaction team: a CPA to test financials and taxes, a lawyer to make the deal legal, and an M&A advisor or investment banker to structure and negotiate it strategically. He says lawyers are not necessarily responsible for creating the best sale. Buyout private equity often relies heavily on debt and financial engineering, while growth investors may provide meaningful help only when it increases their returns, such as distributing software across portfolio companies. Family offices can offer patient capital or become buyers, but their long-term, changing personnel relationships can be more intimate and complex. Welch’s broader advice is to stay patient, remain flexible, and assume every clause will be used against you.