When buyers and sellers cannot agree on the selling price or to make sure that the buyer is committed after the sale is completed, a buyer will often suggest that a fraction of the selling price be deferred and be dependent upon the future performance of the company. This is what an earn out is.
Sales of businesses with an earnout are not an uncommon practice. There is little downside for the buyer in such a transaction:
- The immediate payment to the sellers is minimised
- Both the buyer and the seller benefit if the company does well
- The buyer pays less if the acquired company does not meet plan
- The seller is handcuffed to the acquiring company until the earnout has expired
There are disadvantages to the sellers:
- As some of the purchase price is deferred the seller may never be in a position to earn it
- After completion, the seller may not be able to influence conditions to achieve the future earn out
- Earnouts could invoke the wrong behaviour eg. strategic goals may not be aligned with earn out conditions