Earn-out is that part of purchase price that buyers agree to pay to sellers in future based on future performance of the business. It can be linked to profitability or turnover or other parameters depending on the nature of the business.
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Earn-outs as a mechanism to bridge valuation gap
Earn-outs are often used in acquisitions when there is a substantial gap between valuation of buyer and seller. The gap can be bridged by structuring a payment at completion followed by one or more payments over a period of time based on the future performance of the business. Earn-outs would give a seller an opportunity to realise the future potentials of the business and synergy and expertise that a buyer will be bringing in. From buyers perspective that part of consideration is dependent on the future success of the business so a part of financial risk relating to the acquisition is covered in the event that the business fails to perform following the acquisition.
Earn-outs to ensure sellers future involvement
These future payments are often used when the seller’s continuous involvement in the business is important for the development of the business. In such circumstances as seller you do want to ensure that you are not prevented from being continuously involved in the business. As buyer you would want to ensure that the seller performs his duty and positively contributes to the future development of business and, if not, you have the ability to take action.
Risks and possible mitigation
Either as a seller or a buyer you need to be careful of the pitfalls this arrangement carries. As a buyer you would want to ensure that any earn-outs are determined by a measurable performance in the ordinary course of the business and at the same tim