When acquirers and the shareholders of a company come to an impasse on valuation based upon assumptions about future performance, the pricing gap is sometimes bridged through an earn-out. In an earn-out, the buyer agrees to pay the current shareholders additional compensation as pre-determined future operating metrics are achieved.

For example, if shareholders expect sales to increase next year and the acquirer doesn’t, the acquirer might agree to pay more for the company in the future if sales do in fact increase. Doing so enables the acquirer to protect itself from paying too much for the target in the event that sales don’t increase – the seller takes on the performance risk.

While structures vary greatly, in the plain vanilla version the target is purchased for a base price with the possibility of an additional earn-out. Earn-outs need to be well defined to ensure that both parties know when the payouts are triggered.

Sellers typically try to avoid earn-outs because it requires them to assume the performance risk. However, earn-outs are not uncommon as they are a useful mechanism for allocating risk.