During the mid-1980s, when Brajdas, a Woodland Hills, Calif., holding company, was negotiating to purchase Cypress Electronics, a distributor of electronic components, a typical quandary emerged: "There was a fairly significant difference between what the would-be acquirer believed Cypress was worth -- based on its track record -- and what the sellers believed it was worth -- based on what they saw as its growth potential," recalls Allan Klein, Brajdas's chief financial officer.

But the deal didn't fall apart. Instead, the owners of Brajdas and Cypress created an earn-out agreement that would reward two of Cypress's three original owners -- on top of the sales price -- if the company performed as well after the sale as they expected.

Generally, earn-outs are structured only in deals in which the original owners will stay with the company and thus can have some impact on future performance. Most earn-out clauses are tied to sales and earnings performance over a three-to-five-year period -- generally the same time frame as any employment contracts negotiated with former management.

Earn-outs can be structured in any number of ways, depending on the priorities of sellers and buyers. But with Brajdas, which was interested in jump-starting Cypress into fast growth, Cypress's payout was pegged to revenue and profit growth over a three-year period, with additional rewards built in if the original owners achieved certain targets, which they did. "We wound up paying an additional $1 million on top of the $4-million purchase price," recalls Klein. "But we're not complaining. The earn-out agreement gave us peace of mind, because we knew we'd wind up paying the money only if the company's performance was good enough to warrant it."

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A few caveats for companies considering adding earn-out clauses to sales agreements:

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Keep financial formulas simple.

"I've seen some arrangements that are so complicated that they wind up backfiring because no one can figure out exactly what they're supposed to accomplish and how it will affect their payout," warns Robert Untracht, a partner at the Century City, Calif., office of Ernst & Young. Include in the design stages of the earn-out accountants, lawyers, and all executives involved.

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Avoid long-term-growth disincentives.

"You've got to make certain the earn-out and its resulting pressure for short-term results don't discourage former owners from doing things like spending money on research and development, diversifying, or investing corporate funds in other ways that will produce results only over the long term," warns Klein. Brajdas skirted that risk by guaranteeing Cypress's former owners that "new acquisitions or other long-term investments would be considered as separate from the earn-out agreement -- so that they wouldn't reduce the risk of future payouts." You might also consider using an outside board or financial consultant to evaluate all management decisions to make certain that long-term goals remain important.

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Weigh the costs versus the rewards.

"Earn-outs may produce exactly the wrong kind of results for you, depending on the type of company you're purchasing and your own financial goals," warns Untracht. "If it's a fast-growing business, an acquiring company may want or need to plow all the cash back into growth -- and may not actually care about short-term performance." In such cases, it makes better sense simply to negotiate a purchase price that satisfies all parties. -- Jill Andresky Fraser

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