Whenever a business is bought or sold, there's always a negotiation involved in setting the final price. Typically, the seller tries to maximize the price of the business based on their amazing forecast results while the buyer wants to pay as little as possible to help minimize the risk that the business can't deliver on its promise.
The usual result is that there is some gap in the middle that stands in the way of completing the deal.
One common way that buyers and sellers attempt to bridge this gap is by using what is called an "earn out." This structure work where the buyer pays the seller a big chunk of the money up front, maybe 50% of the price, with the rest paid out over a multi-year period, depending on how well the company meets its forecasts. If the company makes it forecasts, the seller receives the full amount of the selling price. If the company struggles, the seller gets less.
While this sounds like a fairly reasonable and self-correcting agreement on paper, the truth is that it's a bad deal for both sides involved.
As a seller, the downside is that as soon as you sell your company, you're giving up your controlling interest in it - which means you don't get to call the shots anymore. You don't get to control your own destiny, or your pocketbook, anymore. But since your full earn out depends on your business performing to your standards, you might find this arrangement very limiting and annoying. You might even worry that the buyer might try to play some games in a way that helps them limit how much they pay you.
It can also be a bad deal for the seller because it means you have to hang around for a few years instead of hitting the beach and enjoy fruity drinks with umbrellas.
As the buyer, an earn out also can work against you because you might find that the seller will resist any changes you want to make to the business. Many deals are justified on the synergies of the combined companies, be it cost or revenue. If a prior owner is there protecting their earn-out, changes can get really difficult.
That can also become a massive barrier in the cultural integration of the new company into the buyer's company because the seller might create an "us-versus-them" dynamic inside the business as they resist making any changes while the seller is still there.
Unfortunately, this happens all the time.
For example, in one company I worked for, we acquired a Silicon Valley-based tech company where we paid the owner, a prickly engineer type, a lot of money. But he also had a lot more to gain through his earn out. But as soon as we wanted to make changes inside the business-;like integrating the sales force and consolidating the benefits and accounting departments- he resisted and objected. All of a sudden, the different synergies we saw in our two companies- and our ability to drive costs down as well as grown revenues because of them- were threatened. And unless we did something radical, we were going to be stuck with that situation for the next three years.
In the end, we paid the seller the full amount of his earn out after just the first year because we needed to get him out of the way. This happens more often than anyone would like to admit.
That's why when it comes to using earn outs, the best advice is not to use them. Just find a way to pay the full value for the business instead. In the end, everyone will be happier and more productive as a result.