Earn out is a variable part of price paid for a company. Price paid for a company, i.e. for owning the company's equity (usually shares) can be either fixed or variable. The most common and basic part of the fixed amount is cash at closing (of the transaction). When one buys publicly listed shares, a fixed price paid in cash at closing is usually the only possible. On the other hand, in private transaction, a more complicated way of price structure is possible to negotiate. A part of price that is not fixed, but variable, is based on a pre-agreed formula using variables to be known only in the future. This variable part is commonly referred to as an Earn-out. (the selling shareholders who are often the top management team management are "earning-out" part of the price, because they need to work hard to achieve so that the earn-out is paid, hence the term) The most common variable used are future profits, i.e. part of the price paid will be directly determined based on the future profits the company achieves and paid only at that future time.
Example: The buyer pays $10m for 100% of the share capital of the target Company in cash at the closing of the transaction. He also agrees that he will pay an additional $10m over the next 3 years if and only if the Company achieves certain profit targets for the next 3 years.
So it means, if the Company underperforms and fails to achieve the forecast profit targets, the buyer will have paid only $10m. On the other hand, if the Company grows and achieves fully the pre-agreed profit targets, the buyer pays an additional $10m, (for a total of $20m).
It is used to describe the payment to shareholders selling their shares in a company where the payment is contingent on the achievement of certain performance criteria (e.g. company profits) over a specified period after the closing of the sale.
It is often used when small companies in high-growth, high-tech or service industries are sold. The acquirer typically pays 60–80% of the purchase price up front with the remaining 20–40% structured as an earn-out and paid out over time as the acquired company achieves certain levels of sales or profitability.
The purpose of an earn-out is to bridge valuation gaps. For example, if the seller of a business expects a higher price, the buyer can suggest an earn-out (contingent on future earnings) to reduce the risk while committing to a higher price. Risk is reduced because part of the purchase price is contingent upon good performance. While this appears that the buyer is in effect paying more for the business, technically if they pay the full price, they're doing so for a company with greater earnings than at current. Also, the delay of the payment (sometimes as much as five years) reduces the value of the contingent payment due to the effect of time on money. Keeping this in mind, the buyer appears to be paying more for the business, but in real terms it could be much less. Another purpose the earn-out serves is the motivation of the management in place during the earn-out period to achieve good performance. This is especially important in companies that are highly dependent on few key people.
The term is not used by private equity and venture capital investors only, but used also by strategic buyers.
Other financial motivators for top management teams to achieve targets are sweat equity, or management options. Private equity investors religiously use strong financial motivations for the top management teams into which they invested.