In a company sale and purchase agreement, the earn-out is a portion of the purchase price that is subject to the achievement of certain (usually financial) milestones that will be verified after the closing of the sale and purchase.
One of the main reasons earn-outs are used in M&A transactions is to bridge the valuation gap between the buyer and the seller, allowing the seller to obtain the full value it believes the company can generate in the medium term and the buyer to secure a reasonable valuation that avoids overpricing.
This valuation “gap” can arise for various reasons: companies with a poor financial track record but high growth potential; companies with circumstantial revenue shortfalls; companies that are developing a technology that could exponentially increase future revenues…
It is therefore a contingent price (which may or may not accrue), subject to one or more conditions precedent (e.g. reaching a certain EBITDA level in the following year). If the conditions are met, it is paid; if they are not met, it is not paid. In addition, as the earn-out is linked to the achievement of future targets, the achievement of which would no longer be in the hands of the sellers, it is common in transactions where the sellers/managers continue to run the company, in order to reduce monitoring costs.