Adapted from “What Divides You May Unite You,” by James K. Sebenius (professor, Harvard Business School), first published in the Negotiation newsletter.
Mark Twain once quipped that “it is differences of opinion that make horse races.” Along these lines, differences in beliefs about how future events will unfold—what a key price will be, whether a technology will work, whether a permit will be granted or a lawsuit won, and so on—can be the basis of mutually beneficial contingent agreements.
When an entrepreneur seeks to sell her company to a much larger corporation, there is often a gap between the (lower) price the buyer will maximally pay and the (higher) price the seller will minimally accept. The entrepreneur may envision a bright future for her company yet lack the capital and organizational scale required to reach these goals. Meanwhile, the prospective buyer typically will maintain a positive but more skeptical view. The two sides may be able to bridge this value gap by structuring an earnout—a contingent agreement in which the buyer pays a fixed amount up front, with subsequent amounts paid depending upon the firm’s future performance under new ownership and the entrepreneur’s continued management.
Given their differing forecasts, both sides are happy to do the deal, while accepting the possibility of being wrong. Without the earnout, an otherwise mutually beneficial deal could languish.
Contingent deals can create incentives for particular behavior—good and bad—and enable parties to forge agreements based on differences in their beliefs. For example, if the entrepreneur will receive large payments based on the firm’s profits over the next three years, she has a strong incentive to maximize returns. Yet the contingent agreement may create perverse incentives that should be anticipated when the deal is structured. For example, if the performance measure is after-tax profit over the first three years post-sale, the entrepreneur may have an incentive to neglect capital investments that would pay off only after three years.
Despite the difficulties, sizable earnouts are quite common. Other contingent deals driven by underlying forecast differences include performance-based clauses in sports or executive contracts and milestone-based payments in biotech strategic alliances.