At its most fundamental, there is an inherent conflict between the buyer and seller in an earn out. A seller will want to maximise the earn out (possibly without regard to the longer-term success of the business) whereas a buyer will want to minimise its cost for the target (whilst still having a successful business).
As such, earn outs could create an incentive for either party to engage in unethical behaviour. For example, each party may be motivated to manipulate financial statements in order to ensure that the performance milestones are met or missed (as appropriate). Even in less ‘sharp’ situations there’s commonly tensions such as whether revenue is exceptional or repeating and should or should not count towards, for example, EBITDA triggers.
Earn outs can also be difficult to manage and track. The buyer and the seller must agree on specific financial or performance milestones, and they must have a mechanism in place to measure and track these milestones. This can be difficult, especially if the target has complex operations or multiple business units.
As is common in many PE bolt-on acquisitions, a buyer may also want to integrate the target business into its wider group to realise synergies and to drive efficiencies, which can make it hard to track individual performance of the target. Very commonly those benefitting from earn outs have a vested interest in maintaining the separate economic identity of the target business and can resist and slow down the required synergies.
If the terms of the earn out are unclear, it can be challenging to determine whether the performance milestones have been met in a fair and objective manner.
The buyer and the sellers will have directly competing interests – to either minimise or maximise the earn out. Obviously, there are other considerations and factors at play, but it is no surprise that earn outs often result in heavily litigated arguments which can push fragile relationships over the edge.