A phrase used by venture capital investors (and private equity firms) to describe a formula in which the management of a company earns a share of the company's capital by achieving results at or above pre-determined levels. It is used to describe the payment to shareholders who sell their shares in a company, however the payment is contingent on the achievement of certain performance criteria (for example company profits) over a specified period, usually following the closing of the sale.
It is normally used when small companies in high-growth, high-tech, or service industries are sold. For example, the acquiring company pays 60-80% of the purchase price up front with the remaining 20-40% structured as an "earn out" and therefore "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, so that if the seller of a business expects a higher price, the buyer can suggest an earn out (contingent on future earnings) to reduce risk while committing to a higher price. Risk is reduced because part of the purchase price is contingent upon good performance.
While it 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 the current value. 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 actuality, they often end up paying much less, and so an earn out is considered more beneficial for the acquiring company than it is for the start-up.