An earnout is a technique used to help close the valuation gap that often arises between buyers and sellers by making a portion of the purchase price contingent upon achieving specified objectives.

For the most part, earnouts are used in smaller transactions involving private entities and, to a much lesser extent, larger and/or publicly traded companies. Today, close to 40 percent of all deals involve earnouts which can make up as little as 20% of the total consideration, or could potentially double the size of deal.

From the buyer’s perspective, the upside of earnouts is that it helps reduce the financial risk by protecting buyers from overpaying while providing incentives that focus management on achieving specific goals, like meeting revenue and profit projections originally prepared by the seller. The downside is that it reduces the buyer’s ability to completely integrate or restructure the business; they also create divided loyalties and conflicting objectives — the strategic direction of the business versus the earnout prejudice of the acquired entity.

Sellers beware. While the upside is more cash, you need to take into consideration the implications of the loss of control over the operating budget and staffing plans. These often put you at risk for achieving the stated objectives and the likelihood of a reduced payout. Furthermore, changes are inevitable as buyers tend to subordinate most of the seller’s decision making authority, as strategic direction and corporate policies, like compliance with Sarbanes Oxley and financial controls, take precedence.

There is also the ugly side of earnouts when disputes and the threatened litigation arise over contingency payments. Changes to the post-acquisition plan and direction of the acquired entity, as well as revenue recognition policies that diminish the payout or artificially depress revenues during the earnout period are often at the center of these disputes. And, more than money is lost in the case of an earnout disagreement as business suffers, often the result of poor employee morale and turnover. In the end, neither party wins.

However, handled with care, earnouts can be a good practice when both parties are keenly aware of the risks and downsides to the earnout aspect of deal making.

A version of this article originally appeared in Soft•letter and Software Success.