Why should a seller be cautious about an earn-out based on future operating profit?

A seller should be cautious about an earn-out based on future operating profit primarily because operating profits can be manipulated through accounting policies. In the realm of financial reporting, companies have discretion in how they recognize revenues and expenses, which can significantly affect reported operating profits. This often involves choices about depreciation methods, inventory valuation, and revenue recognition timing.

If future operating profits determine the earn-out payment, a seller may face challenges if the buyer's financial reporting practices lead to lower reported profits than the actual economic performance of the business. If the seller is reliant on those operating profits for earn-out payments, this risk of manipulation poses a significant threat, as it might result in receiving less than what's anticipated or deserved based on genuine business performance.

Other factors such as concerns over the buyer's financial capacity to pay the earn-out, the inherent uncertainty of future profits, or perceptions regarding the overall structure of an earn-out may certainly be relevant. However, the ability to manipulate operating profits directly impacts the seller's potential financial returns and hence is critical for consideration when negotiating earn-out terms.