When the time comes to sell a business, entrepreneurs are often faced with a problem: the potential buyers may not be as optimistic about its future as is the entrepreneur. Consequently, the buyers feel a lower price is warranted than does the seller.

And the negotiations reach an impasse.

One way to deal with this problem is utilizing the concept of a "real option," which I discussed previously in this space. To get around this significant difference of opinion, the buyer and seller enter into a performance contract. The price for the business is split in two: an "up-front" amount and a "back-end" amount, which depends on the performance of the business.

An example will best illustrate the principle. Suppose the buyer feels that a business will achieve a lower level of profits than the seller claims. The buyer feels the business could, at best, earn $10 million by the third year after purchase; the seller feels it could easily hit $15 million in profitability by the third year. As a result, the buyer feels the business is only worth $50 million today while the seller believes it is worth $60 million. Under a simple performance contract, the buyer would pay $50 million today and agree to make a future payment at the end of year three - perhaps three times the difference between the actual profits and $10 million. If the profits are $10 million or less, then no "back-end" payment would be made.

Such an agreement can be a winning proposition for everyone involved. The selling entrepreneur, who often agrees to manage or at least consult for the business until the end of year three, has an incentive to make sure the business is successful for the buyer because the second payment depends entirely on how well the business does.

If the buyer is correct and the profits do not exceed $10 million by year three, the business has been purchased for the $50 million that he or she felt was appropriate in the first place. But if the seller is correct and the profits in year three hit $15 million, then the second payment would be $15 million ($15 million less $10 million times three). The seller would be paid a total of $65 million - the $50 million up front plus the second payment of $15 million - and receive the full price he or she felt appropriate.

Of course, most performance contracts are much more complicated than this simple example. One reason for this is the fact that accounting numbers can be manipulated. To avoid manipulation, performance contracts must be written carefully to rule out accounting or operating decisions that may distort profits. Usually it is good to base "back-end" payments on something that neither the buyer nor the seller can control but that directly affects profits.

For example, suppose the business is an oil drilling business and the buyer and seller disagree on future profits because they disagree on the future price of oil. The buyer does not think the price of oil will go above $25 per barrel, and the seller thinks it will hit $40 per barrel. The second payment could be based on the price of oil. The second payment could be for $1 million times the difference between the actual price of oil and $25. Since neither the buyer nor seller can affect the price of oil, the second payment could not be manipulated by either party.

Buyers find this type of contract attractive because, if profits are higher, they have the money to pay the higher price. If profits are lower, they bought the business for the lower price. Sellers find it attractive because they have optimistic views of the future and will receive a higher price if they are right.