Contingent earnouts
Jeffrey J. Reuer and Roberto Ragozzino
A contingent earnout is a contractual agreement stipulating a schedule of variable payments that an acquirer is to make to a seller following an acquisition. While payment for an acquisition typically occurs at the time of a deal’s comple tion, a bidder can turn to a contingent earnout in order to defer payouts and make them depend ent on the attainment of pre specified perform ance objectives for a certain time interval (e.g., 3–5 years). Therefore, one of the features of contingent earnouts that makes them attractive in acquisitions is that acquirers facing uncer tainty about the value of the targeted resources are able to transfer a portion of the valuation risk to the target firm (Reuer, Shenkar, and Ragoz zino, 2004).
The valuation problem for acquirers has been noted by scholars researching acquisitions deal structures and the determinants of merger and acquisition (M&A) failure. Fundamentally, the model is an extension of the widely known ‘‘market for lemons’’ model, which is discussed by Nobel prizewinner George Akerlof in the context of product markets (Akerlof, 1970). Spe cifically, he discusses how information asym metries that exist between buyers and sellers can lead to the problem of adverse selection. When information asymmetries exist, buyers of products are unable to separate the good ones from the lemons in an efficient manner, and because sellers are aware of their advantageous informational position, they have an incentive to misrepresent the value of their products. Asocial institutions (e.g., warranties) and social institu tions (e.g., trust) can therefore take on import ance in rectifying the failure of product markets affected by asymmetric information.
In M&A markets, target firms may likewise hold privileged information about their re sources and be unable to convey it to prospective bidders in a credible fashion. Under these cir cumstances, earnouts can serve as contractual remedies that allow the acquisition to take place despite parties’ potential valuation disagree ments. For example, bidders may agree to pay for the amount reflecting their valuation up front, and disburse the excess amount claimed by targets if and only if the value of these re sources is borne out in the future. Furthermore, targets are provided with an opportunity to signal the veracity of their claims by agreeing to enter into these contractual arrangements (Spence, 1974). This suggests that earnouts will be helpful in acquiring less related targets with disparate knowledge bases vis a` vis the ac quirer.
Another distinct advantage of contingent earnouts is that they can ensure that a target firm’s managers stay on board after an acquisi tion, and earnouts also incentivize them to perform. There is evidence in finance and strat egy research that acquisitions often fail due to losses in human capital in the acquired firm, particularly in high tech acquisitions or other acquisitions reliant on intangible assets. By im plementing earnouts, acquirers find a way to address this additional risk and increase their chances for a successful deal.
While contingent earnouts can be an efficient way to mitigate ex ante information asymmetry problems, as well as the risk of ex post manage ment departures, their characteristics also pre sent a number of drawbacks that can limit their usefulness. First, earnouts will tend to be un suited for acquisitions requiring immediate inte gration of the target firm’s resources. This is because the seller’s assets must be kept separate in order for acquirers to measure the target’s performance and determine whether the de ferred payments are to occur. More generally, it is implicit in the earnout contract that the buying firm should minimize its supervision in the op erations of the target firm over the contract life, so as to avoid ambiguity in the cause and effect linkage between the target firm’s activities and performance outcomes. Targets subject to earn outs therefore will require significant autonomy after the acquisition has been completed.
A second important disadvantage of earnouts is that they may give rise to moral hazard prob lems for acquirers which, like the problem of adverse selection, can thwart the success of a deal. In general, the precise specification of earn out terms (e.g., performance benchmarks, dur ations, etc.) can encourage target management to behave in some ways that are inconsistent with the long term, wealth maximization objectives of the acquiring firm. For example, target man agement may choose investments with a horizon less than that of the earnout contract, while other projects with longer durations may have super ior long term cash flow prospects or embedded options. As another illustration, if the perform ance benchmark chosen for the earnout is based on accounting measures such as ROA, target management may elect to reduce expenses that may nevertheless be in the business’s long term interests. Along the same lines, lack of clarity and completeness in the earnout contract may induce acquirers to behave opportunistically in order to avoid deferred payments. For instance, disagreements may arise regarding inconsistent accounting practices or depreciation methods, which in turn increase the risk of costly litiga tion.
Given their characteristics, contingent earn outs can be attractive deal structuring devices for some entrepreneurial acquisitions for several reasons. Recent research in entrepreneurship has found that entrepreneurs tend to exhibit a number of behavioral biases that can exacerbate valuation disagreements with acquirers. Entre preneurs have been noted to be overconfident about their prospects, underestimate their future challenges, and generalize erroneously from prior experiences. As targets, entrepreneurial firms may therefore hold exaggerated expect ations about their own value, which likely in creases the chances of valuation disagreements with prospective acquirers. Under these circum stances, earnouts are attractive in allowing deals to go forward, even when bidders and sellers hold divergent valuations for the targeted resources.
Aside from some of the heuristics that have been associated with entrepreneurs, there are a number of other reasons why contingent earn outs can be useful in acquisitions of entrepre neurial firms. First, many entrepreneurial firms are privately held and have yet to undergo the IPO process. Privately held targets pose higher informational hazards for bidders, owing to the lack of credible information available on private targets (Shen and Reuer, forthcoming). By undertaking an IPO, the target firm can provide signals to would be acquirers by bearing the direct costs of going public, as well as the indirect costs of underpricing and associating with reput able third parties (Reuer and Shen, 2004). Second, entrepreneurial firms are often new ven tures that lack codified historical information on their operations. Third, entrepreneurial firms can have unique capabilities that differ from those of more established bidders. Often the know how in entrepreneurial firms is embodied in the entrepreneur, and it can be in the best interest of the acquiring firm to ensure his or her continued presence in the target firm for a transitional period after the acquisition has been completed.
The above rationales suggest that contingent earnouts can be particularly useful in acquisi tions of entrepreneurial firms. Recent research has brought evidence that contingent earnouts are in fact most useful in the acquisitions of firms that are privately held rather than publicly traded, newly incorporated versus more estab lished, and that have different knowledge bases from those of acquirers. Earnouts may also pro vide substitute remedies vis a` vis governance solutions such as equity collaborations to the problem of adverse selection in the market for firm resources (Reuer and Koza, 2000). This emerging research presents a broad array of choices for entrepreneurs seeking to grow or exit, ranging from going public to forming vari ous types of alliances, to going forward with acquisitions with particular deal structures tailored to firms’ needs. Given that entrepre neurial firms also engage in acquisitive growth and may find it difficult to evaluate targets (Zahra, Ireland, and Hitt, 2000), future research might also consider the conditions under which earnouts might be useful deal structuring devices for these firms.
Bibliography
Akerlof, G. A. (1970). The market for ‘‘lemons’’: Qualitative uncertainty and the market mechanism. Quarterly Journal of Economics, 84: 488 500.
Reuer, J. J. and Koza, M. P. (2000). Asymmetric information and joint venture performance: Theory and
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Reuer, J. J. and Shen, J.-C. (2004). Sequential divestiture through initial public offerings. Journal of Economic Behavior and Organization, 54: 249 66.
Reuer, J. J., Shenkar, O., and Ragozzino, R. (forthcoming). Mitigating risk in international mergers and acquisitions: The role of contingent payouts. Journal of International Business Studies, 35: 19 32.
Shen, J.-C. and Reuer, J. J. (forthcoming). Adverse selection in acquisitions of small manufacturing firms: A comparison of private and public targets. Small Busi ness Economics.
Spence, A. M. (1974). Market Signaling. Cambridge, MA: Harvard University Press.
Zahra, S. A., Ireland, R. D., and Hitt, M. A. (2000). International expansion by new venture firms: International diversity, mode of market entry, technological learning, and performance. Academy of Management Journal, 43: 925 50.
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