Information Challenges and the Use of Earnouts in Mergers and Acquisitions

In mergers and acquisitions transactions with privately-held target companies, transacting parties will often agree to make payments to the target shareholders contingent upon some post-closing events.  One frequently used mechanism is an earnout.  With an earnout, the parties will agree upon post-closing performance targets, using measures such as earnings, net income, or gross revenue, and the additional amount of consideration that the target shareholders are entitled to receive will depend on whether such performance targets are met over the earnout period, which typically lasts from one to five years after closing.  For example, after paying $10 million at closing, an earnout can allow the target shareholders to receive additional consideration if the acquired company’s (adjusted) EBITDA surpasses a $1 million threshold over a one-year period after closing, where the additional amount can be set as three times the difference between the EBITDA and the threshold $1 million.  Hence, if the acquired company, over the one-year earnout period, realizes an EBITDA of $1.6 million, the target shareholders will receive an additional $1.8 million from the buyer.  If, on the other hand, the acquired company realizes only $800,000 of EBITDA during the earnout period, the target shareholders get no additional consideration.

Practitioners’ understanding of why transacting parties utilize an earnout is that it makes it easier for the parties to come to an agreement, particularly when the parties have difficulty arriving at a mutually acceptable valuation of the target’s assets or business.  When the buyer argues that the seller’s assets are worth $10 million while the seller argues that they are worth $15 million, rather than trying to come to an agreement reconciling that valuation difference—which can be quite difficult and can lead to no deal being consummated—by allowing the buyer to pay $10 million at closing and up to an additional $5 million as an earnout, the contingent payment mechanism may make it easier for the parties to overcome the valuation difference.  In short, an earnout is supposed to make it easier for the parties to consummate the transaction when there is a material informational (or opinion) divergence between them.

At the same time, practitioners also emphasize that implementing an earnout mechanism is difficult and the use of an earnout can engender serious post-closing problems and disputes.  One particular concern is the transacting parties’ post-closing behavior.  If the seller is paid $10 million at closing but is promised a $5 million (maximum) earnout, contingent on certain target accounting measure being met within the earnout period, when the operation of the business remains under the seller’s effective control, to the extent that there often is much discretion in calculating accounting measures and that accounting measures can diverge from fundamentals, the seller’s incentive would be to maximize the chances of collecting the earnout rather than improve the long-term value of the combined company.  If the buyer is in charge of the operations, the opposite is likely to happen.  Partly due to such concerns, some practitioners have even noted that earnouts “are a nightmare to draft, negotiate and…to live with,” and as a result, transacting parties would often “give up on [negotiating an earnout] before too long—they simply compromise on the price.”[1]

As I explain in detail in a more extensive, game-theoretic analysis (available here), there are clear costs and benefits of using an earnout.  In particular, I consider the use of an earnout when one party (in particular, the seller) is better informed about the true value of the target company than the buyer, i.e., in the setting of asymmetric (or private) information.  The main thesis is three-fold.  First, when the parties can utilize an earnout, compared with the case where the buyer makes a single payment at closing, the transacting parties can effectively mitigate or eliminate the problems of asymmetric information and consummate all transactions with positive surplus.  Second, when the size of the earnout payment is subject to limitation (e.g., the buyer cannot pay more than $5 million as an earnout or the seller must receive at least $10 million at closing) or when the post-closing moral hazard is a significant concern, the transacting parties will be much more selective in using an earnout.  Third, the essay considers whether to use the buyer’s stock versus cash in an earnout and shows that there are under-appreciated benefits associated with using the buyer’s stock as consideration.  These benefits stem from the fact that the value of stock consideration is correlated with the true value of the assets (or the company) and, with stock consideration, the transacting parties partially internalize the surplus loss that stems from post-closing, opportunistic behavior.

[1] Kling, L. and Nugent, E. Negotiated Acquisitions of Companies, Subsidiaries, and Divisions (2013) at 17.26.

This post comes to us from Albert H. Choi, the Albert C. BeVier Research Professor and Professor of Law, University of Virginia School of Law. It is based on his recent essay, “Addressing Informational Challenges with Earnouts in Mergers and Acquisitions,” available here.