How Enforcement Quality Affects the Use of M&A Earnouts

In mergers and acquisitions (M&A), one of the trickiest tasks is assessing the value of the company to be purchased or sold. While in some cases buyers and sellers come easily to an agreement, in others the information asymmetry between the two parties is too great or the target company is too opaque, and the deal can fall apart.

Earnouts are contractual agreements that link part of the acquisition price to the future performance of the target. One portion of the price is paid to the selling shareholders up front and the remaining portion is paid only if the target meets certain performance goals. Those goals can be either financial, such as a certain level of sales, or task-oriented, such as obtaining a patent by a certain date. Earnouts can be considered as a bridge between two diverging valuations: With an earnout, a bidder is less worried about overpaying, and shareholders of the target are protected against a low price that does not account for future promising results.

However, anecdotal evidence suggests that earnouts are not very popular. In November 2009, for example, Delaware Vice-Chancellor Travis Laster had to resolve a dispute over payments related to the earnout agreed upon by Airborne and Squid Soap in 2007. Airborne paid $1 million upfront and committed to pay an earnout capped at $26.5 million.  In his opinion, Laster focused on a common criticism: “An earnout often converts today’s disagreement over price into tomorrow’s litigation over outcome.” What’s more, a survey conducted by Morrison & Foerster LLP in 2012 on a sample of over 300 M&A professionals – mainly from the high-tech industry, where earnouts are used most frequently – showed that almost three-quarters of respondents claimed that such clauses led to disputes or litigation and nearly one-fifth of the respondents said there had been post-deal conflicts over earnouts in as many as half their transactions.

Earnouts are relatively uncommon largely because they are rooted in disagreement: Given the complexity of verifying whether defined benchmarks have been achieved and given the risk that the bidder behaves opportunistically to reduce the contingent payment (for example, by reducing the effort put into the acquired company, or by underestimating the reported results), litigation is quite frequent. What’s more, the ability of courts to gather information through discovery on the actual performance of the target and on the way it was managed, and to enforce earnout provisions accurately and completely, varies widely across countries. It is reasonable, then, to expect that the quality of enforcement in a given country will affect whether earnouts are included in M&A transactions.

In a recent academic paper, we analyze an international sample of over 35,000 transactions completed in more than 40 countries between 2000 and 2015 to show the effect of enforcement quality on earnout use Determining the quality of enforcement is complex and influenced by many factors. For this reason, we employ several measures as proxies for enforcement quality: (1) the anti–self-dealing index developed by Djankov et al. (2008), which is a country-based measure of investor protection; (2) the Rule of Law Index developed by the World Bank, which captures citizens’ and firms’ subjective perceptions of the quality of the legal environment; (3) the strength of legal rights index developed by the World Bank in the framework of the Doing Business reports, which measures the ability of the legal and judicial system to protect the rights of creditors; and (4) country-based factors developed by Isidro et al. (2016), which stems from a principal component analysis of analysis based on 72 institutional variables. Our paper shows that the inclusion of earnouts in deal agreements is indeed significantly related to a country’s enforcement quality: In countries with stronger enforcement, earnouts are used more frequently. These results suggest that earnout agreements are part of an efficient contracting framework, in that they are most frequently used when they are most likely to be enforced and, consequently, the risk of opportunistic behavior by the bidder is lower.

In line with previous research, we also find that earnout clauses are mainly used when the target is a private company or a subsidiary or when it operates in the service or high-tech sector, confirming that the likelihood of using earnouts is higher when the target is opaque and there is greater uncertainty about its value or future prospects. Moreover, the bigger the target is in relation to the bidder, the more likely the parties are to include an earnout in the deal, likely due to the fact that smaller buyers may seek the extra protection provided by earnouts to compensate for their lesser information-gathering resources and to reduce valuation error, whose impact is positively associated with the target size. The likelihood of earnouts is also greater in cross-border acquisitions, where information asymmetry is higher.


Djankov, S., R. La Porta, F. Lopez-de-Silanes, and A. Shleifer. 2008b. The Law and Economics of Self-Dealing. Journal of Financial Economics 88(3), 430–465.

Isidro, H., Nanda, D., & Wysocki, P. D. (2016). Financial reporting differences around the world: What matters? Working paper available at =2788741.

Morrison and Foerster LLP. (2012). M&A leaders survey.

This post comes to us from Luca Viarengo, CPA and adjunct professor at Catholic University of the Sacred Heart of Milan, and professors Stefano Gatti and Annalisa Prencipe at Bocconi University. It is based on their recent paper, “Enforcement Quality and the Use of Earnouts in M&A Transactions: International Evidence,” available here.

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