The real effects of earnout contracts in M&As

• Published date: 01 September 2021
• Author: Leonidas G. Barbopoulos,Jo Danbolt
• Date: 01 September 2021
• DOI: http://doi.org/10.1111/jfir.12256

J Financ Res. 2021;44:607–639. wileyonlinelibrary.com/journal/jfir

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607

Received: 30 January 2020

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Accepted: 13 May 2021

DOI: 10.1111/jfir.12256

ORIGINAL ARTICLE

The real effects of earnout contracts in M&As

Leonidas G. Barbopoulos|Jo Danbolt

University of Edinburgh Business School,

University of Edinburgh, Edinburgh,

Scotland, UK

Correspondence

Leonidas G. Barbopoulos, University of

Edinburgh Business School, University of

Edinburgh, 29 Buccleuch Place,

EH8 9JS Edinburgh, Scotland, UK.

Email: leonidas.barbopoulos@ed.ac.uk

Abstract

Earnouts address merger valuation risk by deferring payment

of a large part of deal consideration and making it contingent

on targets’future performance. We find acquirers of unlisted

targets using earnouts gain more (less) than those making full

up‐front payments in cash (stock). Larger and older acquirers

benefit more from earnout‐based deals, as do foreign

acquirers and acquirers advised by top‐tier or boutique

advisors. We address identification through the propensity

score matching method and a quasi‐natural experiment.

Acquirers realize the highest returns from earnouts when the

deferred payment is around 30% of deal value. Deferred

payments are larger after the SFAS 141(R) reform.

JEL CLASSIFICATION

G12, G13, G14, G30, G34

1|INTRODUCTION

Earnout is a contractual payment mechanism in mergers and acquisitions (M&As) where a relatively large part

(often around a third) of the deal consideration is deferred and payable to the target's shareholders at multiple

stages following the M&A announcement, contingent upon some observable measure(s) of the target firm's future

performance within prespecified periods (Barbopoulos, Danbolt, & Alexakis, 2018; Cain et al., 2011).

1

Earnouts

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and

reproduction in any medium, provided the original work is properly cited.

© 2021 The Authors. Journal of Financial Research published by Wiley Periodicals LLC on behalf of The Southern Finance

Association and the Southwestern Finance Association.

1

Following an up‐front payment in the form of cash, stock, or a mixture of both made at closing, one or more future payment(s)—commonlyreferred to as

the earnout payment(s)—is payable (often over 0.5 to 3 years), conditional on the target firm achieving preagreed (financial or operational) performance‐

related metrics. Financial metrics are typically revenue‐or profit‐based, for example, revenues or earnings before interest, taxes, depreciation, and

amortization (EBITDA). Operational metrics are usually measured via milestones, for example, related to new product development. In the pharma-

ceutical sector, earnout payments are often conditional on the regulatory approval of a drug or the granting of a patent.

are very popular among M&As of unlisted (i.e., private and subsidiary) target firms, particularly those operating in

the high‐technology, healthcare, and other innovation‐and patent‐rich sectors, where valuation risk is generally

high because of moral hazard and adverse selection (Kohers & Ang, 2000).

2

Prior studies show that earnouts are

associated with higher acquirer gains, and higher takeover premia, relative to counterpart M&As that are settled in

single up‐front payments at closing (Barbopoulos & Adra, 2016; Kohers & Ang, 2000). This is because earnout

alleviates merger valuation risk by reducing adverse selection and moral hazard issues.

Earnouts affect thousands of firms and managers, and nowadays are used in sizable investments involving the

reallocation of assets worth billions of dollars. They are growing around the world, though the United Kingdom and

United States maintain their leading positions in terms of both absolute and relative earnout activities (Viarengo et al.,

2018). The effectiveness of earnouts depends on their structure, which can be complex and highly sensitive to the

valuation challenges of the target firm, and hence the calculations of the merger's e xpectedpayoff (Battauzet al., 2021;

Cain et al., 2011; Lukas et al., 2012). As a result, earnout‐design expertise and extensive negotiations are required to

reach an agreement between the merging firms. Financial advisors are likely to possess the know‐how to design

“effective”earnout contracts (Bao & Edmans, 2011) and help the merging firms avoid “convert[ing] today's disagree-

ment over price into tomorrow's litigation over outcome”(Judge Laster, as quoted in Viarengo et al., 2018, p. 438). We

are the first to address this important relation. We further study whether resourceful and experienced (larger and

older) acquirers are more likely to better negotiate earnout terms and have an advantage in negotiations with relatively

(mainly unlisted) small and valuation‐challenging targets. Moreover, the US regulatory framework under which earn-

outs operate (in M&As announced by US‐based acquirers) has undergone important reforms, particularly with the

introduction of Statement of Financial Accounting Standards No. 141 (revised) in 2009 (hereafter SFAS 141(R)). SFAS

141(R) requires acquirers to recognize the fair value of earnouts in the acquisition price as a liability in the company's

accounts at the time of the acquisition and to adjust earnout fair values each quarter (Cadman et al., 2014;in

Section 3.3 we offer a detailed discussion of this reform). We offer further evidence on these relations.

Given their growing popularity and the importance of earnouts in shaping the modern corporation, we set out to

systematically examine the real effects of earnouts on acquirer returns.

3

Do investors react more favorably to earnout‐

based M&As of unlisted targets than counterpart deals settled in single up‐front payments? If so, when? What deal‐and

firm‐specific characteristics contribute to the success of earnout‐based M&As? What role do financial advisors play in

the success of earnout‐based M&As? Does the most basic aspect of the earnout structure—the size of the deferred part

of the deal consideration—matter to returns? To what extent did the US policy reform (SFAS 141(R)) affect the use of

earnouts, their structure, and the stock market reaction to such deals? Finally, does the exclusion of listed target M&As

(given their limited earnout use) affect the known valuation effects of earnouts on acquirer returns? These are

questions of significant practical relevance to corporate managers, to which we provide comprehensive answers.

Arguably, the earnout payment mechanism encourages both ex ante information sharing between the merging

firms (thus reducing the risk of adverse selection, similar to stock financing in Hansen's, 1987, model) and retaining

motivated and committed key personnel from the target firm during the integration phase of the merger (thus

reducing moral hazard).

4

Put simply, target managers are motivated to remain in the firm and maximize its

performance (to receive the deferred payments), especially if the managers are also the shareholders, which is

often the case in unlisted companies (Barbopoulos & Sudarsanam, 2012). Therefore, earnouts are expected to

reduce the underlying valuation gap between the merging firms by explicitly linking the target firm's payment in

the acquisition to its future performance. This, in turn, is associated with an increased overall likelihood of merger

2

In recent years, however, earnouts are increasingly used in listed target M&As, yet their frequency remains low (<1% in our sample). Although our

analysis is based on unlisted target M&As, in a separate section we examine the valuation effects of earnouts in listed target M&As. We thank an

anonymous reviewer for suggesting this analysis.

3

The business press has also pointed to the growing popularity of earnouts in unlocking COVID‐19 valuation gaps (see Latham & Watkins LLP, 2020).

4

Differences in opinion between buyers and sellers with regard to target value and expected merger synergies, if not managed and controlled effectively,

may be detrimental to the merger payoff because of potential deal overpayment and failure to improve the resource allocation between the merging

firms (Devos et al., 2009).

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success (and higher merger synergies) and, per our findings, higher acquirer gains relative to counterpart M&As

without earnouts (consistent with, e.g., Barbopoulos, Danbolt, & Alexakis, 2018; Barbopoulos, Paudyal, &

Sudarsanam, 2018; Kohers & Ang, 2000).

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As a result, acquirers in earnout‐based M&As are expected to gain more

(less) than those in cash‐(stock‐) settled M&As without any (with strong and costless) contingent properties

(Barbopoulos & Sudarsanam, 2012; Chang, 1998; Hansen, 1987; Kohers & Ang, 2000).

Our analysis is based on 31,214 M&As involving unlisted (i.e., private and subsidiary) target firms, made by

either UK or US domiciled acquirers between 1986 and 2016. Our preliminary univariate results show that

acquirers in earnout‐based M&As enjoy, on average, significant gains of 1.57 percentage points. M&As with

earnouts outperform M&As settled fully in cash but underperform deals with stock and mixed single up‐front

payments. These findings hold regardless of the listing status of the target (i.e., private or subsidiary).

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This

suggests that earnout payments serve as another (in addition to stock) vehicle through which acquirers can reduce

merger valuation risk by motivating both information sharing and the realization of high synergies from M&As of

unlisted firms (Kohers & Ang, 2000). Our focus on M&As of unlisted target firms only in the study of the pricing

effects of earnout versus nonearnout payments provides an ideal setting, as it avoids the negative pricing effects

of stock‐financed M&As of listed targets in the control group (Fuller et al., 2002; Myers & Majluf, 1984;

Travlos, 1987).

7

We further find that the age and size of the acquirer matters to earnout valuation effects: Larger and more

mature (and therefore more resourceful and possibly more experienced) acquirers are found to enjoy higher gains

from earnout‐based M&As relative to smaller and young acquirers, respectively. In addition, acquirers in smaller

earnout‐based deals relative to their size enjoy significant gains. Along these lines, we find that more resourceful

acquirers, as proxied by their size or cash‐to‐assets ratio, are more likely to use more prestigious financial advisors.

We find that using financial advisors matters to the earnout effect: Top‐tier investment banks, as well as boutique

financial advisors, on either or both sides of the deal add significant value to acquirers in earnout‐based M&As.

Prior earnout studies ignore the important effect of advisors when examining the valuation effects of earnouts in

M&As.

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We also find that the global diversification aspect of the deal matters, with acquirers enjoying higher gains

from cross‐border transactions than domestic M&As based on earnouts. We further find a curvilinear relation

between the ratio of earnout value to total deal consideration (i.e., relative earnout value [REAV]) and acquirers’

gains. In particular, acquirers on average enjoy maximum benefit from earnout‐based M&As when the REAV is

roughly 30% of the total deal consideration. Last, we find that the REAV is significantly larger after SFAS 141(R).

Our finding of strong correlations between the use of earnouts and acquirer gains might not reflect a

causal relation, as certain firm or deal characteristics might affect both the choice of earnout and acquirer

gains. To circumvent this identification problem, we examine the causal effect of earnout choice on acquirer

gains by using two identification strategies: the propensity score matching (PSM) method and a quasi‐natural

experiment. Our finding of a strong positive earnout effect remains robust after controlling for self‐selection

concerns using the PSM method, the effect of which is examined in the multivariatecontext after we apply the

5

We recognize that acquiring firms can use other means through which to provide incentives for target managers to share valuable information and

remain with the acquirer in the integration phase of the deal, such as shares (Chang, 1998; Fuller et al., 2002). We do not intend to analyze the relative

merits of earnouts versus contractual solutions offered by other means.

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Although prior studies investigate the earnout effects on acquirers’gains by including listed target M&As, we offer the first analysis in which only M&As

of unlisted targets are included, and we study whether including listed target M&As can distort the analysis of earnout valuation effects.

7

Recent evidence, however, challenges the traditional view that stock‐swap listed target acquisitions are associated with a negative pricing effect on

acquirer value. Alexandridis et al. (2017) find that stock‐for‐stock deals no longer destroy value, and Eckbo et al. (2018) argue that the more the target

knows about the bidder, the less likely it is for the target to be paid with overpriced shares. De Bodt et al. (2019) further show that once a series of

regulatory incentives are taken away (as they were starting in July 2001), the link between acquirer valuation and the choice to conduct a full stock swap

in an M&A deal is broken. Cleary and Hossain (2020) further show that the 3‐year mean buy‐and‐hold abnormal return (BHAR) increased significantly (at

least at the 5% level) by approximately 18.07% (1.34%) during the postcrisis period.

8

We focus on financial advisors, rather than legal advisors, because financial advisors engage in financing and valuation matters during the deal process.

Krishnan and Masulis (2013) offer an extensive discussion on the distinctive duties of financial and legal advisors. However, wealsoinvestigatethe effect

of legal advisors on the valuation effects of earnouts in M&As and find an insignificant relation. We thank an anonymous reviewer for suggesting this

analysis.

REAL EFFECT OF EARNOUT CONTRACTS

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