Earnout deals: Method of initial payment and acquirers’ gains

AuthorLeonidas G. Barbopoulos,Sudi Sudarsanam,Krishna Paudyal
Published date01 November 2018
Date01 November 2018
DOI: 10.1111/eufm.12135
Earnout deals: Method of initial payment and
Leonidas G. Barbopoulos
Krishna Paudyal
Sudi Sudarsanam
Adam Smith Business School, University
of Glasgow, Glasgow G12 8QQ, UK
Email: leonidas.barbopoulos@glasgow.ac.uk
Strathclyde Business School, University
of Strathclyde, Glasgow G4 0QU, UK
Email: krishna.paudyal@strath.ac.uk
Cranfield School of Management,
Cranfield MK43 0AL, UK
Email: p.s.sudarsanam@cranfield.ac.uk
We analyse the implications of initial payment methods in
earnout deals on acquirersgains. The results, which are
robust to self-selection bias and alternative model specifi-
cations, reveal that earnout deals outperform non-earnout
deals. The acquirers gain the most from earnout deals when
both initial and deferred payments are in stocks. The
positive wealth effect of the choice of initial payment
method in earnout deals is more prominent in cross-border
deals than in domestic deals. Overall, the earnout deals
generate higher gains when both the initial and deferred
payments help spread the risk between the shareholders of
acquiring and target firms.
acquirersgains, asymmetric information, earnout contracts, initial
payment in earnout deals
We acknowledge the comments and suggestions to earlier versions of the paper of John A. Doukas (the Editor), two
anonymous referees, Jana Fidrmuc, Jens Hagendorff, and the participants of the Southwestern Finance Association
conference (Albuquerque, 2013 where an earlier version of the paper was awarded Best paper in Corporate Finance),
EFMA Conference (Basel, Switzerland) 2016, BAFA (Scottish) conference 2016, and the participants of the seminar series
of the University of St. Andrews, University of Glasgow, Old Dominion University, Luxembourg School of Finance,
Kings College London, College of William and Mary, University of Vienna, Vienna Graduate School of Finance, and
University of St. Gallen. Any remaining errors are those of the authors.
© 2017 John Wiley & Sons, Ltd. wileyonlinelibrary.com/journal/eufm Eur Financ Manag. 2018;24:792828.
In a seminal study of the effect of earnout deals on acquirersgains Kohers and Ang (2000) show that
such deals yield higher excess returns to acquirers than single up-front financed deals.
In an earnout
deal, the payment to target owners is made in two stages. The first stage payment (an initial payment at
the time of the deal) can be in cash, stock or a combination of these and other securities.
The deferred
(second part) payment is made over the earnout period and is conditional on the target reaching agreed
milestones. The deferred payment could also be in cash, stock or a combination of cash and different
Earnout contracts have become popular in recent years, reaching 11% of total deals in 2009
from less than 2% in 1986. In spite of such growing popularity of earnout contracts in which a large
proportion of the deal value (about two-thirds) is paid at the time of the deal, the effect of both the
choice of methods of initial and second part payments on acquirersabnormal returns remains to
be investigated. This paper aims to fill this void. The findings of this analysis should be of interest to the
managers and shareholders of firms that are willing to engage in mergers and acquisitions (M&As) and
minimise the adverse effects of information asymmetry through risk sharing.
The choice of payment methodin M&A deals is often guided by the aim of mitigating the valuation
risk which originatesfrom information asymmetrybetween the merging firms for two reasons. First,one
or both merging firmsmay hold private knowledge on their valuation which is not ex-antetransparent to
the other a case of adverse selectionor hidden knowledge. Second, one or both mergingfirms can take
an action ex post that may harm the other a case of moral hazard
or hidden action. Studies show that
adverse selection riskcan be reduced by the judicious choice of the method of payment(Hansen, 1987;
Eckbo, Giammarino,& Heinkel, 1990). Neither cash nor stock payment thatis delivered in a single up-
front paymentcan factor the post-acquisition performanceof the target in the deal value whilean earnout
contract does. The contingentform of consideration (earnout) seeks to achieveboth the reduction of the
adverse selection problem (i.e.,ex-ante overvaluation of the target firm due to target owners/managers
hidingbadinformation regarding the intrinsicvalueof the firm) and the ex-post moralhazard problem
(i.e., contract failure due to shirking or the inability of a party to enforce contract compliance and
performance delivery), thus contributing to the reduction in valuation risk for the acquiring firm.
Studies by Cain et al. (2011) for the US and Barbopoulos and Sudarsanam (2012) for the UK also show that among the
domestic deals, earnout deals yield higher returns to acquirers than single up-front payment deals.
The average earnout component is about 33% of the total purchase consideration (Cain et al., 2011; Barbopoulos and
Sudarsanam, 2012)
Faccio and Masulis (2005, footnote 13) show that the balance is usually paid in cash. However, later in this paper, we
show that in 55% of earnout deals (for which the breakdown is available) the second part payment is made in cash while
stocks are used in 14% of the deals and the remaining deals (31%) are settled in a mixture of cash and stock. Hence,
analysis of the second payment also deserves attention.
Moral hazard arises when contractual performance cannot be precisely monitored or enforced due to weak contract
formulation, imprecise performance measurement, or weak contract enforcement remedies. For a discussion of the adverse
selection and moral hazard perspectives on earnout contracts see Cain et al. (2011).
Several other contractual mechanisms are available for enhancing M&A deal success, such as: (a) termination fees,
lockups, and material adverse change clauses that are designed to prevent, or raise the cost of, either the acquirer or the
target reneging on the deal, (b) collars that are designed to minimise the impact of short-term adverse stock price
movements and, (c) toeholds that are designed to increase the probability of deal success by the acquirer through buying up
chunks of target shares. Unlike earnout contracts that are designed to manage valuation risk, these mechanisms are designed
to eliminate transactional risk and not mitigate valuation risk. Hence, our primary objective in this paper is to analyse the
impact of the combinations of payment methods in earnout deals in mitigating valuation risk in the context of domestic and
foreign acquisitions.
The attractiveness of earnout as a payment mechanism for mitigating the adverse selection and
moral hazard problems has contributed to its increasing use in recent years (see Figure 1). The choice of
initial payment method is also a matter of high strategic importance in managing the valuation risk. For
instance, a combination of stock (as initial payment) and earnout may add more value to the acquirer as
it provides a better risk sharing mechanism between the shareholders of the target and acquiring firms.
Further, the choice of the method of payment in the second tranche (i.e., deferred payment) of the
purchase consideration is also of strategic importance. For example, paying in stocks in both tranches
(initial and second) is likely to send a stronger signal of the acquirer managements strategy in sharing
risk and the confidence of the target management to succeed, as agreement to an earnout or to stock as
second stage payment attests to the latters commitment or bonding.
On the other hand, acquirers who
are confident about the value of the merger may prefer to pay the up-front tranche in cash, so that they
can limit the transfer of wealth gained from M&As to target owners. Thus, in assessing the impact of
earnout as a risk management tool, the interactive effect of the initial payment method and the second
tranche earnout is critical and neither should be evaluated in isolation. Similarly, the analysis should
provide due consideration to the method of payment used in the second tranche. The strategic decision
of designing earnout with a particular combination of initial and second payments is expected to
influence the gains to acquirers. For example, a stockstock combination of first and second tranches
may result in greater risk sharing than a cashstock combination and even more than a cashcash
combination. The implications of such a decision on acquirersgains, however, remain to be
investigated. We fill this void by analysing the impact of the choice of initial and second payments in
earnout deals on acquirersgains.
Due to higher information asymmetry, adverse selection and moral hazard problems may be more
aggravated in cross-border mergers and acquisitions (hereafter CBA) than in domestic deals. One
possible way to minimise the implications of such risks is to enter into a contract that makes the target
management more responsible for the performance of the target firm and hence makes the final pay-off
contingent upon the post-acquisition performance of the target. Although the earnout contract offers
Restricted stock options could also be an effective method of bonding target managers to the long-run interests of the
merged firmsshareholders. However, analysis of the effectiveness of such options, relative to that of earnout contracts,
remains a matter for future empirical investigation.
FIGURE 1 Annual distribution of earnout deals relative to all deals

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