Earnout deals: Method of initial payment and acquirers’ gains

• Author: Leonidas G. Barbopoulos,Sudi Sudarsanam,Krishna Paudyal
• Published date: 01 November 2018
• Date: 01 November 2018
• DOI: http://doi.org/10.1111/eufm.12135

DOI: 10.1111/eufm.12135

ORIGINAL ARTICLE

Earnout deals: Method of initial payment and

acquirers’gains

Leonidas G. Barbopoulos

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Krishna Paudyal

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Sudi Sudarsanam

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Adam Smith Business School, University

of Glasgow, Glasgow G12 8QQ, UK

Email: leonidas.barbopoulos@glasgow.ac.uk

2

Strathclyde Business School, University

of Strathclyde, Glasgow G4 0QU, UK

Email: krishna.paudyal@strath.ac.uk

3

Cranfield School of Management,

Cranfield MK43 0AL, UK

Email: p.s.sudarsanam@cranfield.ac.uk

Abstract

We analyse the implications of initial payment methods in

earnout deals on acquirers’gains. 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.

KEYWORDS

acquirers’gains, asymmetric information, earnout contracts, initial

payment in earnout deals

JEL CLASSIFICATION

G34

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,

King’s 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.

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© 2017 John Wiley & Sons, Ltd. wileyonlinelibrary.com/journal/eufm Eur Financ Manag. 2018;24:792–828.

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INTRODUCTION

In a seminal study of the effect of earnout deals on acquirers’gains Kohers and Ang (2000) show that

such deals yield higher excess returns to acquirers than single up-front financed deals.

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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.

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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

securities.

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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 acquirers’abnormal 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

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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

hiding‘bad’information regarding the ‘intrinsic’valueof 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.

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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.

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The average earnout component is about 33% of the total purchase consideration (Cain et al., 2011; Barbopoulos and

Sudarsanam, 2012)

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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.

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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).

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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.

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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 management’s 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 latter’s commitment or bonding.

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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 stock–stock combination of first and second tranches

may result in greater risk sharing than a cash–stock combination and even more than a cash–cash

combination. The implications of such a decision on acquirers’gains, 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 acquirers’gains.

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

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Restricted stock options could also be an effective method of bonding target managers to the long-run interests of the

merged firms’shareholders. 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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