Earnouts: The real value of disagreement in mergers and acquisitions

• Published date: 01 November 2021
• Author: Anna Battauz,Stefano Gatti,Annalisa Prencipe,Luca Viarengo
• Date: 01 November 2021
• DOI: http://doi.org/10.1111/eufm.12304

Eur Financ Manag. 2021;27:981–1024. wileyonlinelibrary.com/journal/eufm © 2021 John Wiley & Sons Ltd.

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DOI: 10.1111/eufm.12304

ORIGINAL ARTICLE

Earnouts: The real value of disagreement in

mergers and acquisitions

Anna Battauz

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|Stefano Gatti

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|Annalisa Prencipe

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Luca Viarengo

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1

Department of Finance, IGIER and

Baffi‐Carefin, Bocconi University,

Milan, Italy

2

Department of Finance and Baffi‐

Carefin, Bocconi University, Milan, Italy

3

Department of Accounting, Bocconi

University, Milan, Italy

4

Department of Economics and Business

Management, Università Cattolica del

Sacro Cuore, Milan, Italy

Correspondence

Luca Viarengo, Department of

Economics and Business Management

Università Cattolica del Sacro Cuore, via

Necchi 7, 20123 Milan, Italy.

Email: luca.viarengo@unicatt.it

Funding information

Fondazione CARIPLO Mobility Grant

Abstract

Earnoutagreementslinkpartofthepaymentforanac-

quired company to its future performance. Despite their

option‐like features, they cannot be valued using vanilla

option‐pricing methods. Two peculiar sources of risk affect

these contracts: Bidder default before the earnout expira-

tion (default risk) and potential litigation associated with

earnouts (litigation risk). We developed an option‐pricing

model that encompasses these sources of risk, showing

that counterparty and litigation risk can have a remarkable

impact on earnout values. Our model's relevance is further

enhanced by recent accounting standards that require

contingent payments to be valued at fair value.

KEYWORDS

default, default risk, earnout, litigation, M&A, real options

JEL CLASSIFICATION

G12, G13, G33, G34, K41

1|INTRODUCTION

The number of mergers and acquisitions (M&As) that include earnouts, that is, clauses that

link part of the payment to the target's performances after the deal closing, has mushroomed in

recent years. Though seminal papers on this topic showed that these clauses were included only

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We are grateful to John Doukas (the Editor), an anonymous referee, an anonymous associate editor, Konstantinos N.

Baltas, Sasson Bar‐Yosef, Leonidas Barbopoulos, Andrea Beltratti, Stefano Bonini, Joao Cocco, Paolo Colla, Fulvio Ortu,

Giovanni Puopolo, Linus Siming, Andrea Sironi and Itzhak Venezia for helpful comments and suggestions. We thank

Alberto Cois for his excellent research assistance—We gratefully acknowledge the financial support received from

Fondazione CARIPLO Mobility Grant.

in 4% of deals during the 1990s (Datar et al., 2001; Kohers & Ang, 2000), the most recent papers

underscore that earnouts are now incorporated into more than 15% of acquisitions (Allee &

Wangerin, 2018; Bates et al., 2018). The economic uncertainty originated by the COVID out-

break will most likely mean earnouts will be used even more frequently than before (Franklin,

2020a,2020b). The increasing relevance of earnouts in M&As was accompanied by a growing

academic interest in the topic. Earnouts were studied with respect to their rationale, whether it

be to reduce information asymmetry (Choi, 2017; Datar et al., 2001; Kohers & Ang, 2000)or

contribute to deal financing (Bates et al., 2018); their positive effect on bidder announcement

returns (Barbopoulos, Danbolt, et al., 2018; Barbopoulos, Paudyal, et al., 2018; Barbopoulos &

Sudarsanam, 2012; Kohers & Ang, 2000; Kohli & Mann, 2013); and the optimal proportion of

earnout payment with respect to the total consideration Lukas et al. (2012).

One highly pertinent question, however, still remains unresolved: How should these con-

tracts be valued? As an earnout is part of the total payment, an accurate valuation of the former

is necessary to price the deal correctly. This is salient from an academic point of view because it

contributes to the literature that tries to explain the relative importance of earnouts with

respect to total payment (Allee & Wangerin, 2018; Cadman et al., 2014; Cain et al., 2011). More

generally speaking, the broader literature on M&As could benefit as well: The deal value,

expressed as the total deal payment, or the premium paid in an acquisition, are frequently the

pivotal point of the analysis (Barbopoulos & Adra, 2016; de la Bruslerie, 2013; Nathan &

O'Keefe 1989; Wu & Chung, 2019). The question is also salient from the standpoint of the

parties involved in a deal that includes an earnout because to make informed decisions, they

need to know the value of the consideration paid and received. Our paper aims to tackle this

question by providing a valuation framework for earnouts.

Earnouts are often structured as real options on a predetermined measure related to the

profitability of the acquired company (e.g., EBITDA or revenues) or to the achievement of

certain targets or milestones (e.g., successful completion of specified contracts, or attaining

preset key events like passing Food and Drug Administration (FDA) trials in the pharma-

ceutical business).

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If the performance measure is realized beyond the given threshold, or if the

agreed milestones are achieved, additional payments are made to the former shareholders of

the target entity. Given the option‐like features of earnouts, option‐pricing techniques are

called for to value these contracts. Arzac (2004), Bruner (2001), Bruner & Perella (2004) and

Caselli et al. (2006) claim that earnouts should be valued as ordinary (nondefaultable) Eur-

opean calls. However, the characteristics of earnout clauses and the context in which they are

used, make this equivalence less than perfect.

Differently from most real options studied in the field of corporate finance, earnouts are

affected by two peculiar sources of risk that could influence their final payoff: Default risk and

litigation/measurement risks. Default risk concerns the fact that earnouts will be honoured

only if, and up to the point in which, the bidder is still a going concern when the earnout

payment is due (i.e., it has not defaulted). Earnouts are options that expire up to several years

after the moment in which they are written, that is, at deal closing.

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Moreover, on average,

bidders that use earnouts are smaller than those that do not (Bates et al., 2018; Kohers & Ang,

2000). For this reason, the risk of default of the bidder might not be negligible.

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Cain et al. (2011) show that, out of a sample of 498 earnouts, 86% are based on accounting measures, 12.2% are structured on nonfinancial milestones, 1.2% are

linked to stock prices and 0.6% to other parameters.

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Cain et al. (2011) show that the average horizon is 2.57 years and that it can be as long as 20 years.

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BATTAUZ ET AL.

Instead, litigation/measurement risk arises because, after the deal closing, the former

shareholders of the target relinquish control of their company to the bidder. Thus, the bidder is

in charge of measuring the performance of the target company. As the performance measures

used in designing earnout agreements are mainly accounting figures, there is always a certain

degree of risk related to earnings management (Ball & Shivakumar, 2008; Erickson & Wang,

1999; Lennox et al., 2018). This does not necessarily imply an opportunistic intent of the bidder,

as subjectivity and flexibility are natural characteristics of accounting figures

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(Nelson et al.,

2002; Parfet, 2000). Litigation risk might also arise in relation to the fact that it might not be

feasible for the seller to monitor whether the bidder exerted its best effort to realize the

conditions that trigger the earnout payment.

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As a consequence, the seller might not believe

that the target company's realized performance, as reported by the bidder, was indeed properly

measured, or that the bidder acted in good faith in developing the business of the target

company. For these reasons, the seller might seek the protection of the courts and take legal

action

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. Thus, the value of an earnout will also be influenced by the expected outcome of a

potential litigation. This issue is quite material; clauses that link the payment of an acquisition

to accounting variables are likely to originate litigation. Özdem and İnce (2019) indeed claim

that disputes related to purchase price adjustments tend to arise quite frequently in M & As.

Furthermore, a survey performed by Grant Thornton (2019) showed that, alongside completion

accounts, earnouts are the most disputed area of M&As. In light of the above, we aim to provide

a valuation model that is able to properly consider the payoff structure of earnouts and the

peculiar sources of risk that affect these clauses.

We provide, as examples, brief descriptions of two acquisitions that highlight the relevance

of our model. The first involves First Wind Holdings LLC, a leading wind development and

asset management platform, acquired by SunEdison Inc, one of the world's largest renewable

energy developers. The deal, closed in 2015 with an upfront payment of around $1 billion,

included an earnout based on the development of First Wind's business, providing for a con-

tingent consideration of $510 million. Then, SunEdison faced bankruptcy in April 2016 and, in

the same month, filed for Chapter 11. Approximately half of the earnout was unpaid at that

date. The second example is the 2011 Sanofi‐Genzyme acquisition. Genzyme, the target in this

case, is a biotech company that developed a promising multiple sclerosis drug called Lemtrada;

Sanofi is one of the largest pharmaceutical companies worldwide. In addition to $20.1 billion

upfront, the deal included an earnout based on the marketability of Lemtrada which could have

generated additional payments of $3.8 billion, or $14 per share acquired. The earnout was

securitized and traded on the NASDAQ.

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On the basis of its expected cash flows, the earnout

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It is possible that the earnout contract allows the former owner/manager of the target company to remain in charge of managing the company after the

closing. In this case, the seller could have a better chance to prevent the misbehaviour of the bidder, who might find it impossible to manipulate accounts.

However, litigation on measuring target company performances often arises in connection with the specification of the accounting items that should be

included when computing the performance measure (see e.g., Hodges vs. Medassets Net Revenue Systems, LLC, 2008, WL476140—N.D.Ga. 2008). In such a

case, continued involvement in the management of the target provides the seller no clear advantage.

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From the seller's perspective, assessing the performance of the target may be easier if the company remains a separate subsidiary with respect to the bidder.

There is no clear evidence in the literature regarding the frequency of targets operating as separate subsidiaries. However,even when this is the case, the bidder

is still likely to have a relevant influence on the managerial decisions, the resources available and the reporting behaviour of the target.

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Enlightening, in this sense, are the words of a judge who had to settle a dispute on the payments relatedto an earnout: 'An earnout often converts today's

disagreement over price into tomorrow's litigation over outcome'. Judge Trevis Laster, Airborne Health, Inc. and Weil, Gotshal & Manges LLP vs. Squid Soap,

LP, C.A. No. 4410‐VCL (Del. Ch. Nov. 23, 2009). Airborne acquired Squid Soap in 2007, paying $1 million upfront and including an earnout capped at $26.5

million. This case will be discussed in Section 7.2.2 of the paper.

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Earnouts that are securitized are also called contingent value rights (CVRs). The security started trading on the NASDAQ on 4 April 2011. The ISIN of the

security is US80105N1138.

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