Facilitating Mergers and Acquisitions with Earnouts and Purchase Price Adjustments

Albert H. Choi

University of Virginia School of Law

July 28, 2014

This paper examines how post-closing contingent payment (PCP) mechanisms (such as earnouts and purchase price adjustments) can facilitate mergers and acquisitions transactions. The paper examines two informational environments: one in which one party (particularly the seller) has superior information about the deal value (a private information setting) and the other in which the parties differ in their estimates on the deal value but are unable to overcome their difference (a non-convergent priors setting). By conditioning payment on verifiable information that is obtained after closing, PCPs can mitigate the problems of private information or non-convergent priors over valuation and better allow the parties to come to an agreement. Notwithstanding the benefit, PCPs function somewhat differently in the two informational settings. In the private information setting, PCPs function as an imperfect verification, rather than a signaling, mechanism and a pooling equilibrium is possible, in which all positive-surplus deals use a PCP. In the non-convergent priors setting, PCPs can lead to too many deals, even those with negative surplus, being completed: PCPs can work β€œtoo well.” The paper also addresses the problems of post-closing incentives to maximize (or minimize) the PCP payments. When such a moral hazard is a concern, the paper shows that (1) the PCPs will be structured so as to minimize the deadweight loss; and (2) when the deadweight loss is sufficiently large, the parties will forego using a PCP mechanism altogether.

Number of Pages in PDF File: 27

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Date posted: July 1, 2014 ; Last revised: August 5, 2014

Suggested Citation

Choi, Albert H., Facilitating Mergers and Acquisitions with Earnouts and Purchase Price Adjustments (July 28, 2014). Available at SSRN: http://ssrn.com/abstract=2460777 or http://dx.doi.org/10.2139/ssrn.2460777

Contact Information

Albert H. Choi (Contact Author)
University of Virginia School of Law ( email )
580 Massie Road
Charlottesville, VA 22903
United States

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