Contingent Earnouts in Acquisitions of Privately-Held Targets

Abstract

Prior research has devoted significant attention to ownership choices when firms make market-entry decisions (e.g., equity alliance versus acquisition). This article emphasizes the importance of studying firms’ contractual choices as well as the potential relationships between their contractual and ownership choices. This study of acquisitions examines the incidence and determinants of contingent earnouts, which are contracts that specify deferred variable payments to the target. The evidence indicates that the usage of such contracts increases with information asymmetries surrounding mergers and acquisitions, in particular when privately held targets are young or possess knowledge bases that are dissimilar from those of the acquirers. The article also presents evidence that firms’ contractual choices (i.e., earnouts) and ownership choices (i.e., equity alliances) can substitute for one another.

Keywords: contingent earnouts, mergers and acquisitions, strategic alliances, contracts, information economics