Enforcement Quality and the Use of Earnouts in M&A Transactions: International Evidence

Abstract

Earnouts are contractual agreements in merger and acquisition (M&A) deals that link part of the acquisition price to the future performance of the target company. These contracts seem to be a panacea for adverse selection and valuation risk issues in M&As. However, earnouts are not very popular. A likely reason for their limited diffusion is that earnouts have their origin in disagreement and in disagreement they may end: given the complexity of the verification of their outcome and the risk of moral hazard by the bidder, litigation at the time of their payout is far from uncommon. Absent effective legal protection for earnout holders, the potential benefits of these contracts could turn out to be empty promises, thus limiting incentives to include them in acquisition deals. Using an international sample of 37,228 deals completed between 2000 and 2015, we show that the inclusion of these contracts in M&As is significantly related to a country's enforcement quality. Furthermore, we show that a similar relation holds for the proportion of earnout payments with respect to total consideration. Our results hold after controlling for other determinants of earnout suggested by prior literature and for other institutional factors that could affect the use of earnouts.

Keywords: International M&As, Earnouts, Investor Protection, Enforcement Quality, Litigation Risk

JEL Classification: G15, G34, K22, K41