Earnouts: The Effects of Adverse Selection and Agency Costs on Acquisition Techniques

Posted: 29 Feb 2008

See all articles by Mark A. Wolfson

Mark A. Wolfson

Stanford Graduate School of Business

Srikant Datar

Harvard University - Accounting & Control Unit

Richard M. Frankel

Washington University in Saint Louis - Olin Business School

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Abstract

We examine the effects of adverse selection and agency costs on the structure of the consideration offered in an acquisition. Specifically we investigate factors affecting the benefits arising from use of earnouts. We find that when targets have greater private information, consideration is more likely to be based on the future performance of the target. We also find an earnout is more likely to be used in an acquisition if the target is a smaller, private company in a different industry than the acquirer. In addition, earnouts are more likely to be used when fewer acquisitions take place within an industry and when targets are service companies or companies with more unrecorded assets. Finally, we compare the use of earnouts with the use of stock and find that financing considerations are a more important factor in the use of stock.

Keywords: mergers and acquisitions, adverse selection, agency costs

JEL Classification: G34, G32, D82

Suggested Citation

Wolfson, Mark A. and Datar, Srikant and Frankel, Richard M., Earnouts: The Effects of Adverse Selection and Agency Costs on Acquisition Techniques. The Journal of Law, Economics, and Organization, Vol. 17, pp. 201-238, 2001. Available at SSRN: https://ssrn.com/abstract=832271

Mark A. Wolfson (Contact Author)

Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
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(650) 723-4010 (Fax)

Srikant Datar

Harvard University - Accounting & Control Unit ( email )

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Boston, MA 02163
United States
617-495-6543 (Phone)
617-496-7363 (Fax)

Richard M. Frankel

Washington University in Saint Louis - Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

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