Resolving Information Asymmetry Through Contractual Risk Sharing: The Case of Private Firm Acquisitions

Abstract

When private firms are acquired, buyers commonly rely on seller financing and earnouts. Using a novel database of private acquisitions, I find that seller financing and earnouts become more common as information asymmetry increases between the acquirer and the target. Financial statement audits of the targets attenuate these results, which suggests that audits decrease information asymmetry in firm acquisitions. Seller-financed acquisitions also close faster and at higher prices, reducing the private firm discount. These findings suggest that these contract structures are an important channel through

Earnouts: The real value of disagreement in mergers and acquisitions

“…Seminal papers on earnouts (Datar et al, 2001;Kohers & Ang, 2000;Ragozzino & Reuer, 2009) found that such contracts are generally used in transactions where substantial uncertainties exist about the future performance of the acquired entity, or in general about its intrinsic value. By linking part of the payment to the performance of the target following the closing of the deal, earnouts allow for an ex-post verification of the target's value, thus limiting information asymmetry issues (see also Jansen, 2020). Indeed, the authors documented that these contracts are mainly applied in the acquisition of private companies and subsidiaries, for which no market price is available to shed light on their value; in cross-industry acquisitions, where the bidder may lack sufficient expertise on the target's business and, thus, the risk of an overpayment is higher; in the acquisition of startups and in general firms with sizeable growth opportunities, or firms with large amounts of intangible assets, all cases where the uncertainties in the target's future prospects are particularly severe.…”

Fair Value of Earnouts: Valuation Uncertainty or Cookie Jar Reserve?

“…These earnout thresholds are typically related to the target's post-acquisition performance (e.g., sales, earnings or project milestones), and the earnout period ranges from one year to more than five years (Datar et al 2001). 4 Prior studies provide substantial empirical evidence that the use of earnouts is an effective contractual mechanism to bridge a valuation gap between the target and acquirer (Barbopoulos and Sudarsanam 2012;Jansen 2020), retain target management (Cain et al 2011;Cadman et al 2014), or serve as a source of financing for constrained acquirers (Bates et al 2018). Hence, earnouts are used mostly in acquisitions of private targets or targets in certain sectors with high business uncertainty.…”

“…Non-public acquirers are an ideal comparison group to public acquirers with respect to the use of earnouts. The ubiquitous benefits of using earnouts (i.e., mitigating valuation risk, alleviating acquirers' financial constraints) also apply to private acquirers (Jansen 2020). Nevertheless, public firms are more likely to boost short-term profitability because they face greater capital market pressures on near-term performance than do private firms (Golubova and Xiong 2020).…”

“…This finding has an intuitive explanation. The major benefits of using earnouts, e.g., bridging a valuation gap between transaction parties (Cain, Denis, and Denis 2011;Cadman, Carrizosa, and Faurel 2014) or serving as a financing source for constrained acquirers (Bates, Neyland, and Wang 2018), apply to both public and non-public acquirers (Jansen 2020).…”

“…Our findings also provide insights into factors influencing earnout contracting. Prior work largely focuses on the role of earnouts in either reducing valuation risk or serving as a financing source in acquisitions (e.g., Datar, Frankel, and Wolfson 2001;Cain et al 2011;Barbopoulos and Sudarsanam 2012;Bates et al 2018;Jansen 2020). However, there is a lack of clear evidence as to whether fair value accounting for earnouts has a causal impact on earnout contracts.…”