۱- Introduction

۲- Earnouts and acquirer financial constraints

۳- The prior literature on earnouts

۴- Data

۵- Multivariate analysis

۶- Conclusion

References

Abstract

We present evidence that earnout agreements in acquisition contracts provide a substantial source of financing for acquirers. Acquirers in transactions with earnouts are significantly more likely to be financially constrained, face tighter credit market conditions, and use less debt and equity to fund acquisitions. Financially constrained acquirers also book lower fair values for the contingent claim. Earnout use is more likely in transactions that involve liquid sellers, and earnout bids garner higher transaction valuation multiples. Overall, the evidence suggests that earnouts are an economically material and increasingly common source of acquisition financing for acquirers with limited access to external capital.

Introduction

In Modigliani and Miller’s (1958) perfect capital market, all profitable investments receive funding. However, market frictions can drive a wedge between the efficient allocation of capital and valueincreasing investment. Without access to capital markets, firms must forego valuable projects, engage in liquidity management, or find alternative sources of capital to fund investments. In the context of corporate mergers, Harford (2005) shows that sufficient capital and liquidity must be available for firms to efficiently reallocate assets following economic and technological shocks. Almeida, Campello, and Hackbarth (2011) highlight the importance of financial slack from credit lines to finance acquisitions. Similarly, Harford, and Uysal (2014) note that the intensity of acquisition activity is greater for firms with a debt rating. In this paper, we consider how a contracting provision in acquisition contracts, commonly referred to as an earnout agreement, represents a valuable and increasingly common source of liquidity for financially constrained acquirers. Earnout agreements stipulate that acquirers withhold a portion of the total merger consideration until target managers achieve pre-specified performance objectives. These objectives are typically related to post-merger performance measures such as cash flows, sales or earnings. Given their contingent nature, the prior literature has largely focused on the use of earnouts as a contracting device to resolve conflicts between acquirers and targets when transactions entail significant information asymmetry about the value of target assets, or when there are concerns about post-contractual moral hazard. A variety of papers including Kohers and Ang (2000), Datar, Frankel, and Wolfson (2001) and Cain, Denis, and Denis (2011) provide substantial evidence that is consistent with information-based explanations for the use of earnouts. Earnout agreements can also be an important liquidity management tool for financially constrained acquirers. On average, earnouts delay the term of the full payment for the acquisition by approximately three years.