The Mitigation of Asymmetric Information through the Use of Earnouts

We examine the use of a contracting method in mergers and acquisitions known as an earnout. In this type of transaction, the bidder agrees to pay the target an initial amount for the acquisition plus future payments contingent on the achievement of performance milestones. Theory suggests that the contingent payment associated with earnouts should reduce adverse selection problems facing both parties in the merger. The purpose of this dissertation is to study the ability of earnouts to mitigate problems associated with asymmetric information and problem of agency. Specifically, we answer the following questions in analyzing these transactions. First, empirical evidence suggests that earnouts are used in response to differing problems associated with severe informational asymmetries. Given that there are existing technologies addressing these same problems, what is the role of the earnout? To shed light on this issue, we examine a sample consisting of earnout transactions. We also examine the method of payment in these deals and use of investment bank advisors in these transactions. These are two characteristics of acquisitions identified in the literature as mitigating problems associated with informational asymmetries and agency. Second, are earnouts value-increasing events, and if so, how are the gains split between the parties? To answer this question we recognize three sources of value in earnout transactions: (a) merger synergies (b) reduction of problems associated with asymmetry of information and (c) incentive alignment. To isolate the information effects we compare our sample of earnout transactions involving publicly traded targets to a matched sample of traditional acquisitions of public targets, to separate the sources of value created in these transactions. By isolating these effects we are able to test hypotheses concerning the mitigation of problems associated with agency, inefficient risk sharing and informational asymmetries.