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

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

By
Srikant Datar, Richard Frankel, Mark A. Wolfson
Journal of Law, Economics and Organization.
2001, Vol. 17, Issue 1, Pages 201-238

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.