Facilitating Mergers and Acquisitions with Earnouts and Purchase Price Adjustments

The following post comes to us from Albert H. Choi, Albert C. BeVier Research Professor of Law at University of Virginia Law School.

In mergers and acquisitions transactions with privately-held (or closely-held) target companies, transacting parties will often agree to make payments to the target shareholders contingent upon some post-closing measures. Two often used arrangements are purchase price adjustments (PPAs) and earnouts. With a purchase price adjustment mechanism, payment to the target shareholders will be adjusted based on an accounting metric (such as the net working capital or shareholders’ equity) calculated shortly after the deal is closed. For instance, with a purchase price adjustment based on the target’s net working capital, as the target’s post-closing net working capital goes up or down compared to a pre-closing estimate, consideration to the target shareholders increases or decreases in accordance. Similarly, with an earnout, the transacting parties will agree upon post-closing performance targets, using measures such as earnings, net income, or gross revenue, and the amount of consideration that the target shareholders are entitled to receive will depend on whether such targets are met over the earnout period.

Practitioners’ understanding of why parties utilize such post-closing contingent payment (PCP) mechanisms is that they make it easier for the transacting parties to come to an agreement, particularly when the valuation of the target company is subject to some uncertainty. More nuanced rationales over these two mechanisms differ, however. According to practitioners, purchase price adjustments are used when transacting parties basically agree on the valuation of the target but the valuation is subject to (common) uncertainty that poses the risk of over- or under-payment for the target. In contrast, earnouts are useful when the parties cannot agree on the valuation of the target. For instance, when the seller argues that the target is worth $12 million while the buyer thinks it is worth $10 million, rather than trying to narrow that valuation assessment gap, by agreeing to pay $10 million at closing but making additional $2 million to be triggered based on some post-closing performance metric (such as earnings or net income) as an earnout, the transacting parties are supposedly better able to come to an agreement on the valuation issue.

At the same time, practitioners also emphasize that implementing such post-closing contingent payment (PCP) mechanisms is notoriously difficult and the use of such mechanisms will often engender serious post-closing disputes. Such concerns are directed particularly towards earnouts, which typically last for a longer period (one to five years) than purchase price adjustments. One particular concern is the transacting parties’ post-closing behavior. If the seller is paid $10 million at closing but is promised a $2 million earnout contingent on certain target accounting measure being met within the earnout period, when the operation of the business remains under the seller’s effective control, to the extent that there often is much discretion in calculating accounting measures and that accounting measures can diverge from fundamentals, the seller’s incentive would be to maximize the chances of collecting the earnout rather than improving the long-term health of the company. If the buyer is left in charge of the operations, the opposite may happen. Partly due to such concerns, influential practitioners Lou Kling and Eileen Nugent have even noted that earnouts “are a nightmare to draft, negotiate and…to live with,” and as a result, transacting parties would often “give up on [negotiating an earnout] before too long—they simply compromise on the price.”

The purpose of my paper, Facilitating Mergers and Acquisitions with Earnouts and Purchase Price Adjustments, is to better understand the advantages and disadvantages of post-closing contingent payment (PCP) mechanisms in mergers and acquisitions with the help of game theory. The paper presents a simple bargaining game between two players, a buyer and a seller, in which, the parties can utilize a PCP mechanism to tackle bargaining challenges. Importantly, the paper examines two informational environments. In the private information (PI) setting, the seller is endowed with some private information (represented as the seller’s “type”) over the valuation of the seller’s assets, and attempts to use its informational advantage to extract the best possible terms from the buyer. In the non-convergent priors (NP) setting, both parties may attach different opinions (“beliefs”) about the valuation and such difference is known by both, but they fail to agree on a single valuation. In particular, we are interested in a setting in which the seller may be more “optimistic” than the buyer about the underlying value of the assets and is unwilling to compromise its belief solely to close to deal.

In the private information (PI) setting, if the seller has to make a single-price offer, not all positive-surplus transactions get consummated since the buyer becomes skeptical when the seller claims high valuation to the buyer. The parties similarly fail to reach a deal in the non-convergent priors (NP) environment if they have to agree on a single price, unless the difference in beliefs is sufficiently narrow. The paper shows that with a post-closing contingent payment (PCP) mechanism, the parties can alleviate or eliminate the inefficiency that stems from the information asymmetry or the non-convergent priors. By making the buyer’s payment contingent upon post-closing, verifiable information, the parties can tailor the expected payment by the buyer to the underlying valuation. In the private information (PI) setting, for instance, even for the identical payment structure of $9 million at closing and $5 million earnout, if the “high-type” seller has a 60% chance of collecting the earnout while the “low-type” seller has only 20% chance, the buyer’s expected payment will differ by $2 million ($12 million versus $10 million), thereby allowing de facto separation. In the non-convergent priors (NP) setting, using a set of prices that depend on post-closing, verifiable information allows the parties to simultaneously satisfy the divergent views on valuation and successfully close the deal.

The fact that PCP mechanisms are harnessing post-closing, verifiable information has two important implications for the current understanding of the mechanisms. First, notwithstanding the practitioners’ understanding over the different uses of purchase price adjustments and earnouts, to the extent that both rely on post-closing information, both mechanisms can have a similar function of alleviating informational issues between the parties. That is, both can be used to reduce the problems of private information. Second, particularly with respect to the private information issues, because a PCP arrangement incorporates post-closing information, it functions differently from conventional signaling mechanisms. Empirically, it may be unclear whether the adoption of a PCP mechanism operates as a “signal” of high valuation. For instance, suppose the “high-type” seller is worth $12 million while the “low-type” seller is worth $10 million and the former has 60% chance of achieving an earnout target while the latter has only 20% chance. In equilibrium, it is possible for both types to agree to a payment structure of $9 million at closing and $5 million as an earnout. Both types of seller pool and separation is achieved through differences in probability of earnout collection. If such a pooling equilibrium is in play, empirically observing a certain earnout structure may not tell us much about the characteristics of the target company.

The paper also presents an important variation to the model by explicitly incorporating the problems of inefficient post-closing incentive (problems of moral hazard) created by a PCP mechanism. Particularly with an earnout, when the seller is in charge of the operation of the assets after closing, the seller may want to maximize the earnout at the cost of reducing the fundamental value of the assets. If the buyer were in charge, the earnout may create the opposite incentive. Fully rational parties will take such post-closing inefficiencies into account when designing earnouts. In the private information (PI) setting, a separation based on the seller’s types is also likely to result since the low-valuation seller (the “low type”), for whom earnouts are less valuable, will more likely not to use an earnout. In both private information (PI) and non-convergent priors (NP) settings, when the problems of moral hazard are severe, transacting parties are likely to decline to adopt a PCP mechanism. The paper shows that the parties are less likely to use an earnout as the variation in valuations gets smaller (so that the inefficiencies from private information or non-convergent priors become smaller).

The full paper is available for download here.

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