Abstract
ABSTRACTContingent considerations (earnouts) in acquisition agreements provide sellers with future payments conditional on meeting certain conditions. Prior research provides evidence that acquiring firms use earnouts to minimize agency costs associated with acquisitions. Using earnout fair value information, recently mandated by SFAS 141(R), we provide new insights into the economic determinants to include earnout provisions in acquisition agreements, including motivations to resolve moral hazard and adverse selection problems, bridge valuation gaps, and retain target firm managers. We document variations in initial earnout fair value estimates and earnout fair value adjustments that correspond with these underlying motivations. We also provide evidence that target managers stay longer with the firm after the acquisition when earnouts are included primarily to retain target managers. Finally, we demonstrate that earnout fair value adjustments required by SFAS 141(R) provide valuable information to market participants and are negatively associated with the likelihood of contemporaneous and future goodwill impairments.
Highlights
Contingent considerations are provisions of acquisition agreements that provide sellers with payments conditional on the occurrence of specified future events or meeting certain conditions
We find that earnout fair value adjustments are negatively associated with the likelihood of contemporaneous and future goodwill impairments
When we allow the coefficients to vary for upward (EOAdjUpq) and downward (EOAdjDownq) earnout fair value adjustments in quarter q, we find that downward earnout fair value adjustments are significantly related to the probability of contemporaneous goodwill impairments, while there is no significant relation with upward earnout fair value adjustments
Summary
Contingent considerations (hereafter “earnouts”) are provisions of acquisition agreements that provide sellers with payments conditional on the occurrence of specified future events or meeting certain conditions. We find that earnout fair values are a smaller percentage of the maximum earnout payment amounts when firms primarily include earnouts to resolve adverse selection problems and bridge valuation gaps between the acquiring and target firms, which is consistent with high uncertainty underlying these earnouts. For these earnouts, we find earnout fair value adjustments to be large with high standard deviation, consistent with the resolution of uncertainty over time. Our study establishes a link between earnout fair value adjustments and the likelihood of contemporaneous and future goodwill impairments, and contributes to the literature on goodwill impairments by identifying leading and timely indicators of goodwill impairments
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