The Concept of Earnout in Merger and Acquisition Transactions

Abstract

This research paper throws light on assessment on merger and acquisition (M&A) deals based on earnouts. It is often said that M&A transactions involving earnouts possess option-like features, and thus this research paper using a theoretic approach to model the value of such observations made. Moreover, the impact of uncertainty on the optimal timing of M&A using earnouts has been dealt with in this paper. This paper shares a dynamic decision-making approach of the invest-to-learn option which is generated on account of investment made in an acquisition. This research paper also provides the implications of earnouts applied in M&A transactions.It has been found that earnouts provide best hedge to the acquiring companies for minimizing the risk of adverse selection in acquisitions. The reason being earnouts enable an acquiring company resolve the problem of over-valuation and that of non-performance by making part payment contingent on the ex post performance of the target company as well as by retaining target company’s managers respectively. The paper recommends earnouts as a valuable strategy for the acquiring companies in the emerging markets for their future global acquisitions as these companies usually end up overpaying the target companies due to lack of expertise in acquisitions. The paper has tried to fill the void in the existing literature by explicitly analyzing the impact of the different modes of payment on the risk profile of acquiring companies in the post acquisition period.