M & A Law Prof Blog

Editor: Brian JM Quinn
Boston College Law School

Tuesday, March 9, 2010

More on Earnouts

More on why earnouts are a bad idea - a new paper by Libby Weber, The Right Frame of Mind for M&A.  One quibble - although earnout targets or benchmarks are often not meant, this doesn't mean that they are not paid out.  Indeed, if the personnel are valuable to the acquisition, it's important to keep them properly motivated.  And there's nothing less motivating than being told that although you and your team have been working hard that you missed the earnout target and aren't going to get paid.  This is exacerbated by choosing poorly fitting earnout targets that might be out of the control of most of the earnout recipients, a common problem with earnouts.  So it shouldn't be surprising that many buyers will pay earnouts even though they aren't earned.  Of course, my knowledge on this score is anecdotal.  It strikes me as almost unknowable empirically.  Actually, I take that back.  It is knowable, it just takes a lot of work to put the data together!  I guess that's why we have summers.  Just another project to add to the list. 
Abstract: According to agency theory, including performance-based consideration (earnout clauses) in the merger contract should align parent and retained target management incentives, leading to better merger performance. Yet, earnouts are frequently not paid out because retained target management fail to reach the performance milestones specified in the contingent provision. So, why does incentive alignment fail? The decision-making literature offers a possible explanation for the inconsistency. Prospect theory suggests that the performance contingent consideration in an earnout clause may be framed as a potential loss or gain, leading retained target management to display risk-seeking or risk-averse behavior. Risk-seeking or risk-averse behavior may positively or negatively impact merger outcomes, depending on the merger characteristics. In this paper, I examine whether specific merger characteristics, including parent’s customer strategy and characteristics of the target’s technology, impact if the M&A deal value is framed in terms of total consideration (earnout is perceived as a potential loss) or guaranteed consideration (earnout is perceived as a potential gain).



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