M & A Law Prof Blog

Editor: Brian JM Quinn
Boston College Law School

Tuesday, July 22, 2014

Choi on Earnouts

I'm not an earnout fan. They're usually more trouble than they are worth.  Nevertheless ... Albert Choi has posted a new paper, Facilitating Mergers and Acquisitions with Earnouts and Purchase Price Adjustments. His studies suggests that earnouts are a good response to information problems that naturally appear in acquisition transactions.  They permit parties to signal quality and thus avoid the lemons problem. I don't disagree with any of that. Here's the abstract:

This paper examines how post-closing contingent payment (PCP) mechanisms (such as earnouts and purchase price adjustments) can facilitate mergers and acquisitions transactions. By relying on verifiable information that is obtained after closing, PCPs can mitigate the problems of asymmetric information over valuation and, in contrast to the conventional understanding, this benefit applies to both earnouts and purchase price adjustments. When both the acquirer and the target are aware that there is a positive (but uncertain) surplus from the transaction, PCPs function more as an imperfect verification, rather than a signaling, mechanism and a pooling equilibrium is possible, in which all parties adopt a PCP. When the parties are uncertain as to whether a positive surplus exists, on the other hand, PCPs function as a separating device, in which the seller with a positive surplus successfully signals its valuation with a PCP. The paper also addresses the problems of post-closing incentives to maximize (or minimize) the PCP payments. When such a moral hazard is a concern, the paper shows that (1) the PCPs will be structured so as to minimize the deadweight loss and a separating equilibrium is more likely to result; and (2) when the deadweight loss is sufficiently large, the parties will forego using a PCP mechanism altogether.



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