Putting Your Money Where Your Mouth Is: The Performance of Earnouts in Corporate Acquisitions

Abstract

This Article extends the existing literature on contingent earnout provisions in merger agreements by examining the actual performance of these provisions and drawing conclusions about their adequacy as contractual responses to asymmetric information. Recently available data suggests that actual target company performance post-closing often falls short of the expectations of both buyers and sellers – even when those expectations have been discounted for risk. The consistent failure of sellers to meet earnout targets of all types and the declining values of contingent earnout payment suggests that the earnout provision may not be an adequate response to the dual problems of adverse selection and moral hazard. Rather than be an effective contractual tool to overcome information asymmetries, earnouts may be more modestly credited with the distribution of the costs of uncertain adverse outcomes between the parties, thereby insuring buyers against the risk of overpayment without necessarily the benefit of the revelation of private information. Consequently, the earnout mechanism may not have the level of utility ascribed to it by academics studying transactional law. These conclusions with respect to the utility of earnouts have implications for the larger normative project for transactional lawyering, which seeks to provide a conceptual framework to guide the study and teaching of transactional law.