The Use of Earnouts in the Financial Sector Industry Essay

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The Use of Earnouts in the Financial Sector Industry

Introduction

The impact of control and ownership on companies and institutions has been a prominent topic of interest among financial economist since as early as the works of Berle and Means (1930). Mergers and acquisitions are a laboratory for the study of this separation of ownership and control and the problems that ensue. One basic fact that stands out from the numerous studied in this regard is that the successful completion and implementation of a corporate merger and acquisition poses several challenges not only to the acquiring firm but also target firms (Kohers and Ang, 2000).

Several academic works examining the merger exercise have identified the several problems associated with the process. First is the asymmetries of information; private information on both sides of the transaction creates a gap between the target’s and the acquirer’s estimate of the intrinsic value of the deal.

Second is that of agency; though target managers can be critically important for the successful integration of the target and acquiring firms, it is often very difficult to retain them following the acquisition. Another issue is that having received a premium based on expected synergies from the acquisition, target manager-shareholders may have little incentive to generate those synergies even if they do remain with the combined post-acquisition firm (Morck et al 1990; Mulherin and Boone, 2000).

As a result of these issues that often complicate merger process, numerous contracting technologies have evolved to reduce some of these problems inherent in merger and acquisition. In most cases, the major problem is that each party to the merger has incentives to propose a contract that overvalues itself and undervalues its opponent, thereby gaining a larger share of any benefits to the merger. Another possible problem is that informational asymmetry between the two parties may be such that a high quality target may not be identified or if identified may not be able to credibly reveal its value to the bidding firm (Mulherin and Boone, 2000).

Earnouts represent one unique contractual means by which several of these challenges can be addressed. Specifically, payments to shareholders in acquisitions can consist of two components: an upfront fixed payment and additional future payments that are contingent upon some observable measure of performance. This latter payment, commonly referred to as Earnouts, is the focus of this paper.

Although the term “Earnout” is commonly applied to the entire transaction when referring to the contracting form, the Earnout itself, however, is only the contingent payout received by the target at the specified period after meeting the specified target. By tying the target’s consideration in the acquisition to future performance, the Earnout can bridge a valuation gap between the target and the acquirer that is caused by disagreements about the target’s expected future performance (Kohers and Ang, 2000).

Moreover, because the consideration received by the target is contingent on future performance, target manager-shareholders have an increased incentive to remain with the firm in order to maximize this performance. These benefits are not without cost, however. With an Earnout, the target bears greater uncertainty about the magnitude of the acquisition premium, particularly if a portion of the contingent payment depends on the competence of the acquirer’s management. In addition, although the Earnout addresses one type of agency problem, it potentially creates new agency problems.

For example, the acquirer’s management will now have the incentive (and ability) to manage the performance measures in a way such that the contingent payment to the target is reduced. One way to do this is through the allocation of joint costs. Alternatively, depending on the nature of the Earnout, the target may have the incentive to maximise short-term performance at the expense of long-run value. For example, if the Earnout is tied to short-term earnings, target managers might reduce research and development expenditures that would otherwise increase the target’s value. The choice of whether to use an Earnout and how that Earnout should be structured, therefore, entails the tradeoffs of several costs and benefits (Kohers and Ang, 2000; Datar et al 2001).

The last few years have witnessed a surge in the number of contracts resulting to Earnouts, Richmond and Dahl (2003) opine that recent market pressures might have been influencing many deal makers to include Earnout provisions in their contract structures. The author reports that Earnout contingency terms were found in 4% of all reported US deals and nearly 10% of reported deals valued at, or below $250 million in the first four months of 2002, with the percentage of reported deals including earn-outs increasing each year since 1999.

Furthermore, it is reported that several informal surveys involving local investment bankers, attorneys and venture capitalists suggests there has been a significant rise in the number of transactions including earn-outs in the latter part of 2002 and continuing into 2003, particularly where the selling company may have promising but immature technology as its primary asset (Richmond and Dahl, 2003). In the same light, Hanley and Hand (2006) of KPMG reports that contrary to the earlier held notion that the use Earnouts was restricted to smaller deals, several medium to large deals are recently resorting to the use of Earnouts.

They reported the merger deal between Google and dMarc Broadcasting, which runs an online system enabling advertisers to buy radio airtime. In the deal, the upfront purchase price was only $102 million. However, Google agreed to pay dMarc’s shareholders up to a maximum of $1.136 billion in contingent payments over the next three years if certain product integration, net revenue and advertising inventory performance targets are met (Hanley and Hand, 2006).

However, as mentioned earlier, Earnout is not without its costs and risks. Earnouts impose the costs of inefficient risk sharing, increased contractual complexity, increased administrative costs, and litigation risk potentially offsetting any informational benefits. Despite these facts, the use of this contingency payment alternative in mergers and acquisitions has continued to grow. The increased use of Earnouts despite their costs and complexity implies that the benefits associated with this acquisition vehicle outweigh its costs. That is, the gains an Earnout creates or the problems it solves, must be of some significance in order to outweigh the pitfalls that the use of this contracting technology entail (Datar et al 2001).

Therefore, the purpose of this paper is to examine the motivations for use, and the advantages and disadvantages of Earnout use, especially in the financial sector. Subsequently, the author will focus on the use of Earnouts in financial deals and attempt to understand the peculiarity or the factors/circumstances that have made Earnout more readily employed in financial deals compared to deals in other sectors of the economy. In this regard, the rest of the paper will be structured as follows: the next section will provide a background understanding to the study.

Here Earnouts will be examined in the light of other payment options for merger deals, with a view to better understand this concept. The third section of the paper will be a thorough literature review on Earnouts. Here the several features of Earnouts, the motivations for the use of this contracting tool and the numerous identified advantages and disadvantages of Earnout will be highlighted. The fourth section will look at Earnout in the financial sector and seek to explain why this tool is more frequently employed in financial deals compared to other industries. The last section of the paper will be a summary of the facts presented in this paper.

Background

It is obvious that due to several challenging factors, such as the inaccessibility of the public markets and the substantial reduction in venture capital and other growth financing which combine to limit organic growth opportunities and thus resulting in increased merger and acquisition activities, there are increasingly more hurdles to be crossed for merger deal to be successfully and favourably (to both parties) completed.

The gaps in price expectations between buyers and seller have continually being a worrisome problem in merger deals. Moreover, as said earlier, there exist on both sides of the deal, the incentive to propose a contract that overvalues itself and undervalues the other party, thereby gaining a larger share of any benefits that accrue from the merger deal. In the bid to resolve these informational conflicts, several contracting solutions have been invented with the most common ones being: joint venture, partial acquisition and lastly, the Earnout (Kohers and Ang, 2000).

The joint venture approach mitigates these aforementioned issues with merger deals by allowing all parties increased monitoring over the assets contained in the joint venture, allowing for a more informed determination of the assets value and quality. If expectations about the assets in question do not come to fruition, the venture can be terminated. In joint ventures, two or more entities form a corporate alliance involving the joining of assets to accomplish a specific, limited objective. The combined management controls the assets of the joint venture.

Several research studies have shown that these transactions are for the most part, value increasing. The usual explanation is that joint venture that combine specific operations of two firms should generate gains in productivity (synergy) and thus increase the combined market values of the participating firms. Joint ventures are an alternative to a merger or asset sale when a firm has a value-creating project but has limited free cash flow and adverse selection problems that restrict its access to the external capital markets (Lewellen et al, 1999).

The joint venture creates a relationship that reduces asymmetries of information, and can facilitate the financing of projects or the sale of assets. Rather than engaging in a conventional asset sale, a firm can place an asset into a joint venture that is co-owned by a partner firm that is, in effect, a potential buyer. In turn, the potential buyer, while a partner in the ongoing joint venture, has an opportunity to participate in the management of the asset and to gather information about its value before deciding whether to purchase the remaining stake of its partner in a second stage transaction (Lewellen et al, 1999; Martin, 1996).

Like joint ventures, Partial acquisitions can also mitigate informational problems by giving a buyer a major ownership interest in the target firm. The buyer increases monitoring, and can make a more informed decision concerning the value of the target in question. If the prior beliefs concerning the value of a combination of the two firms are not realized, the remaining shares of the target will not be purchased and the bidding firm can sell its equity claim on the target. In partial acquisitions, one entity obtains shares in a target firm such that their ownership stake in the corporation effectively gives them control.

However, this equity purchase is not accompanied by the intent to acquire the remaining shares of the target firm’s stock. Effective control of the firm is transferred to the majority shareholder from the target firm. The target firm is still a distinct legal entity, but is an affiliated subsidiary of the acquiring firm. Evidence, from several literatures, show that partial acquisitions are value enhancing for the target firms and at least a non-negative event for bidding firms.

As in mergers and acquisitions, the change in control of the assets in question is value enhancing and the same explanations for the observed excess returns in mergers holds for partial acquisitions. These explanations, mentioned earlier, can be grouped as efficiency theories, information theories, and theories of agency (Lewellen et al, 1999; Martin, 1996).

Joint ventures and partial acquisitions attempt to circumvent the problems associated with asymmetry of information by providing an “engagement period” in which each party can monitor the other and gain improved information concerning the value of a combination. Therefore, each of these techniques carries the likelihood that sometime in the future, a re-contracting will occur resulting in a completed acquisition. These solutions, however, add the risk of never being completed, in the sense that there is no explicit, final step merging one firm wholly into the other (Martin, 1996; Rau, 2000).

This is where the overriding importance of Earnouts as a merger tool comes to light. An Earnout mitigates informational asymmetries by shifting some of the risk of misevaluation to the target firm. If a bidder misvalues a target, the contingent payment portion of this deal will be reduced, possibly to zero. The Earnout contract also provides the target with the ability to signal its quality. Only high quality targets will agree to have a larger portion of the deal to be paid as a contingent claim based upon future milestones of the combined firm (Kohers and Ang, 2000).

The Earnout alternative is a relative newcomer to contracting technologies in mergers and acquisitions. It involves a contract in which the buyer agrees to pay the seller an initial amount for the acquisition plus a predetermined future payments predicated on the seller’s achievement of certain performance milestones within a specified time period. In this agreement, the acquired assets can be those of either an entire firm or a subsidiary of a firm. It has been argued that the use of this technique in acquisitions leads to a mitigation of buyer’s misevaluation resulting from informational asymmetries between the parties and alleviates adverse selection problems associated with the significant informational asymmetries and agency problems in these transactions.

Yet another reason for the popularity of this acquisition vehicle is that it facilitates retaining valuable human capital from the acquired firm. The contingent nature of this type of contracting method can be arranged such that owner/operator knowledge is retained, non-competitive constraints are placed on these individuals, and the retained human capital has the incentive to put forth optimal effort in order to maximize the contingent payments associated with an Earnout (Kohers and Ang, 2000; Rau, 2000).

Initially, Earnouts were mostly used as a tool for acquiring private or small companies; however, there is growing trend towards the use of Earnout even when public targets or larger deals are involved. While some authors have contended that Earnout is more likely to be used if the target company is a hi-tech or service sector (Datar et al, 2001), however, the present situation implies that Earnouts cut across sectors, and is more commonly used in the finance sector.

In order to adequately understand why this merger tool is becoming more attractive to all sorts of merger deals, it is pertinent to fully comprehend the motives behind the use of this contracting tool, the structures involved and the pros and cons of Earnouts. This paper, through the following sections, therefore seeks to sufficiently illuminate this contracting technique as reported and recorded in several literatures.

Literature Review

Though a latecomer to the field of merger and acquisition deals, Earnout has earned itself considerable attention, not only due to its ability to mitigate information asymmetry and valuation differences that often plague merger deals, but also due to the several agency issues that this contracting technique imposes on the contracting parties (Craig and Smith, 2003).

In one of the very first empirical research studies on Earnout, Kohers and Ang (2000), contend that differences in the expectations about target value is one of the prominent disagreement that often occur between bidders and target in a merger negotiation. Furthermore, these valuation disagreements may be more severe when realisable value of the target depends largely on human capital, such as key managers, who may or may not want to stay after the merger.

The importance of Earnout as contracting technique sterns from the fact that it can adequately provide solutions to these issues. Earnout, has it is practiced, involves a two-part payment; a front end payment at the time of the merger, and a deferred payment or Earnout, which is predicated on the ability of the target company to achieve certain predetermined performance standards within a specified period of time.

The bottom line is that Earnout allows bidders and targets to disagree on their valuation and yet agree to complete the transaction. Therefore, Earnout holds potential and real benefits for both parties in the merger negotiation; it allows the high quality target, who wants to hold to its her expectations to continue with the deal, while at the same time saves the less informed bidder the risk of overvaluation of the target (Kohers and Ang, 2000; Craig and Smith, 2003).

After examining over 900 large merger deals that involve the use of Earnouts, these authors report that the two part payment system enforced by Earnout may serve as a risk reducing mechanism for bidders by hedging against the risk of misevaluating thventures with potentially high asymmetric information. It can also act as a deferred compensation mechanism to retain to retain valuable owners/managers of the target firm.

The study also reported that Earnout was more likely to be employed in acquisitions of divested subsidiaries, privately held target firms and takeovers involving bidders and targets from different industries. However, Earnout has not been without its cost and risks, although, this appears not have affected the reliance on this contracting tool in finalising complex merger tools. This section will examine the motivations for the increasing use of Earnout in merger negotiations, despite its downsides, the merits and risks involved with using Earnouts and the structures put in place by an Earnout deal.

Motivations for the use of Earnouts

To better understand the rationale behind the choice of Earnout deal, on both sides, it is necessary to present the scenario highlighted by Kohers and Ang (2000). It is a known fact that differences in expectations about the target’s true value are often the major cause of disagreement between bidders and targets in merger deals. In a scenario where the difference between the bidder and target on valuation is significant, transactions that require a single upfront payment holds grave risk for both parties, and so, may both be the optimal contracting style.

On the bidders’ side, being the less informed party, he stands the risk of paying too much for the target. While on the target’s side, too, being the party with the most information, there a risk of not receiving the eventual expected worth of the deal. Apparently, there is a very low probability of a mutually beneficial deal taking place. Even with the other alternative of payment in the bidders’ stocks, there is still no chance of a mutually beneficial deal taking place.

The bidder stands the risk of bearing the greater risk, particularly, due to the fact that the target’s ownership in the merged firm is usually relatively small, the bidder would have to bear a disproportionately larger consequence of misevaluation error, as reflected in the post-offer adjustment in the stock of the combined firm. In theory and practice, when Earnout is used as the contracting tool, barring any ugly situation, both parties take equal share of the risks involved in the deal (Mendoza, 1992; Roccili and Joseph, 2001).

Bidders Motivation

Bidders propose Earnout contracts for a variety of reasons, ranging from reduction of the problems associated with asymmetry of information, to reduction of problems associated with agency. It is well known that successful bidders in competitive auctions, including mergers, are likely to overbid, whether due to over optimism and hubris (Roll, 1986) or as a form of winner’s curse resulting from incomplete or uncertain information (Eckbo, et al., 1990).

The latter is especially likely when the target is a private firm, a firm with few assets in place, or when the value of the target is dependant upon the knowledge of the managers or clientele relationships that can easily “pocketed” and taken to another firm. In the absence of competition (explicit or implicit) for the target firm, however, the bidder is likely to protect itself against overbidding resulting from incomplete information about the target and offer a lower price. In cases when the target firm is informationally opaque, managers of the target firm are unable to credibly convey their favourable private information to the bidder (Eckbo, et al., 1990).

The Earnout mitigates this problem through the contingent payments associated with the contract. The bidder will be able to adhere to its valuation of the target by structuring the upfront payment and the contingent payments in such a way that its valuation is verified if the target performs as the bidder predicts. The bidder and the target agree on contingent payments tied to various milestones concerning future performance and structured to reflect the payoffs each believes appropriate to compensate the target. If the future milestones are met and exceeded, the target owners will receive higher payouts, which will compensate them in such a way that is more in line with their own valuation.

Targets’ Motivation

The target can also use the Earnout agreement as an opportunity to signal their quality to the bidding firm. For a signal to be credible, it must be costly to replicate. The proportion of the transaction value that the target is willing to take contingent on future performance serves this purpose. In effect, the situation is the same as the model presented by Leland and Pyle (1977). In their model, an entrepreneur signals the quality of his future opportunities by the amount of ownership he retains in his firm.

By a target accepting a deal that has a greater proportion of the transaction value contingent on future performance, the target is signalling a high quality of future prospects to the bidding firm. This signal is costly to replicate for low quality firms due to the fact that these firms will not be able to achieve the future performance milestones required for the contingent payments to be made. Knowing this, the low quality firms would want to receive the highest upfront payout possible.

The Earnout, as mentioned earlier, also helps to mitigate problems associated with agency. If a target firm is in a service or hi-tech industry, for example, proprietary knowledge and the existing human capital are necessary to the continued success of the firm. Existing clientele relationships are extremely portable, and these relationships are also necessary to the firm’s success. Thus, the retention of key personal is essential to preserving the value of the target.

The Earnout helps to alleviate some of these concerns by requiring key personnel to remain with the firm after the acquisition takes place. The Earnout also helps to align the incentives of these key personnel with those of the shareholders in the combined firm. The contingent payments are, in effect, an equity claim on the post-merger performance of the target (the Earnout is not necessarily an equity claim on the combined firm, however. The contingent payoffs should be based on the post-merger performance of the target only (Slovin et al., 2003).

The Earnout can also facilitate financing the acquisition. If a high growth firm is acquiring another high growth firm, the bidder can use an Earnout agreement in order to postpone some of payment necessary to secure the deal. This type of agreement is superior to an issuance of stock to finance the deal, due to the fact that the target will not be able to share in the future prospects that the bidding firm already has in place prior to the acquisition.

With the Earnout, the only future prospects that the target will share in are those that come about from their operations (Eckbo, et al., 1990). So by using an Earnout, a bidder with valuable future opportunities can make the acquisition while keeping his financing for the future prospects of the firm and prevent the target from sharing in these gains that were in place prior to the acquisition.

Merit and Demerits of Earnouts

To The Bidder:

There are several advantages that the bidder stands to benefits from negotiating an Earnout with the target firm. However, the two primary advantages that accrue from merger negotiation where Earnout is employed are that; one, the bidder is paying less upfront for the business, and two, the bidder gets an experienced entrepreneur familiar with the business operations and existing customer base to operate the business during then transition. The implication of this is that the bidder might not need to employ a new management for the target firm and also have the added advantage of hiring someone who will be trained by the previous owner (Roccili and Joseph, 2001).

The owner/manager, in the Earnout contract, has the incentive to train a successor appropriately, as this also impacts on the value of Earnout payable to the target. But on the negative side, the purchase of a business involves considerable risk. Risk in the sense that, there is no guarantee that the new venture will be successful. Fortunately, this risk is mitigated by the use of Earnout. The less the bidder pays upfront for the target firm, the greater the expected value and the less the risk (Roccili and Joseph, 2001; Hempstead, 2000).

To The Target:

The major advantage that Earnout presents to the target is that the business is sold at a higher expected price. Earnout also allows the target the benefits of earning more than the expected value of the firm, especially if the Earnouts payments become substantial. In addition, the owner/manager is able to earn money as a salaried employee for the next couple of years. Also, the target will have some degree of control over the business operations of the target firm during the transition period, and this can considerably affect the size of the Earnout payment. Nonetheless, the target stands several risks with an Earnout negotiation.

The primary risk involved is that the target is risking the payment that should be paid for the business, i.e. the target may end up getting no Earnout, and as a result would have sold up the business for less that it was really worth, for a lower sum than the target would have received in cash transaction from another bidder. For instance, in a firm that depends on human capital, if the target firm’s personnel refuse to stay after the merger, this could greatly affect the Earnout due to the target.

Furthermore, the target firm is placing itself at the mercy of the future financial viability of the target firm. If the bidder suffers financial difficulty or is less financially strong than it was when the contract was negotiated, the Earnout payments to the target may be greatly hindered, even if the target firm successfully attains the predetermined performance measures as at when due. Although, in some situations, the Earnout agreement often has a re-purchase option with an agreed upon price, as a protection measure for the target (Roccili and Joseph, 2001; Mendoza, 1992).

Other Issues with Earnout Deals

Besides the simplistic outlining of merits and demerits of Earnout to each party involve in the merger deal, there are countless other issues that often arise and that could greatly affect the success of the negotiation. In one word, Hanley and Hand (2006) contend that Earnout though is meant to resolve problems with disagreement over valuation, often create its own valuation problems. Thus, simply including an Earnout provision in a contract does not always end the payment issues with the negotiation, because, it may even be difficult to ascertain or agree on when the Earnout is earned by the target.

For instance, once a small company is acquired by a large company, it is sometimes questionable how much control the smaller company really has over its own business decisions and growth prospects. Though an acquirer may devote some of its marketing staff to the target’s new products, the target company might still believe it is not receiving adequate staffing to meet its goals.

On the flip side, an acquirer might sometimes assume that the target is meeting its growth numbers not because of its own abilities, but simply because it is now part of a larger player with an established customer base. Other complications may result from human resources considerations. It is entirely possible that one person at the newly merged company will receive a substantial benefit if the Earnout conditions are met, but the person in the next office may not have any incentives to meet those same revenue targets (Hanley and Hand, 2006; Hempstead, 2000).

Therefore, before entering into an agreement that incorporates Earnouts, both parties need to consider these types of issues, as well as relevant accounting considerations. For example, if the Earnout is based on a net profit measure, in which “non-recurring” or “exceptional” costs are stripped out, the parties may have different views about how net profits should be calculated. The bidder may change the accounting practices of the target to bring them in line with its own, or allocate group overheads, which might lower profitability, potentially affecting the Earnout.

On the other hand, the seller, as manager of the acquired division, may be able to alter the results in its favour by deferring investment and other expenses, or bringing forward profitable fixed asset disposals. Another accounting consideration for acquirers is how the Earnout payment is treated. In purchase accounting, the Earnout may be considered future compensation, as opposed to part of the purchase price, since it is usually tied in some way to future employment (Hempstead, 2000; Roccili and Joseph, 2001; Hanley and Hand, 2006).

Variables of the Earnout Negotiation

To gain better insight into how Earnout deals are structured, it is important to look at the various variables that interplay during an Earnout merger negotiation. Here I shall look at the potential size of the Earnout payment, the type of performance measure on which contingent payments are made, the length of the Earnout period, the frequency with which performance is measured, and the form of payment.

For instance, while it is generally accepted that Earnout payments are made contingent upon some form of post acquisition performance, Cain et al (2006) further revealed, through an empirical study of several merger deals involving the use of Earnout that in 90% of cases, the Earnout is contingent on the performance of the target firm only, while in another 9% of the cases, it is contingent on the combined performance of the target and acquiring firms. However, in this study, in 0.8% of the sample mergers, Earnout payment was not contingent on the performance of either the target or the acquiring firm.

Furthermore, since in structuring an acquisition agreement with an Earnout, the target and the acquirer must agree on what portion of the purchase price will be paid at closing and what portion will be contingent upon future target performance, the study mentioned above indicated that on average Earnout is equal to 33% of the transaction value, while the maximum possible Earnout payment ranged from 1.4% of the initial transaction value to 160% of the transaction value.

Explaining this finding, the authors hypotheses that if the target and acquirer differ in their estimates of the target’s value, the fixed portion of the acquisition price will pertain to that portion of the target’s value on which both the acquirer and the target can agree, while the contingent portion reflects the difference between the target’s and the acquirer’s estimate of value. Thus, in a sense, the Earnout bridges the valuation gap between the acquirer and the target.

Again, the performance measure upon which Earnout payment is predicated differs widely across sectors and industries. Generally, though, measures most frequently adopted include sales, cash flows, measures of income and profit, and some other non-financial performance measures. The bottom line is that in order to remove valuation problems due to information asymmetry, performance measures that provide the most information about the intrinsic value of the target firm is often preferred. In this regard, net income is often considered the most informative and preferred. However, there are circumstances in which net income will not be as informative as other performance measures (Myers, 2000).

For example, if the target and acquirer are integrated following the acquisition, the acquirer will have some discretion in allocating expenses to the target. Moreover, the greater the degree of integration, the more the target’s measured income will be a function of realized synergies (e.g. cost savings) from the acquisition.

Thus the target’s post-acquisition income will be less informative regarding the target’s specific contribution to the performance of the combined firm. The implication of this argument is that the greater the degree of post acquisition integration of the target and bidder, the lesser the chances of using net income or other measures of income as the determining factor for Earnout payments. In scenarios like this, sales and other non financial measures of performance are more likely to be preferred (Roccili and Joseph, 2001).

The length of Earnout period and the frequency of Earnout payments constitute another important variable of the Earnout contract. The Earnout contract is normally supposed to end after a period of time and this period over which the Earnout extends is ordinarily the period over which information asymmetries are expected to be the most problematic or the period over which target management efforts are expected to have the most impact on firm value. From this understanding, it can be argued that this period will be longer for target firms whose current value is more dependent upon future growth opportunities than on assets in place (Martin, 1996).

However, a problem with extending Earnout contracts over longer periods of time is that it provides more opportunity for factors outside of the control of target managers to affect the value of the future contingent payments. This will be more true the greater the variability of conditions in the target firm’s industry. In the Cain et al (2006), study mentioned above, the mean Earnout for the deals sampled was 2.57years, with the deals ranging from 0.08 to as much as 20years (Cain et al, 2006). Though, there is a general understanding that Earnout contracts should last for about five years (Craig and Smith, 2003). It is not clear; however, what factors should influence the measurement interval employed in Earnout contracts, but the Cain et al study reported that over 77% of Earnout deals measure performance annually.

Thus, it could be concluded that firms who choose longer or shorter periods may have reasons idiosyncratic to the firm or its industry. But since it is reasonable to assume that the performance of assets in place can be measured more frequently than that of growth options, it could be expected that measurement interval would be positively associated with measures of growth opportunities.

The form of Earnout payment is another important part of the deal. Several literatures indicate a number of factors that could potentially influence the choice of payment; between cash and stocks, in non-Earnout merger payments. These factors include acquiring and target firm information asymmetries, risk-sharing considerations, target firm size, and the availability of cash or debt capacity (Faccio and Masulis, 2005; Martin, 1996).

Nevertheless, it could be expected that the same factors that influence payment choices in non-Earnout deals could also influence the Earnout payment choices, based on some of the reasons listed above, although there is another angle to this. It is important to note that because target firm shareholders can typically choose to sell their acquiring firm stock when they receive it, the use of stock as the non-contingent payment in an acquisition address uncertainty only through the time that the acquisition is consummated.

The portion of the acquisition payment that is contingent on future target performance, i.e. the Earnout portion, allows information that is revealed after completion of the acquisition to be reflected in the total consideration paid for the target firm. If the performance measure used in the Earnout contract fully reveals the target’s value, a cash payment should be sufficient. However, if the performance measure is less than fully revealing, payment of the Earnout in acquirer stock forces the target shareholders to share more of the risk of this valuation uncertainty. The reason for this is that the acquirer’s stock price reflects the broader effects of any information revealed about the value of the combined firm between the time of the acquisition and the end of the Earnout period (Shleifer and Vishny, 2003; Mendoza, 1992).

In sum, it could be concluded that the target’s growth opportunities and the degree of post-acquisition integration of target and acquirer are important factors that greatly influences the Earnout contract structure. Greater uncertainty is associated with larger Earnouts, shorter Earnout periods, the use of common stock for the Earnout payment, and the use of sales as the performance measure. Earnouts of targets with greater growth opportunities tend to be larger, they tend to be paid in acquirer stock, and they tend to measure performance over longer intervals of time. Earnouts of targets that operate in a different industry than the acquirer are more likely to use income as the performance measure than either sales or non-financial measures.

In conclusion, from the foregoing, it is apparent that in the absence of an Earnout, severe asymmetric information problems can produce a valuation gap between the target and acquirer that can preclude completion of the acquisition. Therefore, Earnout holds potential benefits for both parties involved in the merger negotiation. However, it is important that Earnout is not a “one size fits all” contracting technique; for the better success, it is important to have the various variables and component of the deal properly spelt out from the onset.

While it is quite beneficial to all, Earnout can lead to conflicts and serious litigations if not properly structured. All of the variables/component of an Earnout deal discussed above should be adequately taken care of during the negotiation stage. With Earnout, considerable success have been achieved with several organisations and industries, thus, it is a fact that misunderstandings and conflicts can be avoided, if both parties carry out the negotiation with each other in mind and with all the details properly identified documented. The resulting successful business will create a win-win situation for both the buyer and seller.

Part II
Use Earnout in the Financial Sector

The financial sector across Europe and the United States has witnessed considerable merger and acquisition deals from the early 1990s onward. Spremann and Gantenbein (2001) suggests that the word ‘paradox’ is often used to describe mergers in the financial sector because, despite the contention that on average these mergers do not create wealth, yet they continue to occur.

While these authors report that mergers in the financial sector, especially banks, has increased over 200% from the 1980s, Campa and Ignacio (2005) more conservatively put the increase in merger and acquisition deals at 47%, though this figure was restricted to the EU zone and the periods between 1997-2000. Whatever statistics is considered appropriate, the basic fact is that the financial sector has witnessed intense merger deals from the 1990s onward.

Furthermore, Campa and Ignacio (2005) reports that the merger transactions that occur during this period under review implied and important qualitative change in the financial industry structure. They argued that prior to this period; merger transactions mostly involved smaller financial enterprises and had the primary objective of reducing costs and improving on efficiency. However, from the 1990s onward, this has changed. Merger deals from this period onward witnessed increased volumes of investment and the transactions involved were more aggressive in pursuing market access and enhancing the competitive advantage of the firms which now find themselves in a more integrated national and global market.

Cabral and others also report that though the insurance industry and other financial intermediaries like security and commodity brokers, insurance agents and brokers, witnessed considerable merger deals, the banking sector accounts for the majority of merger transactions that occur in the financial sector. In this regard, Spremann and Gantenbein (2001), states that deregulation is a primary driving factor behind the increase merger transactions in the banking sub sector. They contend that previously, merger activities were prohibited by the several regulations in place, however, with the deregulation of the banking industry; firms now have the possibility to enable synergy by merger and acquisition.

Examining the rationale for mergers in the financial sector, Campa and Ignacio (2005) argue that the underlying motives for engaging in merger and acquisition transactions lies in the efficiency gains that results from lower costs and higher profits generated by mergers, the geographical diversification generated, the enhancement of competitive strength and increase in the ability to generate value to customer by cross selling of products. It is opined that these efficiency gains constitute the major source of value creation in such mergers. Although, it should be stated that the achievement of economics of scale and the opportunity to cut costs by eliminating overlapping operations and consolidating on backroom operations, are also incentives for embarking on merger deals.

However, examining the proliferation of merger activities going on in the financial sector brings to the fore, concerns about the motivations for, and the consequences of such investment decisions. One implication of the increasing merger activities in the financial sector is that the means of financing the merger is often largely determined by the information regarding valuation of the target firm.

In this respect, the information asymmetry that is rife in the financial sector presents a complex challenge to both the target and bidder. It can also play significant role in determining the success or otherwise of the merger deal. In most instances, the differences in the information held by the target and acquiring firm can become a significant source of disagreement.

As a result, mergers in the financial industry often resort to the use of contingency payments in mergers transactions because of i). the inability of the other methods of payment to provide a mutually beneficial solution when there is significant valuation disagreement between the target and bidder, ii). the distinctive long term contractual nature of this method of payment and the related benefits and complications that it entails and iii). the unique solution that it provides for valuation disagreement between target and bidder and the potential shareholder benefits for both parties (Kohers, 1998).

Although disagreement over the value and worth of the target firm is a general problem across industries, which has made the use of Earnout as a contracting tool more popular, the financial sector has more than its fair share of this valuation disputes. It is widely acknowledged that information asymmetry is a very common issue with merger of financial institutions; as a result, the financial sector has witnessed greater resort to Earnout as the best tool for successfully completing a merger deal.

Spremann and Gantenbein (2001) posit that in the uncertain and risky climate of the financial sector, firms may be more than willing to the ‘wait and see’ option offered by an Earnout structured acquisitions. The rest of this paper shall look at the factors that have made the financial sector, especially the banking industry so opaque that disagreement over real values and worth of firms appears to be the order of the day, making merger deals a more complicated activity.

First, more than any other economic activity, financial operations are concerned with the future, and as a result are characterised by risk and uncertainty. The key services of the financial system in the process of allocating funds between savers and borrowers consist in trading risk and liquidity. As a consequence, expectations play a major role in the pricing of financial assets. However, given this often limited amount of information available valuations of target firms are difficult to obtain. But as new information become available market parties adjust suddenly and collectively their price expectations. Together with low transaction costs in financial markets, this explains the high volatility and inherent instability of financial markets (Hogan, 1995).

As a result, asymmetric information problems arise when market parties have different information. Hence, one party may not have enough information about the other party to make accurate merger decisions. It certainly applies to financial markets where one party often has superior information about the risk being transacted than the other party, or where one party has better knowledge about the risk and uncertainties of involved with a deal, as well as the benefits involved.

Even within the operations of financial institutions, asymmetric information also brings about uncertainty and valuation problems. This is because, financial institutions, especially banks act as financial intermediaries by borrowing out savers’ fund to investors. In this regard, asymmetric information also may create problems of adverse selection before a transaction is entered into, and of moral hazard after the transaction has taken place.

Adverse selection arises, in this sense, because due to incomplete information the lender cannot accurately distinguish good risk applicants from bad-risk applicants before making an investment. Also, in reallocating funds between market parties an agency problem arises between the lender (principal) and the borrower (agent), since the latter has private information about the potential return and risk of his investment project.

Hence, optimal debt contracts typically include extra costs, a so-called external finance premium, that is incurred. They consist of costs incurred in screening loan applicants and monitoring the behaviour of borrowers and include a premium for credit risk. These are dead-weight costs associated with the agency problem and are more particularly due to problems of adverse selection and moral hazard as explained before; and these costs are not often accounted for when valuation of a firm’s asset is carried out.

Another factor that affects the adequate valuation of a financial firm is that financial institutions are often more interdependent than any other sector of the economy. As a result, events in one financial market or institution may have important external affects on the rest of the financial system and on the whole economy. Hence, the present and future value of a financial institution might not be affected by the actions of the institutions alone. This, couple with the tendency of financial institutions to move along the same line together, further complicates the risks associated with this sector of th economy.

Furthermore, at the centre of the financial sector lies a special commodity: money, which on its own has grave implications for stability. Since economy stability and hence worth of a firm is largely influenced by money, and since the financial sector, especially the banking industry is involved with creating money, the value of a banks total assets is therefore at the mercy of the money in circulation, as there is an established link between prices, inflation and the money in circulation. In this type of scenario, agreeing on the value of a target firm cannot be more difficult; the wait and see option provided by Earnout therefore constitute the best contracting tool.

Also, the most part of bank’s assets are intangible, which creates further problems with valuation. Infact, a substantial part of financial assets issued by financial institutions are information intensive and this applies most to banks. However, to further worsen this scenario, an average bank’s debtors and creditors, consist of, to a large extent, small unsophisticated individuals or institutions that are more difficult to monitor or evaluate.

On the other hand, instability is a far more common factor in the banking and other financial industries. The financial sector is so characterised by factors that allow individual institution’s problems to easily spill over and endanger the whole financial system. For instance, failure in one market or institution may create a financial panic and end up in a systemic crisis. Therefore, the future viability of a financial firm does not only depend on the actions of the individual firm, but on the general health of the whole sector.

Banks specifically are faced with a two-sided asymmetric information problem. On the asset side, borrowers may fail on their repayment obligations. Depositors, however, cannot observe these credit risks. The quality of the loan portfolio is private information acquired while evaluating and monitoring borrowers. On the liabilities side savers and depositors may withdraw their funds on short notice. Banks, however, cannot observe the true liquidity needs of depositors. This is private information. A true liquidity risk arises when depositors collectively decide to withdraw more funds than the bank has immediately available. It will force the bank to liquidate relatively illiquid assets probably at a loss. A liquidity crisis may then endanger also the solvability of the bank and eventually lead to bankruptcy within a short period of time.

As Dewatripont and Tirole (1994) observe, the providers of funds are not able to assess the value of the bank’s underlying assets. As a result bad news, whether true or false, may provoke a withdrawal of funds. Moreover, as deposits are repaid in full on a first-come-first-served basis until the liquid assets are exhausted, depositors have an incentive to act quickly. A ‘bank run’ may occur when enough savers lose confidence in the soundness of a bank. All these imply that the viability of bank is essentially based on expectations and intangible assets, which in most cases, can be very unreliable.

There is also the issue of brand. In some cases, the customer base enjoyed by a financial institution, such as bank, may be based on the tradename the institution or one of its products has gained in the minds of the people. Since in most cases, merger or acquisition often lead to integration into another institution with the resultant loss of the brand or product with which the target firm is known, the future prospects of the target firm may be greatly affected in the post-acquisition period.

In a study carried out by Donald P Morgan, the risk and uncertainty that pervades the banking industry, a subsector of the financial sector was examined. Arguing that the pattern of disagreement between bank bond raters suggests that banks and insurance firms are inherently more opaque than other types of firms, the author posited that disagreement between bank raters over bank issues can be seen to reflect the underlying structure of a bank’s assets and capital structure.

Trading assets seem to be a hot area for disagreement, as well as loans, which, in most cases, are the essential structures of a bank. Although, fixed structures, like premises, tend to be a lesser source of disagreement, however, the author contends that such assets are rare at banks. Another resource which could reduce disagreement over a banks value includes capital, both directly and indirectly, through its interaction with various assets, again, this is rather is a rather rare resource.

Trading is considered the ‘dark side’ of liquidity for banks, essentially because trading positions are ‘slippery’ which makes trading risk difficult to monitor or predict. In essence, the uncertainty over these sorts of bank assets may be compounded by their high leverage, which creates incentives for risk shifting or asset substitution (Morgan, 2002). Though, trading assets represent only a small share of total assets of a bank, on average, but the range of values is large; trading has become a big business indeed for roughly several large “trading” banks. Taken together, these and the other financial assets account for over 90 percent of all bank assets on average. Fixed assets, by contrast, make up only about 3 percent of assets. Banks have their premises and the real estate they collect on defaulted loans.

Using the ratings of bank bonds as a yardstick to measure the uncertainty over banks’ assets, the Morgan (2002) study reported that the gap between the mean ratings by Moody’s and S&P was four times larger for bank issues than for the typical nonbank issue.

The author concluded that the pattern or degree of disagreement across sectors suggests a continuum of opacity, with the more asset-backed sectors or securities at the transparent end and the financial intermediaries (banks and insurers) at the other. Utilities and the asset-backed bonds favoured by finance companies generated relatively little disagreement between raters, suggesting the risk of these industries (or securities) is relatively easy to quantify. The raters were much more likely to differ over insurance and banking firms’ bonds.

Furthermore, Morgan (2002) asserted that in any given year, the disagreement over banks can be traced to their assets, suggesting the veil is to some extent inherent to the business. Loans, the defining asset of a bank, are a significant source of disagreement when it comes to estimating the value of a bank, as well as trading assets that are prominent on the books of large trading banks.

“While, trading assets are necessarily opaque and illiquid like loans, they are however, extremely liquid and ‘slippery’. Trading positions can change instantaneously, which makes them hard to monitor from outside the bank. Cash also creates splits between the raters, while premises or banks’ other fixed assets tend to reduce disagreement; the vault, in other words, matters more than the cash it contains, presumably because cash can disappear but the vault is hard to move” (Morgan, 2002 p.890).

As is obvious from the foregoing discussion of the uncertainties and other factors that make valuation a difficult task in the financial sector, therefore, the need for a financing option that allows room for these uncertainties is quite obvious. As mentioned earlier, the inability of any other contracting tool to provide a safe meeting ground for both parties in a merger negotiation, when valuation is encumbered in significant disputes; and the long term contractual nature of the Earnout technique, which allows both parties to monitor the future prospects of the target firm before making conclusive payments, make Earnout the most relevant negotiating tool in the financial sector.

In the Kohers and Ang (2000) study of over 900 merger transactions that involve the two part payment structure of Earnout deals, it was reported that the use of this style of negotiation had two basic explanations; first, the Earnout structure serves a risk reducing mechanism for bidders by protecting them against the risk of overvaluating the target, especially when there is a significantly high asymmetric information. Secondly, the use of Earnout also acts as a deferred compensation mechanism to retain valuable owners/managers of the target firm. Both of these explanations apply to the use of Earnout in the financial sector, especially in the banking industry which has, apparently, the highest valuation problem.

Under the first instance, the uncertainty of viability and prospects, the intangible nature of banks’ assets, the liquid nature of their capital are all factors that make accurate valuation an almost impossible task. The bidder will have to rely on the estimation of the target firm, in the absence of such a contracting tool as Earnout or the negotiation will be inconclusive, due to irresolvable differences between the target and bidders valuation of the target firm. Under the second explanation, also, the banking and other financial institution depends hugely on human capital.

Earnout offers the advantage of retaining the target owners/managers with their wealth of experience with the firm’s operation and the firm’s customer base, through the transition period. This would be impossible under any other contracting agreement. The bottom line is that in scenarios, such as the financial sector, where valuation is an issue of grave disagreement, Earnout provides an exit; it allows bidders and targets to disagree over the value of the target firm and yet agree to continue with the negotiation. From this understanding, the popularity of Earnout in mergers and acquisitions occurring in the financial sector becomes justified.

Summary

The Earnout alternative is a relative newcomer to contracting technologies in mergers and acquisitions. In one of the very first empirical research studies on Earnout, Kohers and Ang (2000), contend that differences in the expectations about target value is one of the prominent disagreement that often occur between bidders and target in a merger negotiation. The bottom line is that Earnout allows bidders and targets to disagree on their valuation and yet agree to complete the transaction.

After examining over 900 large merger deals that involve the use of Earnouts, these authors report that the two part payment system enforced by Earnout may serve as a risk reducing mechanism for bidders by hedging against the risk of misevaluating the targets with potentially high asymmetric information. The study also reported that Earnout was more likely to be employed in acquisitions of divested subsidiaries, privately held target firms and takeovers involving bidders and targets from different industries.

Although the term “Earnout” is commonly applied to the entire transaction when referring to the contracting form, the term ‘Earnout’ itself, however, depicts the contingent payout received by the target at the specified period after meeting the specified target. By tying the target’s consideration in the acquisition to future performance, the Earnout can bridge a valuation gap between the target and the acquirer that is caused by disagreements about the target’s expected future performance (Kohers and Ang, 2000). Moreover, because the consideration received by the target is contingent on future performance, target manager-shareholders have an increased incentive to remain with the firm in order to maximize this performance.

Other contract forms proposed to solve the information problem with mergers include joint ventures and partial acquisition. The joint venture approach mitigates several issues with merger deals by allowing all parties increased monitoring over the assets contained in the joint venture, allowing for a more informed determination of the assets value and quality. Like joint ventures, Partial acquisitions can also mitigate informational problems by giving a buyer a major ownership interest in the target firm.

Effective control of the firm is transferred to the majority shareholder from the target firm. The target firm is still a distinct legal entity, but is an affiliated subsidiary of the acquiring firm. Evidence, from several literatures, show that partial acquisitions could be value enhancing for the target firms and at least a non-negative event for bidding firms. However, Earnout mitigates informational asymmetries by better shifting some of the risk of misevaluation to the target firm. So, if a bidder misvalues a target, the contingent payment portion of the deal will be reduced, possibly to zero. Earnout contract also provides the target with the ability to signal its quality.

Earnout mitigates informational problem through the contingent payments associated with the contract. The bidder and the target agree on contingent payments tied to various milestones concerning future performance and structured to reflect the payoffs both party believe is appropriate to compensate the target. The target can also use the Earnout agreement as an opportunity to signal their quality to the bidding firm. By a target accepting a deal that has a greater proportion of the transaction value contingent on future performance, the target is signalling a high quality of future prospects to the bidding firm.

The contingent payments are, in effect, an equity claim on the post-merger performance of the target. Furthermore, Earnout also allow the target the benefits of earning more than the expected value of the firm, especially if the Earnouts payments become substantial. Also, the target will have some degree of control over the business operations of the target firm during the transition period, and this can considerably affect the size of the Earnout payment. Nonetheless, the target still stands some risks with Earnout negotiation.

For instance, in a firm that depends on human capital, if the target firm’s personnel refuse to stay after the merger, this could greatly affect the Earnout due to the target. Furthermore, the target firm is placing itself at the mercy of the future financial viability of the target firm. If the bidder suffers financial difficulty or is less financially strong than it was when the contract was negotiated, the Earnout payments to the target may be greatly hindered, even if the target firm successfully attains the predetermined performance measures as at when due.

While it is generally accepted that Earnout payments are made contingent upon some form of post acquisition performance, Cain et al (2006) further revealed, through an empirical study of several merger deals involving the use of Earnout that in 90% of cases, the Earnout is contingent on the performance of the target firm only, while in another 9% of the cases, it is contingent on the combined performance of the target and acquiring firms.

Furthermore, since in structuring an acquisition agreement with an Earnout, the target and the acquirer must agree on what portion of the purchase price will be paid at closing and what portion will be contingent upon future target performance, the study mentioned above indicated that on average Earnout is equal to 33% of the transaction value, while the maximum possible Earnout payment ranged from 1.4% of the initial transaction value to 160% of the transaction value.

Explaining this finding, the authors hypotheses that if the target and acquirer differ in their estimates of the target’s value, the fixed portion of the acquisition price will pertain to that portion of the target’s value on which both the acquirer and the target can agree, while the contingent portion reflects the difference between the target’s and the acquirer’s estimate of value. Thus, in a sense, the Earnout bridges the valuation gap between the acquirer and the target.

The form of Earnout payment is another important part of the deal. Several literatures indicate a number of factors that could potentially influence the choice of payment; between cash and stocks, in non-Earnout merger payments. These factors include acquiring and target firm information asymmetries, risk-sharing considerations, target firm size, and the availability of cash or debt capacity. The portion of the acquisition payment that is contingent on future target performance, i.e. the Earnout portion, allows information that is revealed after completion of the acquisition to be reflected in the total consideration paid for the target firm.

The financial sector across Europe and the United States has witnessed considerable merger and acquisition deals from the early 1990s onward. Cabral and others report that though the insurance industry and other financial intermediaries like security and commodity brokers, insurance agents and brokers, witnessed considerable merger deals, the banking sector accounts for the majority of merger transactions that occur in the financial sector.

One implication of the increasing merger activities in the financial sector is that the means of financing the merger is often largely determined by the information regarding valuation of the target firm. As a result, mergers in the financial industry often resort to the use of contingency payments in mergers transactions because of i). Although disagreement over the value and worth of the target firm is a general problem across industries, which has made the use of Earnout as a contracting tool more popular, the financial sector has more than its fair share of this valuation disputes.

It is widely acknowledged that information asymmetry is a very common issue with merger of financial institutions; as a result, the financial sector has witnessed greater resort to Earnout as the best tool for successfully completing a merger deal. Also, the most part of bank’s assets are intangible, which creates further problems with valuation. Infact, a substantial part of financial assets issued by financial institutions are information intensive and this applies most to banks.

Moreover, since in most cases, merger or acquisition often lead to integration into another institution with the resultant loss of the brand or product with which the target firm is known, the future prospects of the target firm may be greatly affected in the post-acquisition period. The bottom line is that in scenarios, such as the financial sector, where valuation is an issue of grave disagreement, Earnout provides an exit; it allows bidders and targets to disagree over the value of the target firm and yet agree to continue with the negotiation.

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