Addressing Informational Challenges with Earnouts in Mergers and Acquisitions

This essay examines the role played by earnouts in mergers and acquisitions transactions. When one party is better informed of the true value of the deal than the other, the parties face the well-known “lemons” problem, which could prevent them from consummating the transaction even when both are aware that the deal will produce a positive (but uncertain) surplus. By harnessing post-closing, verifiable information, earnouts allow the transacting parties to overcome this informational challenge. The essay also analyzes (1) how the adoption and the size of an earnout will vary depending on the various characteristics of the transaction and (2) the earnout design issues when the parties face the problems of ex post moral hazard, such as engaging in inefficient behavior to either maximize or minimize the earnout payment