Albert H. Choi
University of Virginia School of Law
March 10, 2016
This paper examines how post-closing contingent payment (PCP) mechanisms (such as earnouts and purchase price adjustments) can facilitate mergers and acquisitions transactions. The paper examines two informational environments: in the first, the seller has superior information about the value of her assets (private information setting) and in the second, the parties differ in their estimates on the value but are unable to overcome their difference (non-convergent priors setting). The paper also allows the parties to use either cash or the buyer’s stock as consideration. By conditioning payment on post-closing, verifiable information, PCPs can mitigate the problems of private information or non-convergent priors. In the private information setting, PCPs function as an imperfect verification mechanism (like a product warranty) and can lead to all parties using the same PCP. In the non-convergent priors setting, PCPs can be used to satisfy different, non-convergent beliefs. The paper also addresses the problems of limitations on the size of payment and post-closing incentives to maximize (or minimize) the PCP (particularly, earnout) payments. When such issues are a concern, the paper shows that (1) neither party may use a PCP (particularly an earnout); and (2) stock-based PCPs will generally work better than cash-based PCPs. Stock works better than cash because (1) its value is partially correlated with the value of the combined company, thereby reducing the burden of having to structure a large contingent payment; and (2) with respect to post-closing moral hazard, the parties partly internalize the deadweight loss from engaging in earnings management.