Earnouts: The Effects of Adverse Selection and Agency Costs on Acquisition Techniques

We examine the effects of adverse selection and agency costson the structure of the consideration offered in an acquisition.Specifically we investigate factors affecting the benefits arisingfrom use of earnouts. We find that when targets have greaterprivate information, consideration is more likely to be basedon the future performance of the target. We also find an earnoutis more likely to be used in an acquisition if the target isa smaller, private company in a different industry than theacquirer. In addition, earnouts are more likely to be used whenfewer acquisitions take place within an industry and when targetsare service companies or companies with more unrecorded assets.Finally, we compare the use of earnouts with the use of stockand find that financing considerations are a more importantfactor in the use of stock.