The effect of asymmetric information concerning the bidder on earnout agreements

Abstract

It has been argued that earnout contracts has a great attribute in being able to mitigate asymmetric information concerning both parties of a deal simultaneously, but this aspect of earnout agreements has not yet been empirically investigated. To our knowledge, this is the first study that explicitly investigates how the use of earnout agreements is impacted by asymmetric information concerning the bidding company. We examine a large sample of post SFAS 141 (R) acquisitions, and model for asymmetric information on both sides of the deal. We also look at how the interaction between asymmetric information concerning each party affects the likelihood of earnout contracts being employed. Our analysis reveals that characteristics of the bidding company associated with asymmetric information has a significant and positive impact on the likelihood of earnout agreements being employed. We also find that more asymmetric information concerning the target value, has greater impact on the likelihood of employing earnout agreements, when the target also has difficulties in estimating the true value of the bidding party.