Do Earnouts Sweeten the SPAC Deal? An empirical study on the effect earnouts have on SPAC deals

Abstract

The purpose of this research is to explore contractual agreements related to Special Purpose Acquisition Companies (SPACs). Even though this backdoor to the public market has been around for decades, the SPAC market has seen a spike in popularity during the last two years. Despite the rise in attractiveness, the SPAC sponsor’s equity stake has gained criticism due to misaligned incentives. Moreover, information asymmetries connected to the valuation risk of the target firm have also reached the agenda. These two areas of improvement have facilitated the introduction of earnouts. Earnouts have been relatively unexplored in research about SPACs, and we aim to contribute with new insights into the effect of earnouts. We study 226 US-listed SPACs that announced a target between January 2020 to the end of May 2021. By applying an event study methodology using the market-adjusted model, we investigate whether target or sponsor earnouts affect SPAC’s cumulative abnormal returns (CAR) on announcement returns for stock and warrant securities. In addition, we examine the relationship between redemption rates and earnouts. Earnouts are often portrayed as something positive, but our results indicate the opposite. We find a negative association of CAR regressed on earnouts. Moreover, our results show that CAR is higher for earnout than non-earnout deals conditional on sponsor experience. We further find that large deals that include at least one earnout agreement, sponsor earnout, or both target and sponsor earnout are, on average, associated with higher redemption rates. This demonstrates that investors are skeptical towards earnout-based SPAC deals, perhaps because they tend to be associated with other negative deal characteristics or used in less valuable transactions. Market participants should thus consider the whole picture before applying earnouts to the deal contracts.