We examine a large sample of mergers involving earnout payments made by bid
ders to target shareholders. Our findings suggest that earnouts serve two n
ot mutually exclusive functions: as risk reduction mechanisms against misva
luation of high asymmetric information targets, and as retention bonuses fo
r target human capital in mergers with feasible contract implementation. Ar
ound the merger announcement, bidder shareholders show significant positive
responses, which are not reversed over the subsequent 3 years. In the post
merger period, the frequency of earnout payment and the percentage of targe
t managers staying beyond the earnout period are high, supporting the use o
f earnouts as retention bonuses.