Earnouts: The effects of adverse selection and agency costs on acquisitiontechniques

We examine the effects of adverse selection and agency costs on the structu re of the consideration offered in an acquisition. Specifically we investig ate factors affecting the benefits arising from use of earnouts. We find th at when targets have greater private information, consideration is more lik ely to be based on the future performance of the target. We also find an ea rnout is more likely to be used in an acquisition if the target is a smalle r, private company in a different industry than the acquirer. In addition, earnouts are more likely to be used when fewer acquisitions take place with in an industry and when targets are service companies or companies with mor e unrecorded assets. Finally, we compare the use of earnouts with the use o f stock and find that financing considerations are a more important factor in the use of stock.