Earnouts as Payment Currency and Value Gains to Bidder Shareholders

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Chapter 2.3.1, Cash and Stock:

A broad literature has evolved analysing the impact of stock and cash as method of financing on bidder shareholder wealth. Travlos (1987) analyses takeover bids in the period of 1972 to 1981 and finds that bidder stockholders experience significant losses for stock-only bids but 'normal' returns for cash financed bids at the takeover announcement. Moreover, Huang and Walking (1987) provide evidence for the years 1977 to 1983. In this sample period cash financed takeovers result in significantly and substantially higher abnormal returns than stock or mixed financed takeovers. Furthermore, Amihud et al. (1990), Martin (1996) and Ghosh and Ruland (1998)) study the US corporate takeover market in a sample period from 1978 to 1988 and come to similar conclusions. In addition, Eckbo et al. (1990) and Eckbo and Thorburn (2000) state that the average bidder announcement period abnormal stock return is lowest for stock-only deals, highest for cash-only deals, with mixed deals in between. The empirical evidence of negative abnormal return for stock financed takeover is consistent with the theory of the signaling effect of common stock, conveying negative information about overvaluation as discussed in chapter 2.2.1 (Faccio et al. (2006)). In contrast, Goergen and Renneboog (2004) find in their study on European takeovers that CARs in stock financed bids significantly surpass those in cash financed deals. This suggests that when competition in the market for corporate control is less intense the negative signaling effect of stock financing might be diluted.
However, results differ when target listing status is taken into account. Moeller et al. (2007) provide evidence that announcement period returns for public targets in the case of equity financing are negative, but positive for cash financing. Zero or positive bidder announcement returns are also found for stock financed acquisitions of private targets by Moeller et al. (2004), Fuller et al. (2002) and Chang (1998). In conclusion, if asymmetric information is high, there is empirical evidence that the application of stock as contingent method of payment is rewarded by the market and acquirers are more likely to make use of stock instead of cash (Chang (1998)). A reason for this might be the creation of blockholders in takeovers if private targets are owned by a small number of shareholders. Shleifer and Vishny (1986) suggest that those may take the function of effective monitors of managerial performance. In contrast, several other studies argue that the creation of blockholders may lead to a reduction of firm value if it allows managerial entrenchment or makes takeovers more costly (Morck et al. (1988); Stulz (1988)).
2.3.2, Earnout:

Contrary to the broad literature on stock and cash financing, only a few studies have dealt with wealth effects of earnouts in the announcement period focusing mainly upon the US and UK takeover market.
For the US, Kohers and Ang (2000) find that earnout transactions of bidders acquiring private targets outperform all cash and all stock transactions. In their sample the average abnormal return for earnout takeovers is 1.348% on the announcement date whereas it is 0.867% for the cash offer sample and 0.868% for the stock offer sample. Similar results are reported by Barbopoulos and Sudarsanam (2012) for the UK market. The study finds that significant value gains result from takeovers when earnout currency is used as earnout bids yield significant higher returns than non-earnout bids. Furthermore, it is shown that earnout bids significantly outperform cash and stock bids, but little difference exists for returns of mixed financed takeovers. In addition, Kohli and Mann (2013) analyse the Indian corporate takeover market. They conclude that earnout currency generates significant positive announcement returns, but earnout wealth gains are not superior to those of stock financed takeovers. Furthermore, Datar et al. (2001) provide evidence that foreign bidders of US targets are less likely to use earnouts than US acquirers. They suggest that this results from different accounting practices and corporate governance systems. Consistent with this study, Mantecon (2009) provides evidence that cross border acquirers, contrary to domestic acquirers, do not benefit from earnout currency.
Cain et al. (2011) empirically investigate the form of earnout contracts in the US market. These authors provide descriptive statistics on EAL and EAMs and link the relationship of high uncertainty situations and REAV, EAL and EAM. The study reports that when uncertainty is high and moral hazard problems are present, e.g. in industries with many intangible assets or for acquisitions of private targets, REAV is potentially larger and EAL is longer. In addition, the findings show that REAV is negatively related to the precision with which managerial efforts can be measured. Moreover, it is stated that performance measures are chosen primarily based on their informativeness with respect to target effort or firm value.