Should I Trust You? Bidder’s Earnings Quality as an Indicator of Trustworthiness in Earnout Agreements

The research problem This paper aims to test whether an acquirer’s past earnings quality (proxied by the level of earnings management) serves as an indicator of its trustworthiness in view of the inclusion of an earnout agreement in an acquisition contract. Motivation Prior studies highlighted the benefits of earnout agreements, showing that they help reduce adverse selection problems and valuation risk faced by the acquirers. However, not much attention has been paid to the risks that these contracts entail. The majority of earnouts are based on accounting performance measures, which may be subject to earnings management by the acquirer to reduce, or even avoid, contingent payments. Therefore, the decision to include an earnout in an acquisition may depend on the sellers’ perceived probability that the acquirer will use opportunistic tactics to avoid the contingent payment, as indicated by the acquirer’s past behavior. The test hypotheses Hypothesis 1: The likelihood of inclusion of earnouts in acquisition deals is negatively associated with the level of earnings management in the acquirer’s past financial statements. Hypothesis 2: The relation between earnings management and the use of earnouts is stronger when the bidder has no acquisition track record. Target population M&A advisors, financial analysts, stakeholders of companies engaging in M&A deals. Adopted methodology Logit regressions, propensity score matching analyses for robustness. Analyses Using a sample of 8,968 acquisition deals completed by US listed companies between 2002 and 2014, we examine the association between the use of earnouts and bidder’s earnings quality (proxied by the level of earnings management) controlling for the determinants of the use of earnouts described by previous literature. We collected acquisitions data from Thomson ONE Banker and accounting information from Compustat. Using logit models, we regress the choice to include an earnout in an M&A deal on several earnings management proxies and on the interaction between the latter variables and bidder’s acquisition track record. Findings We find robust evidence that the level of the acquirer’s past earnings management is negatively associated to the probability of inclusion of an earnout in acquisition contracts. This association is stronger if the bidder has no prior acquisition history and is robust to various measures of earnings management and to controls for other external monitoring mechanisms.