The risk of disagreement in M&A deals

In recent years, we’ve seen a dramatic rise in the number of mergers and acquisition agreements (M&As) that include clauses linking part of the payment to the target’s performance in the years following the deal closing. These clauses, known as earnouts, can be considered the equivalent of financial instruments that derive their value from future company performance. This may be measured in terms of profitability (EDITDA or turnover, for example), or be contingent on hitting specific objectives (for example, successfully concluding specific contracts or achieving key milestones). When company performance meets or exceeds the agreed-on thresholds, the former owners of the company receive additional payments.

Although in the 1990s earnouts were only contained in 4% of M&A deals, today we find them in over 15% of acquisitions. And the economic uncertainty unleashed by the Covid-19 outbreak will likely lead to even more frequent use of these mechanisms.

But how can we correctly value an earnout? Because these clauses are similar to financial options, the same pricing methods are applied. But in light of the characteristics of earnouts and the contexts in which they are used, we need a valuation model that can adequately factor in two main sources of risk relating to earnouts: default of the buyer and litigation between the two parties.

Unlike financial options, earnouts are based on measures of corporate performance, which the bidder can manipulate or influence through opportunistic behaviors. This means it is necessary to consider the bidder’s creditworthiness and the effect of this on expected payment when estimating the impact of default and litigation risk. In our recent study, we propose an innovative valuation model that is capable of incorporating the sources of risk that target companies are subject to, risks that can influence final profit. We capture uncertainty in terms of three different components: performance of the target company, the debt process and the value of the buyer’s assets. We also take into account the attitude toward risk of the former owners.

In a scenario where there is no uncertainty, the model we propose arrives at the same conclusions as others that are commonly used. However, it would be difficult to attribute the same risk value to a promise of payment made by a large, unlevered firm as compared to a small one with sizeable debt. For this reason, we augmented our model to encompass the effects of the buyer’s creditworthiness in case of default or litigation.

There are two cases in which the buyer could go bankrupt: if it is overleveraged, or if the target company fails. Taking these scenarios into consideration, we built two indicators into our model, one as a function of company management and the other of the creditworthiness of the buyer. We found that the value of earnouts is the same as what we would get by applying a linear valuation method, corrected for one element (credit value adjustment (CVA)), which reflects solvency (i.e., the risk that the buyer will not be able to make the additional payment). This correction for creditworthiness is negligible if the buyer is much bigger than the target, if the buyer’s leverage is low, and if the correlation between the two companies is high. If instead the buyer’s leverage is high or the correlation is low, the impact of default risk rises.

A prime example of this is the 2004 acquisition of CPM (the owner of a number of hospitals in Maryland) by Paincare Holdings, a highly-specialized healthcare service provider. CPM’s future profitability was extremely uncertain, so the final agreement stipulated that nearly half of the payment would be made via earnouts linked to CPM’s EBITDA in the three years subsequent to the acquisition. Applying our model, we see that the earnout value dropped as the debt rose. Moreover, there was a positive correlation between the length of the time horizon and the likelihood of default by the bidder.

Generally speaking, after deal closing the former owners give the buyer full control of the company, and in doing so no longer have any way to directly verify company performance. If performance as reported by the buyer is worse than expected, the sellers may well opt to take legal action. Naturally, this route would be a costly one, so the sellers would go to court only if they expect to gain more than the buyer is willing to pay, net of all the trial-related expenses.

We inserted two functions in our model. The first is the seller’s mistrust of the buyer. The second estimates that proportion of the payment that the judge might grant, bearing in mind information asymmetry, the degree of discretionality that is inevitable in interpreting accounting figures, and the length of the trial. So at this point, we added a new element to our model (LitVA=Litigation Value Adjustment), which adequately reflects the costs associated with a legal suit and the risk of having to accept a lower payment. We find that the easier it is for the bidder to behave opportunistically, the more uncertain the outcome of a trail and the longer it lasts, the higher the litigation risk. On the other hand, the higher the direct costs of going to trial (e.g. lawyer’s fees), the lower the value of the relative earnouts.

In 2011, Sanofi, one of the biggest pharma companies in the world, acquired Genzyme, a biotech company that had developed a promising drug for the treatment of multiple sclerosis. The terms of the agreement included an earnout based on six milestones to be reached in the subsequent years of operations. There was a concrete risk, which was also reported in the press, of controversy regarding Sanofi’s pledge to make ‘diligent efforts’ to develop the new pharmaceutical. And in fact, in the years to follow, this risk materialized, and the drug failed to hit the targets set down in the contract. This led the former owners of Genzyme to file suit against Sanofi. Calculating litigation risk in the valuation, and corroborating how the market can influence prices, the model we propose in our study explains the difference between the estimated value of the shares and their actual trading price, which was far lower.

• Earnouts are helpful tools when parties to an M&A disagree on the value of the target company. These clauses are even more useful during times of uncertainty, as with the Covid-19 pandemic, when future performance is more difficult to predict. But valuing earnouts is anything but simple.
• There is a general tendency to overestimate the value of the target company if we fail to consider two fundamental elements: default risk and litigation risk. For the first, it is always advisable to verify the correlation between the industries of the bidder and the target company, and the leverage of the bidder. The second type of risk lowers the value of the consideration paid.
• Beyond providing an innovative framework for valuing earnouts, the model we propose in our study adds new information to the literature on options and on the relationship between payment methods and premiums paid on acquisitions. In addition, our model can be a useful tool for compliance with American and European accounting principles that require companies to value earnouts at fair value.