Disagreement about firm value between potential buyers and sellers is particularly prevalent in private startups’ mergers and acquisitions (M&As). Startups are generally uncertain about their future performance and lack a robust financial track record. In M&A transactions, sellers often have more and better information (e.g., detailed information about the startup’s products and product markets) to extrapolate future startup performance than buyers. However, startup insiders might be unwilling or unable to disclose private information to buyers, jeopardizing potential deals. Venture capital firms (VCs), sophisticated investors in early startups, potentially play an important role in bridging the information gap between buyers and sellers. In my new paper, I empirically explore the role of VCs in alleviating information problems between buyers and sellers in the private M&A market.
M&A Contracting: Earnouts
To study the informational frictions between buyers and sellers in private M&A settings, I focus on a commonly used contractual mechanism in M&A contracts: contingent consideration (“earnouts”). An earnout is “an arrangement where part of the merger consideration is made contingent on a future event (e.g., drug approval or first product sale) or (financial) performance measure (e.g., revenues, net income, or EBITDA).”
Why use earnouts? Earnouts generally address information problems between sellers and buyers in the private M&A market. Think of a U.S.-based private startup founded by entrepreneurs (insiders) that has produced a new technology and a larger public technology firm that wants to acquire the startup. Given that the startup developed and owns the new technology, there is much uncertainty about its future (financial) performance, and the insiders likely have better information regarding the technology and its long-term commercial applications than the buyer. However, the startup’s valuation will depend heavily on each party’s expectations of future performance (cash flows). The main issue is that it might be difficult for the insiders to credibly provide private information to the buyer regarding future performance. In other words, the buyer might not trust the insiders because insiders have an incentive to only provide information that maximizes the startup’s valuation. Whenever one party has an informational advantage over another party in transactions, contracts can be designed to address informational frictions (Holmstrom, 1979). An earnout contract operates as a contractual mechanism that shifts risk to the insiders, who have the informational advantage, by decreasing the initial upfront price of the start and making part of the total price conditional on future performance. Note that an earnout is a mechanism to screen startups, separating good from bad startups. Insiders with private information confirming great future performance will be more likely to opt for an earnout contract than insiders with information detrimental to the startup’s future performance.
VCs Substitute for Earnouts
For this study, I collect a representative sample of proprietary M&A contract data from U.S.-based private startups that either have a VC or do not. The main finding in the study is that buyers and startups use earnouts less frequently in M&A contracts when a VC participates in the transaction. This finding suggests that VCs play a similar role as earnouts in alleviating information asymmetry and uncertainty between buyer and seller about the value of the business entity. Using the physical distance between the headquarters of the VC and the buyer as a measure of information asymmetry between both parties, I further show that the use of earnout contracts increases when the information asymmetry between VC and buyer is high.
VC-Buyer Relationships Are Key
I hypothesize that VCs can play this informational role because they play a repeated game in the M&A market. In support of this hypothesis, I document that relationships between buyers and VCs through previous M&A transactions further reduce the need to use earnout clauses in the M&A contract. Additionally, buyers are more likely to work with a VC on a future M&A transaction if the VC and buyer worked together on a transaction in the past, implying that buyer-VC relationships are important drivers of the private startup M&A market. These results indicate that VC-buyer relationships create additional value in the startup M&A market by reducing information asymmetry between startups and buyers.
VC-Specific Preferences over M&A Contracts
Lastly, I focus on two economic frictions specific to the VC in the startup M&A market that could further explain the use of earnouts in contracts. An important cost for VCs when using earnouts is that an earnout requires the VC to monitor the startup’s operations after the M&A transaction and verify the earnout consideration. I show that VCs are less likely to use earnouts when monitoring costs are high from their perspective, as measured by the physical distance between the VC and the startup. VC funds have a closed-end structure and, on average, liquidate themselves in about ten to twelve years. Investors in the fund require their returns at the end of the fund’s lifetime, and the VC must turn its assets, including its stake in startups, into cash. Comparing early and late M&A deals in the same VC fund, I document that early M&A deals in the lifecycle of the VC fund have a higher likelihood of having an earnout than later deals. The finding implies that VCs incorporate their idiosyncratic liquidity needs when negotiating M&A contracts. These results indicate that VCs have idiosyncratic preferences over the use of earnouts that might or might not align with the preferences of other investors.
In conclusion, this paper provides several new insights for startups to consider when choosing a VC investor (or VC fund) and how this can potentially affect M&A contractual outcomes. Given that a large amount of (successful) startups exit the market through an M&A, it is an economically important decision for startups. Among the most significant of my findings is that buyers can substitute the role of earnouts with VCs in reducing the friction caused by information asymmetry between the buyer and seller. The VCs play a crucial role in establishing credibility in the startup M&A market. VCs also protect their idiosyncratic interests, such as checking the opportunity cost emanating from monitoring costs and converting assets into cash at the end of the VC fund’s life when deciding the optimal M&A contract.
Lauren Vollon is an Assistant Professor of Accounting at the Bocconi University Department of Accounting.
This paper is adapted from her “Venture Capital and Private M&A Contracting” paper, which is available on SSRN.