Earnouts: the real value of disagreement in mergers and acquisitions

Earnout agreements link part of the payment for an acquired company to its future performance. Despite their option-like features, they cannot be valued using vanilla option pricing methods. Two peculiar sources of risk a¤ect these contracts: bidder default before the earnout expiration (default risk) and potential litigation associated with earnouts (litigation risk). The paper includes an option pricing model that encompasses these sources of risk, showing that counterparty and litigation risk can have a remarkable impact on earnout values. The model's relevance is further enhanced by recent accounting standards that require contingent payments to be valued at fair value.