Managing M&A Risk with Collars, Earn-outs, and CVRs*

by Stefano Caselli and Stefano Gatti, Universit Bocconi, and

Marco Visconti, Merrill Lynch*

ergers and acquisitions often aim to achieve a

strategic transformation of the buyer and target
companies, with the expectation of creating
signicant shareholder value. But, as a large
body of academic research suggests, this expectation is
often not borne out. When one considers all the risks that
can adversely affect the outcome of the deal, this result is
not too surprising. Modern risk management techniques
have been developed to help companies manage some of the
risks associated with M&A.
M&A transactions expose both the bidder and target
shareholders to a number of major risks both prior to the
close of the deal and during the post-close integration phase.
The main pre-closing risk is the possibility that uctuations of
bidder and target stock prices will affect the terms of the deal
and reduce the likelihood the deal closes. After the closing, a
major risk for bidder shareholders is the failure of the target to
perform up to expectations, thus resulting in overpayment.
The pre-closing price risks appear to have been enlarged
by developments in 2006 that have contributed to stock
price volatility worldwide. A number of factors have been
at work here: the stock market pullback from May through
July of 2006 (during which the VIX volatility index rose
sharply), fears of an imminent U.S. economic slowdown,
record commodities prices, increasing concerns about the
potential effects of the bursting of the U.S. real estate
bubble, and an increasingly unstable international political environment. All these factors have made the valuation
of companies more challenging and uncertain.
At the same time, 2005 was a record year in terms of
M&A activity, with about $2.2 trillion worth of completed
deals worldwide. And 2006 is on pace for a new record,
with around $1.7 trillion worth of completed deals and
$2.2 trillion of announced deals as of the end of August.1
The combination of price uncertainty and growing pressure
on corporate managers to create value through M&A means
increased demand for management of both pre-closing price
volatility and post-merger performance risk.
In this paper, we discuss a number of tools that can

be used to manage risks arising in M&A practice, using

actual examples to illustrate the structure and pricing of
such tools. As suggested, M&A risks can be divided into
two classes: pre-closing and post-closing. In the category of
pre-closing instruments, offers with collars can provide
managers of publicly traded target companies with an effective way out in case of material share price uctuations. Such
instruments can also be used by bidders to cap the payout
to selling shareholders (by using xed collar offers) or
to limit the dilution of selling shareholders claims (using
oating collar offers) resulting from the deal.
Post-closing instruments, which include earn-outs and
contingent value rights (or CVRs)can be used to manage
the risk of substandard performance and the overpayment
that would result from underperformance. When viewed
as an add on to upfront payments in cash or stock, earnouts can also be used to increase the total consideration
paid to private sellers, especially in the event of exceptional
post-merger performance; and in this sense, they can be
viewed as providing sellers with protection against underpayment. But perhaps more important, a well-designed
earn-out can function as an incentive compensation plan
that, in cases involving listed as well as private sellers, retains
and motivates key managers. Besides strengthening target
managers incentives to perform after the deal closes, earnouts also provide an effective way to bridge the valuation
gap in acquisitions involving private, typically fast-growing
target companies with limited track records.2
CVRs are used by listed companies when attempting
to take over other public targets. They provide the bidders
management with nancial exibility and the ability to
customize their offers to the target shareholders preferences. CVRs are themselves often listed instruments that,
although easier to structure than earn-outs, can lead to
higher than expected cash outlays if not set up carefully.
Moreover, they leave the bidder exposed to general risks,
such as adverse stock market conditions (e.g., a high volatility environment, or negative macro developments).
In one of his recent books on M&A, Robert Bruner

* The authors would like to thank Avanhidar Subrahmanyam, Ajay Subramanian,

Yakov Amihud, Bill Megginson, Enrique Arzac, Ian Cooper, Jason Draho, Adam Shepard,
and Don Chew (the Editor) for helpful comments and suggestions on various drafts of the
paper.

1. According to the Thomson Financial M&A Database.

2. As discussed later in the article, Ebays acquisition of Skype Technologies, which
was announced on September 12, 2005, involved an earn-out with estimated worth of
as high as $1.5 billion.

M
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91

reported that of all U.S. deals closed between 1992 and

2000, only 1.2% involved the use of earn-outs, while even
fewer (0.6%) involved the use of collars (though, in the
case of collars, the rate of usage jumps to almost 6% for
deals larger than $1 billion).3 Such low percentages suggest
that risk management tools may offer signicant untapped
potential for adding value in M&A deals.

the bidder companys shareholders from overpayment in

xed-collar offers, or against shareholder dilution in oating-collar offers. Meanwhile, the lower bound protects the
target companys shareholders from the effect of a reduction
of the bidders share price in xed-collar offers, and from a
reduction of their ownership stake in the combined entity
in oating-collar offers.

Pre-closing Risk Management: Collar Offers

Stock price volatility has always been a problem in M&A
deals, particularly those involving two listed companies
that are structured as stock-for-stock swaps. In many such
cases, the pre-closing price risk has been hedged using plain
vanilla equity derivatives, such as call and put options. In allcash acquisitions of listed companies, the bidding company
can protect itself against a post-offer jump in the value of
the target companys shares by acquiring call options on
the shares and then capping its acquisition payment at the
weighted average strike price of the options acquired. At the
same time, the target companys shareholders can acquire
put options on their shares or, if the transaction is stocknanced, they might hedge their exposure by acquiring put
options on the bidders stock.4
These risk management techniques allow their users
to hedge price risk effectively, but they do not account for
the possibility that one (or both) of the companies might
lose interest in the deal if the stock prices of the companies
involved change materially from the prices assumed in the
agreed-upon transaction price. M&A practice has developed a particular kind of contingent offer, called a collar
offer, that provides counterparties of a stock-for-stock deal
with the option to walk away from the deal if the bidder
stock price falls below a certain level (as in a xed-collar
offer) or the ratio of the bidders to the targets stock price
moves outside a pre-specied range (as in a oating-collar
offer). If the ratio falls below the lower or rises above the
upper bound of the collar, an option to abandon comes into
effect (also known as a sudden birth option) that can be
exercised by either counterparty.5 The upper bound protects

Fixed-collar Offers
In stock-nanced transactions between listed companies,
xed-collar offers specically address share price volatility
for the companies involved in the deal. This begins with
a pre-negotiation of the exchange ratio (for example, two
shares of the bidding company for each share of the target
company, or 2:1) that will be used in the transaction, and
an agreement on a trading collar for the bidder share price.
For example, if the bidders share price during the negotiations is around 10, the parties might agree to a collar
that ranges between 9 and 11, which effectively establishes an acceptable range of values for the target from 18
to 22. Should the bidder companys share price go below
9 or above 11, either bidder or target would have the right
to cancel the deal (see Figure 1).6 The lower bound (9)
protects the target company by allowing its shareholders to
cancel the transaction if the bidder companys share price
falls below the specied threshold, or, in other words, when
the medium-of-exchange value decreases. The upper bound
(11), meanwhile, protects the bidder companys shareholders by limiting the effective purchase price to 22 if market
conditions make the transaction unattractive at the prenegotiated exchange ratio (2:1 in our example).7
When the two companies in the deal are negotiating to
x the levels of the two bounds, they should keep in mind a
well-documented phenomenon affecting M&A announcements. Soon if not immediately after the announcement
of a transaction, both bidder and target shares experience
stock returns that, on average, are signicantly positive for
the target and range from zero to slightly negative for the
bidders.8 Any expected negative reaction to bidders is likely

3. See R. Bruner, (2004), Applied Mergers & Acquisitions (John Wiley and Sons).
4. An example is the recently announced Telecom ItaliaT.I.M. merger, in which about
50 million options were negotiated by the parent company Telecom Italia to manage the
risks associated with the tender offer launched on T.I.M. shares. The company acquired 25
million American call options (expiration date, January 31, 2005), entitling it to buy up to
50 million T.I.M. ordinary shares and up to 25 million non-voting shares; at the same time,
Telecom Italia entered into an agreement to sell up to 25 million put options on the same
amounts and classes of shares (Telecom Italia December 21, 2004, press release).
5. A sudden birth (or sudden death) option is an option whose existence (or expiration) is contingent on a condition; if the condition is met, the option comes into existence
(or expires). The most common conditions involve the underlying asset price reaching
negotiated thresholds moving upward (up-and-in, up-and-out) or downward (down-andin, down-and-out).
6. Technically this option resembles a sudden-birth barrier exchange optionone that
allows each counterparty to cancel the transaction by exchanging the share amounts
indicated in the pre-negotiated exchange ratio, only in the opposite direction. With an
exchange ratio of n:1 (2:1 in our example), the target companys shareholders could
exchange n (2) of the bidder companys shares for one of their own shares. See K.P.
Fuller, (2003), Why Some Firms Use Collar Offers in Mergers, Financial Review, Vol.

38 (1), pp. 127-150, and M. Ofcer, (2004), Collars and Renegotiation in Mergers and
Acquisitions, Journal of Finance, Vol. 54, pp. 2719-2740.
7. Fuller (2003) argues that the collar might be interpreted as a particular form of a
Material Adverse Change (MAC) clause. However, market evidence does not seem to
conrm this argument, both because MAC clauses exist independently of the collar in
collar offers, and because they look more like a renegotiation point, rather than a negotiation break-off. Moreover, a MAC clause has a much broader scope, while collar offers
dene conditions only on the bidder companys share price or exchange ratio. In both
cases, as we will explain later, the conditionality relates to the total consideration paid to
the target company.
8. For an excellent review of empirical studies focused on the effects of M&As on bidder and target shareholders wealth, see Robert Bruner, Where M&A Pays and Where It
Strays: A Survey of the Research, Journal of Applied Corporate Finance (Fall 2004); S.
Chang, (1998), Takeover of Privately Held Targets, Methods of Payment, and Bidder
Returns, Journal of Finance, Vol. 50, pp. 773-784; M. Mitchell, T. Pulvino, and E.
Stafford, (2004), Price Pressure Around Mergers, Journal of Finance, Vol. 59, pp. 3163. For implications in an option pricing perspective, see A. Subramanian, (2004),
Option Pricing on Stocks in Mergers and Acquisitions, Journal of Finance, Vol. 59, pp.
795-829.

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Figure 1 Payoff Structure for a Typical Fixed Collar Offer as a Function of Bidder Company Share Price at Closing
When the bidder share price falls between the lower and upper bound (9 and 11, respectively,
in our example), the transaction is settled at the pre-negotiated exchange ratio (2:1 in the numerical example).
This implies that in such a case the cash value of total consideration received by the target shareholders
is a linear function of the bidder company share price. Outside of the two bounds, the exchange ratio is
free to oat, guaranteeing a xed cash amount to the target shareholders; even more importantly, the abandon
option becomes exercisable.

to be magnied by the activity of institutional investors,

such as M&A arbitrage hedge funds, that try to prot by
both buying the target companys shares to push up their
price and sellingoften short-sellingthe bidder companys shares to depress their trading price.
If a symmetric collar is negotiated with respect to the
bidders pre-announcement pricethat is, the current stock
price is at the same distance from each boundthen the two
companies shareholders are likely to be similarly protected.
But if the market is expected to respond negatively to the
announcement of the deal, the collar should be shifted
downward to align it with the post-announcement (not the
pre-announcement), bidders share price, thus guaranteeing
the expected level of protection to the bidder company.

Building Expectations Into a Fixed-price Collar

One way to incorporate the effects of negative abnormal
stock returns (ARs) into a model of abandonment option
pricing is to use Black-Scholes or Monte Carlo simulations
with a lower current share price for valuation input. AlterJournal of Applied Corporate Finance Volume 18 Number 4

natively, using the binomial trees approach, it is possible

to dene a higher probability for the down parameter used
in the simulation. Paths a and b in Figure 2 illustrate
the effects of incorporating negative ARs into the simulation of a future share price, using a lower starting point. In
this case, the collar would be aligned to the post-announcement, not pre-announcement, bidder share price.
In path b, the probability that the share price will break
the lower bound at closing increases from 16% in path a to
28%. The upper bound is violated in path b in only 14%
of the simulated outcomes, as compared to 20% for path a.
Although the presence of negative ARs can be accounted
for in different ways, this result is consistent with our
argument: if signicant ARs are expected, they will affect
the level of protection provided to the two counterparties.

Floating Collar Offers

Floating collar offers differ from xed collar offers in that the
exchange ratio is free to oat, although only within a negotiated range of values. For example, in the deal just discussed
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93

Possible future paths followed by a stock

price that equals 10 at present, based
on Monte Carlo simulations. A collar
(9-11) is also shown by the two parallel
horizontal lines.

Figure 2.a

Possible future paths of the same stock as in

Figure 2.a when ARs are accounted for, as a
reduction in the share price at time zero (9.5
instead of 10.0). A collar (9-11) is also
shown by the two parallel horizontal lines.

Figure 2.b

where the exchange ratio of bidder to target shares is set at

2:1, lets assume that the ratio is now allowed to oat as low
as 1.82 (but no lower) and as high as 2.22. In this kind of
transaction, provided the ratio stays within the bounds of
1.82 and 2.22, the target company shareholders are guaranteed a constant euro price per share (20 in this case).9
But if the ratio moves above or below those bounds,
as shown in Figure 3, the price per share paid will be a
linear function of the bidder companys share price, with
a slope equal to the exchange ratio upper bound (2.22 in
our example) if the upper bound is violated, or equal to
the lower bound (1.82) if the lower bound is crossed. The
upper bound, as can be seen in Figure 4, allows the bidding
companys shareholders to avoid a material dilution if the
bidder companys share price should fall sharply in the
period between when the board sets the cash amount for
each target companys share and when the transaction is
actually closed. The lower bound guarantees that the target
companys shareholders will receive at least a pre-determined percentage of merged entity shares (in the example
in Figure 4, at least 21.4%).
The AIG-AGC merger
The recent merger of AIG and AGC exemplies how collar
structures can be used to manage price risks before a transaction is closed. In 2001, facing competition from Prudential

UK in a takeover of U.S.-based insurer American General

Corp (AGC), the U.S. insurance company American International Group (AIG) proposed a counteroffer for AGCs
shares. AIGs proposal was structured as a oating collar
offer, with the exchange ratio of the transaction allowed to
uctuate between 0.5462 and 0.6037 over an agreed-upon
period before the transaction closing. This offer enabled
AIG to guarantee AGCs shareholders a price of $46.00 for
each share in the offer, provided AIGs share price stayed
between $76.20 and $84.20. If the price moved outside
these bounds, the exchange ratio would be 0.5462 for an
AIG share price above $84.20 or 0.6037 for an AIG share
price below $76.20. Just before its oating collar offer was
launched (after the close of trading on April 3, 2001), AIGs
shares last traded at $80.21, roughly the midpoint of the
collar uctuation range.
The oating collar allowed AIG to top Prudential UKs
offer, a xed collar offer whose value at the time of AIGs
bid stood at $39.00, representing just a 6% premium over
AGCs April 3 closing price of $36.80. By comparison,
AIGs offer amounted to a 25% premium for AGCs shareholders. Whats more, the use of the oating collar allowed
AIG to manage its dilution risk, giving AGCs shareholders
a signicant potential upside. To the extent AIG share price
moved above $84.20 prior to the close, the lower bound on
the exchange ratio would have given AGCs shareholders
the benets of a further appreciation of AIG shares. The

9. The terms herein follow those used in Fuller (2003).

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Figure 3 Floating Collar Offer Payoff Structure.

When the exchange ratio calculated at current market value falls between the lower and the upper bound at closing,
the total consideration paid is xed (horizontal segment). Outside the two bounds, the total consideration is a linear
function of the bidder company share price, with a slope equal to the exchange ratio implied in the violated bound.

at Closing
PayoffPayoff
at Closing

Figure 4 Floating Collar Offer Shareholding Structure.

The stake obtained by the target companys shareholders in the merged entity as a function of the exchange ratio used in the transaction.
The constant cash amount has been assumed to be 20 for each target companys share, while the bidder company share price ranges
from 9 to 11. The number of bidder company shares outstanding is assumed to be 100 million. The target companys shares outstanding are assumed to be 15 million. Lower and upper bounds are assumed to be 1.82:1 and 2.22:1, respectively. Given the particular payment structure, in this transaction the target company shareholders stake in the combined entity ranges from 21.4% to 25%, corresponding to a 1.82:1 and to a 2.22:1 exchange ratio, respectively. Within the two bounds, cash consideration paid is xed at 20 per share.

Target Shareholders Stake in the Combined Entity

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Table 1

Summary of Payoffs for the Two Collar Offers Described

Fixed Collar Offer
Bidder Stock Price
Payoff
at Closing
at Closing

Lower Bound

8.0
8.2
8.4
8.6
8.8

9.0
9.2
9.4
9.6
9.8
10.0
10.2
10.4
10.6
10.8

Upper Bound

11.0

11.2
11.4
11.6
11.8
12.0

Floating Collar Offer

Transaction
Exchange ratio

Bidder Stock Price

at Closing

18.0
18.0
18.0
18.0
18.0

2.25
2.20
2.14
2.09
2.05

18.0

2.00

9.0

18.4
18.8
19.2
19.6
20.0
20.4
20.8
21.2
21.6

2.00
2.00
2.00
2.00
2.00
2.00
2.00
2.00
2.00

9.2
9.4
9.6
9.8
10.0
10.2
10.4
10.6
10.8

8.0
8.2
8.4
8.6
8.8

22.0

2.00

11.0

22.0
22.0
22.0
22.0
22.0

1.96
1.93
1.90
1.86
1.83

upper bound, meanwhile, limited the extent to which the

voting power of AIGs shareholders could be diluted in the
combined entity.
Finally, the collar in AIGs counteroffer allowed
the company to make a more attractive pure stock offer
than Prudential UK by reducing the target shareholders
uncertainty about the value of the shares being offered in
exchange. During the battle for control, the UK insurers
shares fell by over 30% (between January 2, 2001 and
April 3, 2001); and since the proposed exchange ratio for
Prudentials offer was xed at 3.6622, the drop in the value
of its shares reduced the effective premium it was offering
for AGC, making AIGs offer all the more attractive.
As the result shows, AIG managed the merger quite effectively. The day after AIG announced its counteroffer, the
value of its shares dropped to around $76. But the oating
collar enabled AIG to keep the transaction equally attractive
to AGCs shareholders since the exchange ratio increase fully
compensated them for the decrease in the value of the shares.
The transaction closed on August 29, 2001 within the oating collar bounds, at an exchange ratio of 0.5790. And despite

11.2
11.4
11.6
11.8
12.0

Payoff
at Closing

Transaction
Exchange Ratio

17.8
18.2
18.6
19.1
19.5

2.22
2.22
2.22
2.22
2.22

20.0

2.22

20.0
20.0
20.0
20.0
20.0
20.0
20.0
20.0
20.0

2.17
2.13
2.08
2.04
2.00
1.96
1.92
1.89
1.85

20.0

1.82

20.4
20.7
21.1
21.5
21.8

1.82
1.82
1.82
1.82
1.82

Upper Bound

Lower Bound

the markets initial negative reaction, the deal has proved to

be positive for AIGs shareholders, as can be inferred from the
quick rebound in AIG share price following its drop after the
announcement. Just two weeks after the launch of the deal,
AIGs stock price had returned to its pre-announcement level,
closing above $80 on April 18th.

Recommendations to Bidding and Target Companies

From a management standpoint, it is clear that the described
contractual structures have the potential to offer a signicant competitive advantage in a takeover battle. As recent
papers have highlighted, the negotiation of a collar represents a cost for the bidders management in terms of the
complexity of the offer structure and the time and effort
required for the negotiations.10 The justication for bearing this cost is the expected value of the reduction of the
negotiation costs; should the collar be violated, the transaction could immediately be cancelled by either counterparty
with no need to resort to material adverse change clauses

10. See J. Houston and M. Ryngaert, (1997), Equity Issuance and Adverse Selection: a Direct Test Using Conditional Stock Offers, Journal of Finance, Vol. 52, pp.
197-219 and Ofcer (2004).

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Table 2

Fixed vs. Floating Collar Offers: Pros and Cons

Bidder

Company

Fixed Collar Offers

Floating Collar Offers

Pros

Cons

Pros

Cons

Dilution risk minimized

Price risk management

Perfect risk management of

Sub-optimal dilution risk

(pre-negotiated exch. ratio)

Simpler to negotiate vs.
oating collar offers
Abandon option outside of

sub-optimal in presence

the cash value of the

of small relative move-

consideration paid

ments of bidder vs. target

share prices

management

Abandon option outside

of negotiated bounds

Target Company

negotiated bounds

Achievement of a

Price risk management

Guaranteed cash value of

pre-negotiated interest in the

sub-optimal in presence of

the medium of exchange

bidder company

small relative movements

Abandon option outside of

Abandon option outside of

negotiated bounds

of bidder vs. target share

Uncertainty regarding the

pro-forma ownership structure

negotiated bounds

prices

(MACs) or similar measures, which are often unsuccessful.

The existing literature on market practice reveals
that collar offers are used more frequently in the nancial services industries, especially in the banking industry,
largely because regulatory capital requirements favor the
use of stock as a means of payment. In particular, oating collar offers provide the target shareholders with greater
certainty about the per share payment, while at the same
time preserving the nancial exibility of the bidder.
Interestingly, empirical analysis suggests that the use
of collars has the effect of reducing the negative abnormal
stock returns (ARs) typically experienced by bidders in
stock-for-stock offers. More specically, studies suggest that
the ARs are the most negative in the case of pure stockfor-stock offers, less negative for xed-collar offers, still less
negative for oating-collar offers, and typically positive in
the case of all-cash offers.11 These ndings suggest, among
other things, that a oating-collar offer is interpreted by the
market as a signal of the bidders managements condence
in its companys value.
By effectively managing dilution and overpayment
(and underpayment) risks, a collar offer allows the bidders
management to be more aggressive in its pricing of a stockfor-stock deal and hence be a competitive player in a battle
for control. A xed collar offer is more attractive when
target shareholders are willing to accept a certain amount
of uncertainty about the consideration received. Floating

collars, by contrast, are likely to be more effective when

dealing with a signicantly risk-averse (e.g. retail) investor
clientele, since they effectively guarantee a xed price per
share provided the bidders price stays within the specied
range (and if it doesnt, the two counterparties have the
option to cancel the deal).

11. Ibid.
12. See, among others, R. Roll, (1986), The Hubris Hypothesis of Corporate Takeovers, The Journal of Business, Vol. 59, pp. 197-216; R.G. Hansen, (1987), A Theory for the Choice of the Exchange Medium in Mergers and Acquisitions, The Journal of
Business, Vol. 60, pp. 75-95; J. Houston and M. Ryngaert, (1997).

13. See S. Myers and N.S. Majluf, (1984), Corporate Financing and Investment
Decisions when Firms Have Information Investors Do Not Have, Journal of Financial
Economics, Vol. 13, pp. 187-221; B.E. Eckbo, R. Giammarino, and R. Heinkel, (1990),
Asymmetric Information and the Medium of Exchange in Takeovers: Theory and Tests,
Review of Financial Studies, Vol. 3, pp. 651-675.

Journal of Applied Corporate Finance Volume 18 Number 4

Dealing with Post-merger Uncertainty:

The Use of Earn-outs
Although collar offers can have signicant benets in a
competitive bidding environment and reduce overall transaction costs, they offer no protection against the possibility
that the target will fail to live up to expectations after the
deal closes. Should the two integrated companies fail to
realize most of the expected synergies, the bidder company
will likely have overpaid for the target. M&A practice has
developed two main instruments to manage performance
risk in the integration (or post-closing) phase: earn-outs
and contingent value rights.
A number of studies have documented the potential importance of asymmetric information and moral
hazard in M&A transactions.12 To the extent the target
companys insiders (managers or shareholders) have better
information about their company, they can value it more
accurately than the bidders management.13 Furthermore,
the targets insiders will sell at a price no less than the fair
value of the company; and given the uncertainty about a

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97

The Saeco Tender Offer

n March 2004, Paribas Affaires Industriels Private

Equity Funds, through the controlled companies El
Gringo Investimenti, Giro Investimenti, and Giro Investimenti I, acquired a 67% stake in Saeco S.p.A., the leading
Italian manufacturer of espresso coffee machines, from the
companys controlling shareholders. As required by Italian law, after control of Saeco changed hands, a tender
offer was launched for all of Saecos remaining outstanding shares.
The acquisition involved signicant issues. For one thing,
the company needed to retain key managers whose expertise
was necessary for Saeco to compete effectively in the future.
Second, Saecos protability had to be restored. Its EBITDA
margin had dropped from around 27% in 2002 to 19%
in 2003, and EBITDA had fallen from 110.0 million to
79.7 million. To address these issues, the selling shareholders and the acquiring vehicle negotiated an earn-out clause
as part of the shareholders agreements, which effectively

consisted of two parts: a performance plan and an incentive

loyalty plan.
According to the performance plan, in the event of a
merger between the offering vehicle (Giro Investimenti I)
and Saeco, three of the Saecos selling shareholders, with a
combined stake of 52% in the companywere entitled to a
variable payment ranging from 1.0 million to 6.0 million.
The payment was a function of the merged entitys consolidated EBITDA for the year ending on March 31, 2005.
In particular, the 1.0 million payment was contingent on
EBITDA being above 120.0 million, and would increase
linearly up to 6.0 million should EBITDA reach 130.0
million, after which it was capped.17
The loyalty incentive plan, although similar to the
performance plan, added an important clauseone that
effectively matches the payment from the performance plan,
provided only that, as of September 30, 2005, all of the
above managers are still with the company.18

target companys fair value, sellers can exploit their information advantage by accepting an overvalued offer. The
potential moral hazard problem refers to the actionsor
in some cases the inactivityof the target companys
management in the post-merger phase. If a companys
success depends critically on valuable human capital, an
M&A transaction with such a company is riskier because
those people could leave.14 To reduce this risk, it might be
necessary to offer current managers incentives to remain
active in the targets management.
These problems of information and incentives represent barriers to M&A deals, and the greater the uncertainty
about the targets fair valuewhether due to asymmetric
information or moral hazardthe more likely that counterparties will look for risk management solutions. Earn-outs
allow the parties to limit the effects of such uncertainty by
dividing the payment into two tranches.15 The rst tranche
is certain to be paid out, and is usually settled at the closing
of the transaction. The second tranche will be paid at a
future date only if certain conditions, negotiated in the
present, are met. The second payment tranche is typically
tied to the target companys future performance.

The likelihood of using an earn-out contract depends

on how much uncertainty there is about the target companys true value. Although synergies can be an important
consideration, the valuation of the target will often depend
heavily on the targets future expected performance as a
stand-alone entity. By structuring the deal with an upfront
payment plus an earn-out, acquirers can reduce the risk of
mispricing the target company to the point where their only
risk is that the cash consideration paid at the closing exceeds
the target companys fair value plus realized synergies.
One potential benet of earn-outs is their effectiveness as
a self-selection mechanism. Target managements are likely
to acceptand in fact they are even likely to proposea
deal with an earn-out only when they are convinced of their
companies ability to meet the conditions that trigger the
second set of payments.16 Low-quality companies would
be reluctant to accept such payment structures since the
management knows that the contingent tranche has a low
probability of being paid in the future. In sum, the earnout provides a self-selection mechanism that addresses both
the asymmetric information and moral hazard problems by
(1) enabling companies with uncertain prospects to make

14. See N. Kohers and J. Ang, (2000), Earnouts in Mergers: Agreeing to Disagree
and Agreeing to Stay, The Journal of Business, Vol. 73, pp. 445-476.
15. There might be more than two tranches, and they will be either certain or conditional. Therefore, it is possible to categorize payments according to the two characteristics above.
16. See R. Bruner, (2001), Does M&A Pay?, Darden School of Business and Administration, University of Virginia.
17. Given the limited value of the earn-out provisions relative to the value of the 52%

stake (a maximum of 12 million vs. about 370 million), the discussed earn-outs appear
to be designed primarily to retain the three managers rather than addressing any perceived disagreement about the value of the rm.
18. The contract payoff was also contingent on the same EBITDA thresholds as before
(with payment ranging from 500,000 for an EBITDA of 120.0 million to 6.0 million
for an EBITDA above 130.0 million).

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credible statements of condence in their own future and

(2) providing them with strong incentives to back their
statements with strong performance.
Some Applications of Earn-outs
The special structure of earn-out contracts makes them
better suited to high-tech industries or transactions
involving non-listed companies that do not have to meet
the extensive disclosure requirements of listed companies.
To the extent the value of a company depends heavily on
intangible assets that are difcult to value, the buyer will
want to be protected from a possible misvaluation of those
assets.
For the target company, the earn-out is an opportunity
to cash in on the full value of the company. This is a key
concern, especially for small innovative companies that do
not have a sufcient track record to prove their real value.
Without contingent payment contracts, these companies
may have to resign themselves to selling at a discount to
their perceived intrinsic value.
Earn-outs are also used for companies that depend on
a key managerial team. The contract provides an incentive
for the target management to remain with the company
after the merger.
The typical life of an earn-out ranges from two- to
ve- years after the transactions close, with the average
being around three years.19 The payments resulting from
an earn-out contract are typically tied to performance
gures such as revenues; earnings before interest, taxes,
depreciation, and amortization (EBITDA); earnings
before interest and taxes (EBIT); and net income. The
choice depends greatly on the industry in which the
company operates. Research analysts generally focus on
particular multiples for each industry that are deemed
to be the most meaningful. For some industries, it is
enterprise value over EBITDA; in others its the more
conventional price-to-earnings ratio.
One of the key issues relating to the use of earn-outs is
the possibility of future lawsuits stemming from problems
with accounting transparency and the discretion allowed
by GAAP and IFRS in determining accruals and deferrals,
depreciation, and provisions. Legal disputes could center on
whether or not the target company has reached the performance targets in terms of EBIT or EBITDA. If the bidder
has material control over the merged entity, some expenses,
such as R&D, depreciation, amortization, and provisions could be allocated to the acquired company, thereby
depressing its EBIT (due to D&A and provisions items)
or its EBITDA (in the event R&D expense is allocated or
owing to transfer prices). And the opposite could happen
as well. If the target company remains largely independent,

the companys management might decide to underinvest

in R&D, minimize provisions, or depreciate and amortize
assets over longer periods of time.
To address the problem created by managerial discretion
in accounting, the parties to an earn-out should consider
preparing separate sets of statements for the target company,
and then appointing a mutually agreed-upon independent
auditor to sign off on them. But even so, in cases where target
companies remain largely independent after the acquisition,
the risk of improper accounting policies and legal disputes
over the achievement of the performance targets is likely to
be material.
A recent example of the use of an earn-out is eBays
acquisition of Skype Technologies. On September 12, 2005,
eBay agreed to pay $2.6 billion for Skype, half in stock and
half in cash, plus an earn-out involving a contingent all-ornothing payment of $1.5 billion in 2008 or 2009 in either
cash or stock (at eBays discretion). The payout was tied to
several performance indicators, including aggressive targets
for active users, gross prot, and revenues. Skype generated
$7 million in revenue in 2004 and was expected to generate $60 million in 2005 and $200 million in 2006. The
company had yet to report a prot at the time of the acquisition, but had more than 54 million registered users.
With this earn-out having the potential to amount to
over 35% of the total possible consideration of $4.1 billion,
the eBay acquisition of Skype illustrates the potential value
of using an earn-out to bridge the valuation gap in the
M&A process. What the case also makes clear, however,
is the need for the bidder and the target to keep separate
sets of audited statements to determine if the contingent
payment should be paid. But despite the associated risks,
well-designed earn-outs can be useful tools that bring exibility and value-adding potential to the M&A process.
The Pricing of Earn-outs
For pricing purposes, earn-outs resemble options on the
target companys fair value. The target companys shareholders hold what amounts to a long position in a call
option on their companys valuean option that entitles
them to cash in, at the dates negotiated in the contract,
some percentage of the difference between the price received
at closing and the companys estimated fair value (assuming the latter is higher). The future contingent payment of
earn-out contracts is also generally capped at a negotiated
level (which implies that the target shareholders sell a call
option to the buyer with a strike price higher than the one
implied by the initial part of the payment to the bidder
companys shareholders). From that point on, all the excess
value generated by the merger accrues to the buyer.
The payoff structure of earn-outs thus suggests that they

19. See Bruner and Stiegler (1999).

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Figure 5 Simulation of Saecos March 2005 EBITDA Levels

Estimated by selling shareholders (blue line) and the bidding company (black line).

should be valued as options rather than using discounted

cash ow (DCF) analysis. And if one uses an option pricing
model to value an earn-out, then bidders will aim to reduce
the length of the earn-out period (all other things equal)
while the target companys shareholders will seek a longer
contract.20 This reects the fact that in an option pricing
environment, the longer the tenor of the option, the more
likely it is to expire in the money and thus the higher its
value. Another consequence of using the option pricing
approach to value earn-outs is that high underlying asset
variability increases the contract value.
But if we instead price earn-outs using a DCF approach,
the bidders shareholders benet from an increase in the
contractual life of the agreement due to the time-valueof-money effect, while the target companys shareholders
prefer earn-outs with shorter tenors to avoid the negative
effect of discounting.
DCF is probably better suited to pricing cash-ornothing contingent payments, when a xed amount must
be paid if future conditions are met. Typical examples are
a new product launch or an increase in the market share
of the company. Pricing such payments means assigning
a probability of success to the future conditions, and then
discounting, at the risk-free rate, the contingent payment

multiplied by the probability of successor, to put it

another way, discounting future payments at a rate that
includes a failure risk premium.
In most earn-out valuations, the key issue that must
be addressed is the potential difference in the two companies views of the probability that the embedded option will
expire in the money. Going back to the Saeco case-study,
the earn-out clause entitles selling shareholders to receive a
contingent payment only if their estimates of the companys
future performance are realized. It seems clear from the
terms of the deal that the bidders controlling shareholders
were unwilling to bear the risk of valuing Saeco on the basis
of a projected 2005 EBITDA above a certain valuein this
case, 120.0 million. On the other hand, the willingness of
the selling shareholders to defer part of their payment and
tie it to the projected EBITDA suggests their condence in
their ability to achieve such prots.
Recall that Saecos last reported EBITDA for the year
ending December 31, 2003 was 79.7 million, representing an EBITDA margin of about 19.0% of total reported
2003 revenues of 419.8 million. Based on this gure,
it might seem unlikely that the company will be able to
achieve the negotiated threshold of 120.0 million, above
which the earn-out produces a payoff. But consider also that

20. See R. Bruner and S. Stiegler, (1999), Technical Note on Structuring and Valuing
Incentive Payments in M&A: Earnouts and Other Contingent Payments to the Seller,
Darden School of Business and Administration, University of Virginia.

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Table 3

Valuation of the Performance Plan and of the

Incentive Loyalty Plan
Value Estimated by the
Selling Shareholders

Value Estimated by the

Bidder Company

Earn-out 1:

2.49 million

zero

Earn-out 2:

2.75 million

zero

EBITDA for the year 2002 was 110.0 million, resulting in

an EBITDA margin of 26.8%. Given the broad range of
possible outcomes indicated by these two gures, the two
parties used the exible, option-like pricing of the earn-out
to bridge the valuation gap.
When computing the value of such instruments, one
can use Monte Carlo simulations to generate the probability distributions that are especially useful in option pricing
applications. Since a payoff from the earn-out will occur only
if the option expires in the money (and there is no possibility
of a negative payoff ), one can estimate the future value of
the underlying assetthe merged entitys EBITDAusing
Saecos current EBITDA of 79.7 million together with
random draws from a triangular distribution.21, 22
We performed the simulations for EBITDA over the
time period between December 31, 2003, the date of the
last reported EBITDA, and March 30, 2005, the expiration
dates of the two earn-outs. We did so from both the bidder
and seller perspectives, assuming that the bidder would use
the lower 2003 EBITDA as a basis for forecasting, whereas
the seller would use the higher 2002 EBITDA.23
As can be seen in Figure 5, the difference in the valuations obtained by the two parties to the merger is clear.
According to the 500 simulations run for the bidder
company, at no future point will the negotiated earn-outs
produce a payoff. Yet, the target companys management
expects a payoff in 98.8% of possible future scenarios.
Assuming a 10% discount rate for selling shareholders,
we calculated expected values for the two earn-outs that are
shown in Table 3. According to our estimates, selling shareholders expected a payoff from the earn-out of about 5.24
million. At the same time, the bidding company effectively
assigns a value of zero to the earn-out portfolio.
21. See Bruner and Stiegler (1999) and Bruner (2004).
22. The random extractions will necessarily fall between a minimum value and a
maximum value. The third parameter that completes the triangular probability distribution is the most likely value (or top value) for the EBITDA growth rate. Monte Carlo
simulations are used here over ve observations: generally, from one value to the next
(namely, two interim reports), there will be a time span of not less than three months. As
a result, we divided the time period over which the derivative is written into ve intervals.
This allows us to capture the increased uncertainty about future outcomes.
23. The pricing of the two instruments starts from the following hypotheses regarding
the assumptions of the two counterparties: the target companys management evaluates
the contracts from a starting point of 112.5 million for 2003 EBITDA (obtained by applying the 2002 EBITDA margin to the 2003 sales), and then discounts future payoffs
at maturity at a certain discount rate, relatively high, to compensate for use of the high

Journal of Applied Corporate Finance Volume 18 Number 4

As we already noted, these contracts allowed the bidder

to manage the variability of the total consideration paid,
while limiting the sum of the two contingent payments
to 12 million. At the same time, selling shareholders are
motivated by the loyalty payment to stay with the company
and by the performance-based contracts to contribute to
increases in protability. Whats more, by their willingness to enter into a contingent payment contract based on
Saecos value, the selling shareholders demonstrated their
condence in the value of their company and signaled to
the market that the company is a high-quality target.
Nevertheless, as has become clear from some recent
examples, poorly designed earn-outs have the potential to
create unexpected nancial burdens for the merged companies. For the managers of the bidder and seller, having a solid
understanding of the mechanics of an earn-out, particularly
with regard to the pricing and future payments required by
such contracts, can be critical to success.
Contingent Value Rights
Contingent value rights (CVRs) range from plain vanilla to
exotic stock options that are issued in stock-nanced M&A
transactions. CVRs are used in many transactions, often
under different names such as warrants or stock options,
and are frequently listed on regulated markets.
From a technical standpoint, CVRs are exible instruments that are often structured as binary (or digital)
options that result in all-or-nothing payments. In this case,
the instrument payoff does not depend in a linear way on the
underlying asset price, but rather involves a bullet payment
made either in cash or in stock. In a typical stock payment,
the stocks to be assigned under the CVR agreement are
issued at the transaction closing and then deposited into an
escrow account.
Other examples of CVRs negotiated in M&A transactions involve exotic options, such as sudden death options
(like up-and-out puts), where the claim expires without
value or payoff if the underlying asset price breaks the
collars upper bound. To reduce uncertainty, however, the
underlying asset is often an average over several trading
days and not a spot price.
Other CVR structures have upper and lower bounds
that are not xed, but increase over time at a predetermined
2002 EBITDA margin (+8% vs. 2003 margin) as a simulation driver (Bruner and
Stiegler, 1999). However, when performing the analysis from the bidders perspective,
we use the actual 2003 EBITDA gure, a at margin of 19.0%, to simulate possible
future EBITDA values. The minimum, maximum, and top values representing revenue
and EBITDA growth (since we assume no change in the EBITDA margin over each quarter) from one quarter to the next, are set at 2%, 4%, and 3% for both target and bidder
company management.

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101

growth rate. With still others, the instrument tenor can be

modied by the parties. Given the vast universe of tailored
options available, the CVRs actual structure will ultimately
be determined by the bidders management, perhaps in
negotiation with the seller.
What explains the use of CVRs in M&A deals? One clear
factor is the effectiveness of CVRs in protecting target shareholders from drops in bidder stock price. This protection can
be provided in the form of either cash compensation or the
issuance of new shares by the bidder. Such contracts aim to
make a stock-for-stock offer more attractive for target shareholders, without burdening the acquirers nancial structure
with excessive nancial leverage.
Another explanation for CVRs is their attractiveness
to certain kinds of investors. When the target is a public
company, the vast majority of shareholders are often nancial investors (i.e., mutual funds as well as individual
investors) as opposed to other companies. To make the
offer as attractive as possible for this category of shareholders, CVRs effectively guarantee the target shareholders a
minimum cash value for the stock offered in the transaction. This helps reduce the potential for a hostile reaction by
target shareholders, who, without the CVRs, might not be
willing to tender their shares for those of another company.
Even though they have the option to sell the received shares
on the market after closing, they might not be willing to
look for another investment opportunity. CVRs can address
these issues.
CVRs can also be used to avoid the cash outlay associated with mandatory tender offers that have to be launched
following the change of control over the target company.
Interestingly, CVRs can be designed either to encourage or
to deter the target companys nancial shareholders from
delivering their shares to a tender offer. The CVRs that are
used to discourage shareholders from delivering shares to a
public offer are typically written on the target companys
shares in order to guarantee a minimum price (e.g. a put
option) to all shareholders who keep their shares, thus
making those instruments more attractive to them.
As in the case of earn-outs, the use of CVRs can have
unforeseen and unwanted consequences. For example, a
few instruments that were issued near the peak of the U.S.
and European stock markets in 2000 resulted in unexpectedly large payouts by bidder companies at the end of their
contractual lives. Hence the need for management to
understand how to value these instruments as well as the

potential limitations of option pricing using the standard

Black-Scholes model.24
The Use of CVRs: Two Illustrative Examples
In June 1998, the German insurance group Allianz issued
CVRs to the shareholders of Assurances Generales de
France (AGF) to discourage them from tendering their
shares into their offer for AGF. In this friendly takeover, the German company aimed to keep a satisfactory
percentage of total AGF shares as free oat but, according to French law, it had to launch a mandatory tender
offer for all outstanding AGF shares. To avoid the massive
cash outlay needed for such a purchase, Allianz assigned
one CVR to each share not delivered to the tender offer,
at no charge. The instrument effectively guaranteed its
holder, at a future date, a minimum price for each share
not tendered.
The promised payoff to the holder of this CVR can
be viewed as a combination of two exotic put options: a
down-and-out put and a down-and-in put. The downand-out put entitled its owner to receive the difference (if
negative) between the future market price of AGF shares
and FRF360 at the exercise date (between June 1, 2001
and June 15, 2001) if the AGF price (about FRF 350 at
the time of the offer) fell between FRF320 and FRF360.
Below FRF320, the option would expire without any
payoff (sudden death at FRF320), but the down-and-in
put option would come into existence (sudden birth at
FRF320). The down-and-in was an exchange put option
that allowed the option holder to deliver AGF shares
and receive FRF360 per share (see Figure 6). In sum,
the combination of puts built into this CVR effectively
guaranteed its holders a minimum value of FRF360 at the
exercise date.
Thanks in part to the CVR offering structure, the
offer by Allianz prevailed over a competing bid by the
Italian insurer Assicurazioni Generali for 8.0 billion.
And besides offering downside protection for some of
AGFs shareholders, the down-and-in put options also
protected Allianz in the event of a signicant reduction in
AGFs share price. The main reason for using two options
with non-overlapping regions was to provide Allianz with
the right, in the event the value of AGFs shares dropped,
to acquire all of the portfolios underlying shares at the
specied exercise date. By encouraging AGF shareholders not to deliver their shares in the tender offer, CVRs

24. For instance, a violation of the Markov assumption on which the Black-Scholes
formula is basednamely, that current stock prices could be inated by irrational expectationsmight determine distortions in the Black-Scholes pricing mechanism. This was the
case for the CVRs issued by France Telecom for the acquisition of Equant in 2000 that
will be described in the next paragraph. Other possible alternatives, given their optionlike nature, are to price CVRs by using Monte Carlo simulations or the binomial trees
technique.

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Figure 6 Total Value of the Described Portfolio

(one AGF share plus one CVR) at CVR exercise date

allowed Allianz to limit the total size of the cash outlay

at the transaction closing. At the same time, by allowing
for what amounted to a selective purchase of the companys controlling stake, it made possible an offer valued at
10.5 billion, approximately 2.5 billion higher than the
Generali bid.
CVRs can also be used to protect target shareholders
from downside risk when a tender offer is not launched
for all the target shares; that is, when a controlling stake is
acquired in a private transaction outside the stock exchange
and there is no legal obligation to launch a mandatory
tender offer. In 2000, for example, France Telecom (FT)
acquired a controlling stake in Dutch telecommunications
carrier Equant NV by purchasing (on the stock exchange)
the 34% stake held in the company by the Sita Foundation.
FT acquired Sitas 34% stake by exchanging one of its own
shares for 2.2 Equant shares.
At FTs current market price, this exchange ratio implied
a value of about 51.0 for Equant shares, which represented
a 37% premium over its pre-transaction price of about 37.
To make the transaction more attractive to Equants minority shareholders, FT announced at the same time that it
would grant one CVR to each Equant share not previously
held by Sita. The rationale for this transaction was to give
Equant minority shareholders downside protection.
Each CVR effectively entitled Equant shareholders to
sell one share to FT for 60 three years after the closing,
provided Equants price remained 45 or higher (thus effectively capping the payout on each contract payout at 15).
Because Equants price ended up below 45 at the end of
the three-year period, the CVRs issued by FT to Equants
minority shareholders resulted in a cash outlay by FT of
Journal of Applied Corporate Finance Volume 18 Number 4

about 2 billion (i.e., 15 per each CVR) at the expiration

of the CVRs.
Conclusions
Although the use of M&A risk management instruments
is still relatively limited in international nancial markets,
recent increases in stock market volatility have increased the
likelihood they will be used in the future. We classify such
instruments into two categories: (1) instruments for managing pre-closing risks, notably the changes in bidders stock
price that can end up affecting the terms of the deal; and
(2) contingent value instruments that guard against the
risk of overpayment by making the price of the deal contingent on post-close performance of the target.
In the rst category of instruments, collars provide
bidder and target companies with a means of limiting
dilution and price risk, which in turn reduces ex post negotiation costs and gives the managers of both companies an
easy way out in case of material share price uctuations.
Post-closing instruments such as earn-outs and CVRs can
be used to limit the risks of over- or under-payment and for
their tailoring potential, particularly when takeover offers
address minority shareholders preferences. Earn-outs are
likely to be an effective risk management tool in acquisitions involving high-growth companies with limited track
records and uncertain, if promising, future performance.
Earn-outs can also be effective in retaining and motivating a target companys managers. But if earn-outs provide a
way of bridging the valuation gap during negotiations for a
takeover, they have a number of limitations, including the
difculty of pricing them, the expense of negotiating them,
and their vulnerability to legal dispute.
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CVRs, by contrast, are better suited to companies

engaged in competitive bidding to take over public targets,
providing the bidders management with greater nancial
exibility and signicant potential for tailoring their offers.
They are easier to structure as instruments than earn-outs;
and because they are often listed, CVRs are probably most
suitable when both bidder and target companies are listed.
Like earn-outs, CVRs can be used to encourage target shareholders either to deliver or to retain their shares (in selective
purchases). But, unless carefully structured, they can lead to
higher than expected cash outlays while leaving their issuer
exposed to volatile macro and stock market conditions.

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stefano caselli is Associate Professor of Banking and Finance at

Universit Bocconi Milan and Director of Customized Programs in Banking and Insurance Firms at SDA Bocconi School of Management.
stefano gatti is Associate Professor of Banking and Finance and
Director of the BSc in Economics and Finance at Universit Bocconi,
Milan.

marco visconti is a European equity sales trader at Merrill Lynch

in Milan.

A Morgan Stanley Publication Fall 2006