VC firms, which invest in early-stage startups, play a crucial role in the startup industry. Most startups are acquired through M&A deals, but there is little research on the specifics of private M&A contracts due to a lack of data.

Research from Bocconi University aims to plug that gap and explores the role VCs play in the M&A market. The author focuses on earnouts, which are a commonly-used mechanism in M&A contracts. Earnouts are “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).”

Changing the market

The paper illustrates that when venture capital (VC) firms are involved in a merger and acquisition (M&A) transaction, the use of earnouts, a contractual mechanism that links part of the purchase price to future performance, is less frequent. This finding suggests that VCs play a similar role as earnouts in addressing information asymmetry between the buyer and seller about the value of the business. This is because VCs have experience and repeat participation in the M&A market and pre-existing relationships between buyers and VCs further reduce the need for earnouts.

The research also explores two unique sources of friction that are specific to VCs in the M&A process. First, earnout contracts require the VC to monitor the startup’s operations after the M&A transaction and verify the earnout consideration. The study finds that VCs are less likely to use earnouts when monitoring costs are high, such as when the VC is physically distant from the startup. Second, VC funds have a closed-end structure and typically liquidate themselves within 10-12 years, which can affect the use of earnouts.

Comparing early and late M&A deals in the same VC fund, the study finds that early M&A deals in the lifecycle of the VC fund have a higher likelihood of having an earnout than later deals. These results indicate that VCs have unique preferences for the use of earnouts that may or may not align with the preferences of other investors.

The study provides new insights for startups to consider when choosing a VC investor or VC fund, and how this choice can potentially affect M&A contractual outcomes. On average, the use of earnouts is lower for VC-backed startups compared to other startups, and previous relationships between VCs and buyers further decrease the use of earnouts. This is consistent with the idea that VCs can alleviate information asymmetry