Expanding the definition of bounded rationality in strategy research: An examination of earnout frames in M&A

When an M&A contract contains an earnout clause, a performance-contingent consideration provision, the value of the deal can be framed as: (1) total potential consideration, the sum of the guaranteed upfront payment and the contingent payment, or (2) guaranteed consideration, the upfront payment with the possibility of earning additional payment. The way the parent firm frames the merger value influences how retained target managers perceive the earnout. They view the earnout as a potential loss if the deal value is framed in terms of total consideration and as a potential gain if the deal value is framed in terms of guaranteed consideration. Prospect theory suggests that the contrasting views lead to different behavioral risk profiles. Under a total consideration frame, retained target management displays risk-seeking behavior in an attempt to avert certain loss. Alternatively, if the merger value is framed in terms of guaranteed consideration, they display risk-averse behavior in an attempt to preserve the gain. Parent firms have specific goals for different mergers. Because risk-seeking behavior may be more appropriate to accomplish one merger goal, but not another, it is important to understand when to use total or guaranteed consideration frames to induce risk-seeking or risk-averse behavior, respectively. When deal frames are strategically aligned with parent merger goals, retained target management has a higher likelihood of displaying the behavior desired by the parent, leading to a greater probability that the parent's merger goal will be met and retained target management will receive the earnout payment.