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

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Content EXPANDING THE DEFINITION OF BOUNDED RATIONALITY IN STRATEGY RESEARCH: AN EXAMINATION OF EARNOUT FRAMES IN M&A by Libby Leann Weber A Dissertation Presented to the FACULTY OF THE USC GRADUATE SCHOOL UNIVERSITY OF SOUTHERN CALIFORNIA In Partial Fulfillment of the Requirements for the Degree DOCTOR OF PHILOSOPHY (BUSINESS ADMINISTRATION) August 2010 Copyright 2010 Libby Leann Weber ii DEDICATION I dedicate my dissertation to the three most important men in my life: my husband, son and father. First, my dissertation is dedicated to my amazing husband Brett, who graciously shares his life with a person who spends more time inside her head than in the real world. Without his support, encouragement and love, I would have never been able to pursue yet another graduate degree, and certainly would not have been able to complete these studies. I love you Brett! Thank you for letting me be me. Second, I dedicate this dissertation to my wonderful son Annan, who endured all the times that mom had to work, instead of play. His unconditional love made it possible for me to dedicate the necessary time to my dissertation. In fact, I came up with the idea for these studies while rocking him to sleep one night, so he is truly the inspiration for this work. Finally, my dissertation is dedicated to my dad, who is dealing with significant health issues, but understands that I do not have more time to visit or call. Because of my dad, I love pursuing knowledge and reading, two important factors that led me to my career in research. iii ACKNOWLEDEGEMENTS It would have been next to impossible to write this thesis without the help and guidance of Dr. Kyle Mayer, my PhD advisor. He has been a wonderful mentor and friend throughout this process. I truly appreciate all of your help and guidance in making me who I am, as a researcher today. I would like to acknowledge all of the help that I received in finishing this dissertation from my committee members: Dr. Nandini Rajagopalan, Dr. Jackson Nickerson and Dr. Norman Miller. Each of you has expanded my thinking, making me a better researcher. Additionally, it is a pleasure to thank those who loved and supported me throughout this process. First, I give my heartfelt gratitude to my husband, Brett, and our son, Annan, who sacrificed so much to make this possible. Thank you also to my wonderful friends, who understood that I have not been available, especially during the last year. Special thanks to Teri Mayer, Rui Wu, Laura Erskine, Val Frazee, and Megan Sachs for all of your support during my program. Finally, thank you to Viento Y Agua coffee shop, for good coffee and a nice “office” to go to everyday. iv TABLE OF CONTENTS DEDICATION ii ACKNOWLEDGEMENTS iii LIST OF TABLES viii LIST OF FIGURES ix ABSTRACT x CHAPTER 1. Introduction 1 OVERVIEW OF STUDIES 4 CHAPTER 1 REFERENCES 7 CHAPTER 2. Literature Review 9 TRANSACTION COST ECONOMICS 9 My Contributions to TCE 10 THE RESOURCE-BASED VIEW 11 My Contributions to RBV 12 BOUNDED RATIONALITY 13 Psychological Theories Pertinent to BR 16 Regulatory Focus Theory 16 Prospect Theory 19 Negativity Bias 20 Expectancy Violation Theory 21 Non-conscious affect 23 Out-group stereotypes 24 My Contributions to BR 25 MERGERS & ACQUISITIONS CONTEXT 26 My Contributions to the M&A Literature 27 CHAPTER 2 REFERENCES 28 v CHAPTER 3. Framed! The Impact of Earnout Frames on Retained Target Management Behavior and Fairness Perceptions in M&A 36 THEORETICAL FRAMEWORK 37 Prospect Theory 41 Loss-framed Earnouts 44 Gain-framed Earnouts 46 Fairness 48 METHODOLOGY 49 Experiment 50 Independent Variables 50 Dependent Variables 51 RESULTS 51 Impact of Frame on Behavioral Profile 51 Behavioral Profile Robustness Test 53 Impact of Frame on Perceived Fairness 54 Perceived Fairness Robustness Test 56 DISCUSSION & CONCLUSION 57 CHAPTER 3 REFERENCES 62 CHAPTER 4. The Right Frame of Mind for M&A: Framing Mergers to Get 66 What You Pay For EARNOUT FRAMING IN MERGER ANNOUNCEMENTS 69 Traditional Strategy Perspectives on Earnouts and Merger Framing 72 Prospect Theory & Merger Value Framing 74 Total Consideration (TC) Frame 77 Guaranteed Consideration (GC) Frame 78 Parent Manager Motivation to Use TC or GC Frames 79 Risk-seeking and Risk-averse Organizational Behavior 81 Using Merger Value Frames to Get What Managers Paid For 82 Customer strategy 83 Technological Needs 85 EMPIRICAL ANALYSIS 89 Industry Context 89 Data 90 Dependent Variables 91 Independent Variables 91 Control Variables 93 Empirical Estimation 95 Empirical Results 97 Empirical Robustness 103 DISCUSSION 105 CHAPTER 4 REFERENCES 111 vi CHAPTER 5. Simon Says: Expanding the Definition of Bounded Rationality 117 CONCEPTIONS & SOURCES OF BOUNDED RATIONALITY 119 Common Operationalizations of Bounded Rationality 119 Simon’s Bounded Rationality 121 BR OPERATIONALIZATION IN STRATEGY RESEARCH 123 Transaction Cost Economics 123 Positive Agency Theory 124 The Resource-based View 125 Bounded Rationality in Strategy Research 125 SOURCES OF PERCEPTUAL BIASES 126 Cognitive Sources 127 Frames 127 Heuristics 129 Expectations 129 Affective & Emotional Sources 130 Social Sources 131 NEW QUESTIONS IN STRATEGY RESEARCH 131 Cognitive Sources 132 Framing: Regulatory Focus Theory in Intra-firm Incentives 132 Heuristics: Negativity Bias in Inter-firm Relationships 134 Expectations: Expectancy Violation in M&A 137 Emotional Sources: Non-conscious Affect in Contract Design 140 Positive non-conscious affect 142 Negative non-conscious affect 142 Social Sources: Out-group Stereotypes in Contract Design 143 IMPACT OF A MORE COMPLEX CONCEPTION OF BR ON TCE 145 Governance 147 Low informational-Low perceptional 147 High informational-Low perceptional 148 Low informational-High perceptional 149 High informational-High perceptional 149 Opportunism 151 DISCUSSION 153 CHAPTER 5 REFERENCES 158 CHAPTER 6. Conclusion 165 CHAPTER 6 REFERENCES 169 COMPREHENSIVE BIBLIOGRAPHY 170 vii APPENDIX A.Typical earnout clause taken from a merger between 183 Investtools and Service Enhancement Corporation APPENDIX B. Experimental Conditions 184 APPENDIX C. Values in Experimental Conditions 188 APPENDIX D. Target Firms 189 APPENDIX E. Variables to Examine Merger Frames and Deal Characteristics 192 APPENDIX F. Merger Value Frame Probit Analysis 194 viii LIST OF TABLES Table 1. Behavioral Risk Profile Crosstabs Analysis 52 Table 2. Behavioral Risk Profile Analysis Correlation Statistics 53 Table 3. Behavioral Risk Profile Regression Analysis 54 Table 4. Behavioral Risk Profile Economic Significance Analysis 54 Table 5. Fairness Perception Crosstabs Analysis 55 Table 6. Fairness Perception Analysis Correlation Statistics 56 Table 7. Fairness Perception Regression Analysis 57 Table 8. Fairness Perception Economic Significance Analysis 57 Table 9. Matching Merger Value Frames with Parent Merger Goals 83 Table 10. Merger Value Frame Analysis Summary Statistics 98 Table 11. Merger Value Frame Correlation Statistics 98 Table 12. Merger Value Frame Multinomial Probit Analysis 100 Table 13. Merger Value Frame Economic Significance Analysis 102 Table 14. Merger Value Frame Robustness Test 104 Table 15. Impact of a More Complete BR Conception on TCE 146 ix LIST OF FIGURES Figure 1. Loss and Gain Framing of an Earnout 40 Figure 2. Total and Guaranteed Consideration Framing of Merger Value 76 x ABSTRACT 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. 1 CHAPTER 1. Introduction Mergers and acquisitions (M&A) have been examined extensively in the strategic management field (see Hitt et al., 2006; Barkema & Schijven, 2008; Haleblian et al., 2009 for reviews on this and related topics). M&A researchers have investigated a variety of topics, ranging from individual-level executive compensation in M&A (e.g. Agrawal & Walkling, 1994, Haleblian & Finkelstein, 1993; Hambrick & Finkelstein, 1987) to firm-level antecedents to acquisition activity (for e.g. Baum et al., 2000; Graebner & Eisenhardt, 2004). However, earnout clauses, performance-contingent consideration provisions, have not been well-researched, even though they are present in half of all small business acquisition contracts (Fields, 2005) and are predicted to become more prevalent due to the current tight credit market (Melazzo, 2008). An earnout clause requires the parent firm to pay additional consideration (beyond the upfront payment) to the target firm owners or managers, if pre-specified performance goals are met. The performance metrics in earnouts vary widely, but could include renewing contracts with key target customers or meeting a specific financial goal, based on revenue or profit. Earnout clauses are typically tiered, with different performance levels leading to different payment amounts. They also usually require target managers to remain with the newly acquired firm, for at least for a short period of time, so that performance can be assessed. Yet, according to an M&A specialist in Southern California, earnouts are often not paid out, despite their frequency in small business mergers and their projected increase in use. Headlines such as “Club Penguin Founders miss $175 Million earnout in 2 '08” (Lewis, 2009) and “Bruce Sherman's firm forgoes Earnout from Legg Mason” (Lash, 2009) demonstrate this phenomenon. Unfortunately, when earnouts are not paid out, both merger parties suffer. The target does not receive additional consideration beyond the upfront payment, and the parent’s new business unit is not performing to expectations. Thus, it is important for managers at both the parent and target firms to understand how earnouts function. However, researchers have only started to investigate earnout clauses. The work that has been done examines them solely from an economic perspective, using agency theory or the asymmetry of information perspective to examine when to use earnout clauses in mergers. Agency theory (Jensen & Meckling, 1976; Fama & Jensen, 1983) attempts to align principal and agent incentives, so the agent will behave in a manner desired by the principal (Eisenhardt, 1989). Earnout research using agency theory examines when parent firms should include earnout clauses in the merger, as opposed to only upfront payments. These studies show earnouts are more likely to be used when human assets are key to acquisition success, such as when the target is a high-tech firm (Chatterjee et al., 2004) or a service industry (Datar et al., 2001; Chatterjee et al., 2004). Earnout studies using an information asymmetry lens suggest earnouts are used to bridge information gaps. When a parent firm cannot accurately value a target and a target has difficulty communicating their value to potential parents, earnouts are used to allow the deal to occur. The parent feels they are not overpaying for the target, because they only pay their pre-determined target valuation amount upfront. However, the target has a chance to earn additional consideration (in line with its estimates of its value) if it meets 3 higher performance goals. Studies using this perspective suggest that earnouts are more likely to be used when the target is difficult to value, such as when the target is a new venture (Kohers & Ang, 2000; Ragozzino, 2004), rapidly growing (Datar et al., 2001; Chatterjee et al., 2004), private (Kohers & Ang, 2000; Datar et al., 2001; Ragozzino, 2004), or from outside the parent’s home industry (Datar et al., 2001; Ragozzino, 2004) or country (Datar et al., 2001). Thus, economics-based earnout research prescribes when earnouts should be used for the most efficient merger outcomes. The economics-based studies provide clear guidelines for managers about when to use earnouts. However, an earnout’s influence on a merger may not be limited to straightforward economic mechanisms. Because an earnout (contingent payment) is typically used with an upfront payment (guaranteed payment), it can be perceived as either a potential loss or gain, which has previously been shown to impact emotions (Roney et al, 1995; Tykocinski et al., 1994) and behavioral risk profiles (Kahneman & Tversky, 1979). Additionally, interviews with industry experts suggest that merger framing impacts deal success. Taken together, these two ideas suggest that cognitive mechanisms may play a role in how earnouts impact mergers. However the role of cognitive mechanisms in earnout clauses has not been investigated, because the economic-based theories used to examine earnouts rest on an incomplete definition of bounded rationality (BR). In the two perspectives (agency theory and information asymmetry), bounded rationality is operationalized as limitations on the quantity of information individuals can process, not limitations on how they process the information. So, neither agency theory nor the information asymmetry perspective is able 4 to examine the impact of cognitive mechanisms of earnouts. Thus, in order to study the impact of earnout frames on mergers, we need to expand our conception of bounded rationality in the field of strategy to include perceptual limitations. OVERVIEW OF STUDIES My dissertation attempts to accomplish two objectives. First it examines the impact of earnout frames on mergers. Second, it proposes that a more complete conception of bounded rationality, based on Simon’s original intentions, can expand the strategy field’s understanding of organizations by allowing researchers to ask new questions and expand the predictive value of current strategy theories. To accomplish the objectives, I present a literature review, a theoretical paper and two empirical studies. The literature review (Chapter 2) provides a survey of the theories and phenomena that I draw on in my dissertation. It surveys transaction cost economics, the resource-based view, bounded rationality and pertinent psychology theories. It also examines the mergers and acquisitions (M&A) literature, which is the context for the empirical studies. Additionally, the literature review points out where my studies augment these theories and phenomenon-driven studies. The first empirical study (Chapter 3) is a scenario experiment that uses prospect theory to examine the impact of earnout framing on behavioral risk profiles and perceptions of fairness. It demonstrates that when the earnout is framed as a loss, people employ risk-seeking strategies, and perceive nonpayment of the earnout consideration as unfair. In contrast, if the earnout is gain-framed, they display risk-averse behavior and perceive nonpayment of the earnout as acceptable. 5 The second empirical study (Chapter 4) uses archival data to examine if managers frame deal values to accomplish their merger goals. It demonstrates that managers frame deal values in terms of guaranteed consideration (the upfront payment only, plus the possibility of additional consideration) when they wish to retain the target’s customers, acquire mission critical technology from a target, or acquire an early-stage technology from a target. In contrast, they frame the deal value in terms of total consideration (the sum of the earnout and the upfront payment) when they want to use the target’s technology or products to acquire new customers (beyond those they received with the target purchase) and when they acquire a firm with an exploratory technology. Although my interviews with business development managers do not suggest they consciously consider how to frame merger values to accomplish their merger goals, they do use prior successful mergers as templates for subsequent mergers with similar properties. So, if they talked about the value of a merger deal in a specific way and the merger was a success, they are more likely to talk about a future merger with similar characteristics in the same way. Thus, their trial and error approach leads to the development of specific routines for merger framing, which are explored in this study. Finally, the theoretical chapter (Chapter 5) examines how a more complete conception of bounded rationality allows researchers to consider cognitive influences on strategic topics. This chapter accomplishes three goals. First, it separates processing and perceptual bounds on rationality to suggest why current bounded rationality operationalizations in strategy research are incomplete. It also suggests that bounded rationality can be both a limitation as well as an opportunity for managers to align 6 behaviors with task characteristics. Finally, it augments transaction cost economics’ predictive power by incorporating the more complete bounded rationality assumption into Williamson’s theory of transaction cost economics. 7 CHAPTER 1 REFERENCES Agrawal, A. & Walking, R.A. 1994. Executive careers and compensation surrounding takeover bids. The Journal of Finance, 49(3): 985-1014. Barkema, H. G., & Schijven, M. 2008a. How do firms learn to make acquisitions? A review of past research and an agenda for the future. Journal of Management, 34: 594-634. Baum, J.A.C, Li, S.X & Usher, J.M. 2000. Making the next move: How experiential and vicarious learning shape the locations of chains' acquisitions. Administrative Science Quarterly, 45: 766-801 Chatterjee, R., Erickson, M. & Weber, J.P. 2004. Can accounting information be used to reduce the contracting costs associated with mergers and acquisitions? Evidence from the use of earnouts in merger and acquisition agreements in the U.K. Working paper. Datar, S., Frankel, R. & Wolfson, M. 2001. Earnouts: The effects of adverse selection and agency cost on acquisition techniques. Journal of Law, Economics, and Organization, 17: 201–238. Eisenhardt, K.M. 1989. Agency theory: An assessment and review. Academy of Management Review, 14: 57 - 74. Fama, E.F. & Jensen, M.C. 1983. Agency Problems and Residual Claims. Journal of Law and Economics, 26: 301-325. Fields, A. 2005. How to survive an earnout. BusinessWeek SmallBiz, Summer: 71-74. Graebner, M.E., & Eisenhardt, K.M. 2004. The seller's side of the story: Acquisition as courtship and governance as syndicate in entrepreneurial firms. Administrative ScienceQuarterly, 49: 366-403. Haleblian, J., Devers, C.E., Macnamara, G., Carpenter, M.A. & Davison, R.B. 2009. Taking stock of what we know about mergers and acquisitions: A review and research agenda. Journal of Management, 35: 469-502. Haleblian, J., & Finkelstein, S. 1993. Top management team size, CEO dominance, and firm performance - the moderating roles of environmental turbulence and discretion. Academy of Management Journal, 36: 844-863. 8 Hambrick, D.C., & Finkelstein, S. 1987. Managerial discretion─A bridge between polar views of organizational outcomes. Research in Organizational Behavior, 9: 369- 406. Hitt, M.A., Tihanyi, L., Miller, T., & Connelly, B. 2006. International diversification: Antecedents, outcomes, and moderators. Journal of Management, 32: 831-867. Jensen, M.C. & Meckling, W. H. 1976. Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3: 305-360. Kahneman, D. & Tversky, A. 1979. Prospect theory: An analysis of decision under risk, Econometrica, XLVII: 263-291. Kohers, N. & Ang, J. 2000. Earnouts in mergers: Agreeing to disagree and agreeing to stay. The Journal of Business, 73: 445-476. Lash, H. 2009. Bruce Sherman's firm forgoes earnout from Legg Mason. http://www.reuters.com/article/marketsNews/idINN1031332820090210?rpc=44 Lewis, R. 2009. Club Penguin Founders miss $175 Million earnout in '08. http://www.techvibes.com/blog/club-penguin-founders-miss-175-million-earnout- in-2008 Melazzo, F. 2008. Why earn-outs may come back into fashion. http://corp.bankofamerica.com/public/public.portal?_pd_page_label=products/abf /capeyes/archive_index&dcCapEyes=indCE&id=372 Ragozzino, R. 2004. The structuring and performance implications of entrepreneurial acquisitions. Unpublished dissertation. Roney, C. J. R., Higgins, E. T., & Shah, J. (1995). Goals and framing: How outcome focus influences motivation and emotion. Personality and Social Psychology Bulletin, 21:1151-1160. Tykocinski, O., Higgins, E. T., & Chaiken, S. 1994. Message framing, self-discrepancies, and yielding to persuasive messages: The motivational significance of psychological situations. Personality and Social Psychology Bulletin, 20: 107- 115. 9 CHAPTER 2. Literature Review In my dissertation, I draw on both economics-based strategy theories and psychology theories. As such, I explore three main perspectives in strategy research: transaction cost economics, the resource-based view and bounded rationality. I also employ several theories from psychology that can inform the strategy perspectives, including regulatory focus theory, prospect theory, expectancy violation theory, non- conscious affect, and out-group stereotypes. I then examine the mergers and acquisitions (M&A) literature, the context for the two empirical studies, focusing particularly on earnout provisions. Finally, I discuss how my dissertation augments the three strategy perspectives, leading to new questions in strategy research, as well as increased predictive power for traditional theories. TRANSACTION COST ECONOMICS I employ transaction cost economics (TCE) in my dissertation (Williamson, 1975, 1985). TCE’s primary goal is minimizing transaction costs through appropriate governance of economic exchanges. Transaction costs occur because exchanges are not costless. Instead, costs are incurred due to search, coordination, negotiation, etc. TCE rests on two important behavioral assumptions: opportunism and bounded rationality. Opportunism is “self-interest seeking with guile” (Williamson 1985: 72). While Williamson does not suggest that all people possess this trait, it is difficult to tell who will be opportunistic and who will not, so firms need to safeguard themselves against the possibility of opportunism. According to Williamson, if opportunism were absent, exchanges could be successfully governed by “general clause” contracting, 10 because both parties will comply with the spirit of the contract. Bounded rationality is the second behavioral assumption in TCE. Absent bounded rationality, Williamson argues that exchanges could be governed by comprehensive contracts, because all possible contingencies could be incorporated into the contract. Because bounded rationality does not allow firms to include all possible contingencies in their contracts and opportunism allows for the possibility that the exchange partner will take advantage of the situation if the contingencies are not spelled out, serious contractual difficulties can prevent exchanges from occurring. Frequent exchanges characterized by high levels of asset specificity that take place under uncertainty lead to market failure. No supplier will commit to a market exchange involving high asset specificity, because they can be held up by the supplier, who has other potential options. Thus, in an exchange with high transaction hazard levels, hierarchy may be necessary for the exchange to transpire. Alternatively, contracts or spot market transactions may lower transaction costs in exchanges with lower levels of transaction hazards. Thus, transaction cost economics provides managers with a guide for choosing efficient governance for their transactions. My Contributions to TCE Transaction costs economics assumes “…the principal ramification of bounded rationality for the study of economic organization is that all complex contracts are unavoidably incomplete.” (Williamson, 2000: 8). So, information processing limitations prevent actors from listing all possible contingencies that may arise and potentially impact the exchange, resulting in unavoidably incomplete contracts. However, 11 Williamson’s view of bounded rationality ignores perceptual limitations such as framing, heuristics, expectations, emotion and social influences. These cognitive forces distort the information that actors do process, so the traditional TCE bounded rationality assumption ignores these potentially important factors. While Williamson’s actors experience processing biases, they are not subject to perceptual biases. So, they are still imbued with significant foresight, which some scholars argue allow them to retain some aspects of neoclassical economic (i.e., hyper- rational) man (Simon, 1997: 38). Additionally, qualitative research further suggests that managers are slower to recognize and react to issues than TCE implies (e.g., Mayer & Argyres, 2004). Thus, under its current conception of bounded rationality, TCE examines a simplified view of organizational governance decision processes; however it could provide a more complete conceptualization if augmented with a more complete BR assumption. My dissertation examines how implementing a complex bounded rationality assumption in TCE leads to greater prediction power. THE RESOURCE-BASED VIEW My dissertation also utilizes the resource-based view (RBV) (Barney, 1991; Peteraf, 1993). RBV suggests that valuable, inimitable, rare and non-substitutable resources and capabilities serve as the basis for sustainable competitive advantage. Because strategy research is interested in firm performance, examining sources of variance in performance is an important focus in the field. In contrast to the prevailing focus on industry-level competitive dynamics, Wernerfelt (1984) suggested that resources and capabilities may influence performance 12 differences. The proposed shift from industry to intra-firm factors was bolstered by the research suggesting that firm-level factors drove four times the variance in rate of return than industry-level factors (Rumelt, 1991). The idea that intra-firm factors drove performance variance was formalized in the resource-based view (Barney, 1986, 1991; Peteraf, 1993), which suggests that firm-specific resources and capabilities serve as the basis for sustainable competitive advantage. My Contributions to RBV The resource-based view has been criticized for being retrospective, and thus difficult for managers to implement. It does not theorize about creating new resources, but focuses on identifying current resources (Foss, 1998). My dissertation addresses this criticism by adding psychological theory to the resource-based view, allowing easier operationalization and identification of a capability ex ante. Additionally, my dissertation allows the RBV literature to be extended to merger capabilities. My dissertation suggests that merger capabilities are not limited to target selection (for e.g. Capron & Shen 2007) or integration management (for e.g. Ranft & Lord 2002; Zollo & Singh 2004). Although much has been written about developing these capabilities, no prior research has been conducted on capabilities concerning M&A deal development. My dissertation takes a first step in examining how the development and perception of the deal can significantly impact its success before actual integration issues arise. If a parent firm frames the deal appropriately, they may actually experience smoother integration, as the behavior of the target management is now aligned with the desires of the acquirer. Although integration challenges come in many different flavors, a 13 merger framing capability serves to align target behavior with parent goals, and thus addresses at least one key source of integration challenges. BOUNDED RATIONALITY My final essay examines the concept of bounded rationality (BR). Under Herbert Simon’s definition of BR, “human behavior is intendedly rational but only limitedly so” (Simon, 1961: xxiv) because of actors’ restricted cognitive capacities. Simon developed bounded rationality in response to strict rational models in neo-classical economics, because he wanted economists to incorporate realistic decision-making processes into their research (Bromiley, 2005). According to Simon, when rational man faces uncertainty, the objective environment, or “real world” he experiences, is very different from his subjective environment. Because of the division between reality and perception, Simon believed that researchers cannot predict even rational behavior from the characteristics of the objective environment because active perceptual and cognitive processes directly influence behavior as much, if not more than, objective factors (Simon 1982). Simon recognized that Tversky and Kahneman (1981) enhanced our understanding of bounded rationality by examining the impact of heuristics and framing effects on economic behavior. Kahneman, supporting Simon’s view, suggested, “Our research attempted to obtain a map of bounded rationality, by exploring the systematic biases that separate the beliefs that people have and the choices they make from the optimal beliefs and choices assumed in rational-agent models.“ (Kahneman 2003: 1449). Thus, Simon intended bounded rationality to encompass both what individuals are able to 14 process as well as how they perceive what they do process. However, in strategy research, biases related to perception are largely ignored. Information processing limitations are well-established in both psychology and neuroscience literatures (e.g. Shiffrin, 1976; Cowan, 2000), and strategy researchers primarily rely on these restrictions for their implications of bounded rationality. For example, Williamson argues that a main implication of bounded rationality in transaction cost economics (TCE) is unavoidably incomplete contracts (Williamson, 1975). His conclusion suggests that the most important aspect of bounded rationality is an individual’s inability to know all possible outcomes in a decision, resulting in limited consideration sets, which are solely the result of processing limitations. Some researchers recognized that our current bounded rationality conception is incomplete, and called for a refinement of its operationalization in strategy (Foss, 2003; Gavetti et al. 2007). Foss (2003) suggested that organizational economics fails to incorporate psychology into bounded rationality. He recommended that researchers incorporate psychology into BR, and offered examples of the potential impact of four specific biases: availability heuristic, reference level biases, adaptive preferences and preference reversal. Additionally, Gavetti et al. (2007) called on Carnegie scholars to further develop the bounded rationality concept, providing a long list of potential candidates for bounds on rationality. My dissertation answers their call for a more complex conception of bounded rationality. First, it explains why psychological factors are missing from strategy’s conception of bounded rationality, by distinguishing between perceptual and processing 15 limitations. The strategy literature currently confounds perceptual and processing limitations (e.g. Williamson, 2000), by speaking about them as a general limitation on rationality. However, it still suggests that only processing implications are important for strategic decisions in organizations. Two issues arise from this view. First, actors are subject to biases that potentially distort the information they can process. So, when theories like TCE ignore the fact that the limited consideration set of contingencies contains distorted options, they fail to accurately model the governance decision process. Second, not taking into account perceptual biases allows some researchers to suggest that actors maximize on their limited consideration sets. Thus, bounded rationality is in essence optimization subject to search cost constraints (e.g. Conlisk 1996). Critics of the maximization view argue that the actors would need greater information processing faculties than those required under strict rationality assumptions, because actors perform two complex calculations instead of one (Bromiley 2005). However, even apart from this criticism, a constrained maximization view of bounded rationality fails to incorporate perceptual biases that may distort the decision even further. As a result, when decision processes are modeled as less detailed versions of reality, strategy researchers are not incorporating all known influences on decisions into their models, and are thus testing a simplified view of a perfect world. In my dissertation, I distinguish between perceptual and processing bounds on rationality, pointing out how both types of limitations bound rationality in different ways. 16 Additionally, starting with Simon’s original definition, bounded rationality has traditionally been seen as a limitation on efficient decision making. In contrast, I suggest that BR can also be viewed as a potential opportunity. Because perceptual limitations produce systematic biases, managers can use them to align behaviors with desired outcomes. By delving into the psychology literature, I can further explain this concept. Psychological Theories Pertinent to BR Regulatory Focus Theory. Regulatory focus theory suggests that there are two internal systems to regulate behavior, a prevention and a promotion focus (Higgins, 1998). A prevention focus is guided by oughts, characteristics the individual or other people believe should be possessed. Under a prevention focus, a goal is seen as minimal (Brendl & Higgins 1996), something that must be reached. If it is not reached, it is perceived as a loss, leading to feelings of high-intensity agitation; but, if it is reached, it is perceived as a non-loss, resulting in feelings of medium-intensity contentment (Higgins, 1998). Alternatively, a promotion focus is guided by ideals, characteristics that an individual or others aspire to possess. Under a promotion focus, the same goal is perceived as maximal, something that a person aspires to achieve. If the goal is met, it is perceived as a gain, leading to high-intensity happiness. However, if it is not met, it is perceived as a non-gain, resulting in low-intensity disappointment (ibid). Therefore, different regulatory focus systems produce vastly different views and experiences of the world. 17 Regulatory focus influences behaviors as well. Because people have a greater desire to avoid high-intensity negative emotions from missing a minimal goal, than to experience medium-intensity positive emotions from meeting a maximal goal, they display vigilant behavior, under a promotion focus, to avoid sins of commission. In contrast, people have a greater desire to experience the high-intensity positive emotion from meeting a maximal goal than to avoid the medium-intensity negative emotion from missing a maximal goal, so they creative and flexible behavior to avoid sins of omission. Relationships are also viewed differently under the two regulatory systems. For example, a prevention focus leads people to list a greater numbers of negative thoughts about a partner or a relationship, while a promotion focus generates more positive thoughts about the person, event or interaction (Tykocinski et al, 1994). Focusing on negative or positive aspects of the relationship leads to very different impressions of it. A prevention focus, with its emphasis on the negative aspects of the relationship, is related to lower relationship quality (Winterheld & Simpson, 2006). In contrast, a promotion focus, with its emphasis on the positive aspects, is associated with higher relationship quality, including feelings of higher satisfaction, commitment, trust, fondness, and closeness. Although most people have a chronic prevention or promotion focus, it can be overridden by situationally-inducing a regulatory focus through loss/non-loss or gain/non-gain frames (Roney et al., 1995). A loss frame induces a prevention focus, while a gain frame induces a promotion focus. Because framing induces two different views of the world that systematically lead to different behaviors, emotions and views of 18 relationships, managers can use them to strategically evoke behaviors that may be more appropriate for accomplishing specific tasks, potentially leading to better task performance (Shah et al., 1998). For example, if a firm wants to develop a more positive relationship with a partner firm. It can create a more cooperative outcome in a negotiation by framing the contractual issues as gains and non-gains (Galinsky et al., 2005). Additionally, if the gain is accomplished, the partners will experience high-intensity positive emotions that can serve as the basis for a high quality relationship. In contrast, if a firm wants to develop a more arms-length relationship with a partner, it can use loss/non-loss framing to invoke feelings of contentment if the goal is reached. Additionally, if a firm wants its partner to vigilantly fulfill the contract, it can use loss/non-loss framing to invoke that behavior. Alternatively, if greater effort (Roney et al., 1995) or greater search for creative solutions (Pham & Higgins, 2005) is desirable, then a gain/non-gain frame can be used to activate a desire to prevent sins of omission, which prompts maximum effort for innovation and creative problem solving. The rational choice model assumes that framing does not impact preferences or behavior. However, Kahneman and Tversky found that people displayed inconsistent preferences when the same option was framed differently, even though the choices had the same expected value (Tversky & Kahneman, 1981). Thus, framing is a clear bound on rationality. But, framing may also be used to invoke specific behaviors, emotions and views of relationships. By framing goals as losses or gains, managers have an opportunity to align behaviors with task characteristics, potentially leading to increased exchange 19 performance. Additionally, managers can likely shape exchange relationships through framing. Thus, although framing limits strict rationality, it also allows managers to increase the likelihood of a successful exchange. Prospect Theory. Prospect theory examines risky choice under loss versus gain framing (Kahneman & Tversky, 1979). It suggests that rather than always displaying risk-averse behavior, a primary tenet of utility theory, people instead display risk-averse behavior only in the face of gains. In contrast, they display risk-seeking behavior in the face of losses. The behavioral risk profiles are due to concave of the value function in the gain region, and convexity in the loss region, which produce the classic s-curve value function mapped by Kahneman & Tversky, using mean values derived from their experiments (Bromiley, 2009). Additionally, the value function is steeper for losses than gains, so losses loom larger than gains. Thus, a loss (actually giving up something you had) is more aversive than a forgone gain (not receiving something that you may receive), and an averted loss (not giving up something you had) is more pleasant than a gain (receiving something that you may receive) (Kahneman et al., 1986). The proposed emotional reaction occurs because a loss is a move towards an undesired state, while a foregone gain is a move away from desired state; and an averted loss is a move away from an undesired state, while a gain is a move towards a desired state. That is, movement towards or away from an undesired end state leads to higher intensity emotions than movement towards or away from a desired end state (Chen Idson et al., 2000). 20 Additionally, loss aversion explains why people perceive a situation as fair or unfair, based solely on whether the outcomes are framed as potential losses or gains (Kahneman et al., 1986). If people do not receive an outcome that is framed as a potential loss, they feel like something was taken away from them. As a result, the situation is perceived as unfair. In contrast, if the same outcome is framed as a potential gain, people interpret the situation as not receiving something they did not previously possess; so they feel the situation is acceptable. Rational actors are not supposed to be subject to the influence of framing, yet framing effects are prevalent (Tversky & Kahneman, 1981). Thus, framing is a clear bound on rationality. However, instead of being a limitation, managers can shape peoples’ behavioral risk profiles and perceptions of fairness to increase the probability of better task performance or decrease perceptions of unfairness in the event that outcomes are not attained, for example. Negativity Bias. Many studies examine negativity bias in the context of healthcare (Siegrist & Cvetkovich, 2001), interpersonal interactions (Amabile & Glazebrook, 1982) and political campaigns (Meffert et. al., 2006). Negativity bias occurs when a person places greater weight on negative information than positive information of the same magnitude (Fiske, 1980; Anderson, 1974; Carlston, 1980; Dreben, Fiske, & Hastie, 1979; Hodges, 1974; Oden & Anderson, 1971). The bias occurs because people are able to better categorize others using negative rather than positive information (which is less telling about whether a person is good or bad), so they place more weight on the negative information. People believe that both good and bad people commit minor bad 21 acts, but they assume that only bad people commit extremely bad acts. Additionally, people assume that a bad person will display both good and bad behavior, but a good person will be consistently good. So, a person who commits one memorable negative act is a bad person, even if he or she also committed positive acts of similar magnitude (Skowronski & Carlston, 1989). Negativity bias is a clear bound on rationality, as utility theory would suggest that the valence (positive or negative character) of information should not impact its weight in a decision. Instead, all information is accessed in terms of expected values, which are not impacted by valence. Although negativity bias may act as a bound on rationality, it can also be an opportunity for managers. For example, managers can use an understanding of negativity bias to shape their inter-firm relationships. Businesses often contract with new parties with which they have no prior experience (Gulati, 1995). If two firms with no prior history enter into an exchange, negative information may serve a categorization role, which aids in impression development. Therefore, firms can manage the positive or negative tone of information in their interactions with new partners to shape their experience of positive or negative emotions, which serves as the basis of their future relationship. Expectancy Violation Theory. Meeting or violating expectations leads to very different emotional reactions, which potentially bound rationality. A confirmation of expectations will always result in an initial positive emotional response, followed by a medium-intensity emotion in the direction of the expectation. What happens when expectations are violated though? Although a violation of expectations always leads to an 22 initial negative emotional reaction due to increased uncertainty (Olson et al, 1996), expectancy violation theory suggests that a secondary high-intensity emotional response in the direction of the violation arises. If expectancies are negatively disconfirmed, then people’s initial negative reaction is augmented. However, if the violation is positive, the secondary emotional response will be positive (Jussim et al., 1987; Jackson et al., 1993; Burgoon, 1993; Bettencourt et al., 1997; Kernahan et al., 2000). Since the secondary response is much higher in intensity than the primary response, the initial negative reaction is overcome by the positive reaction (ibid). A violation of expectations causes a person to examine the situation in detail, leading the old expectation to be replaced by a new one. In contrast, when an expectation is confirmed, he or she only pays superficial attention to the situation because it conforms with their previous beliefs, so the original expectation will not be changed (Clary & Tesser, 1983). The increased scrutiny, from the violation, allows for reassessment regarding the person. If the violation is positive, the interpretive cognitive activity leads to an increase in positive emotion over that experienced if a positive expectation is confirmed. Expectations clearly bound rationality by inducing different emotional reactions to the same situation. The outcome in the situation is the same. It is merely what is expected from the situation that is different. Thus, utility theory predicts that expectations should not impact decisions. However, it is clear that expectations do impact emotions, which impact the relationship between the parties. Again, although expectations bound rationality, they also present an opportunity for managers to shape emotions and commitments to a partner relationship or a firm. If a 23 party experiences positive emotions from either meeting a positive expectation or violating a negative expectation, the partner or employee is more satisfied and committed to the relationship (Gross & John, 2003). However, negative emotions from meeting a negative expectation or violating a positive expectation, can be used to maintain a more arms-length relationship with a partner or employee. Non-conscious Affect. Affective primacy, first suggested by Zajonc (1980), argues that higher order cognition is not required for primitive affective distinction. That is, a person is able to make distinctions between positive and negative stimuli of which they are not consciously aware; however, they are not able to further distinguish these stimuli into discrete emotions (Murphy, 2001). Instead, the descriptive meaning of emotion is acquired later (Stapel & Koomen, 2005), while the basic evaluative meaning of good or bad occurs only 100-200 milliseconds following the stimuli, as evidenced by the presence of event-related potentials in the insular cortex (Werheid, Alpay, Jentzsch, & Sommer, 2005), a brain structure related to affective processing. The process of unconscious affective priming has been shown to be a replicable phenomenon (Draine & Greenwald, 1998) that can automatically activate attitudes of the same valence (positive or negative) independent of attitude accessibility or strength. For example, priming with positive and negative words that were both strong and moderate in intensity led to quicker pronunciations of target words with the same valence as opposed to words with a different valence (Bargh, Chaiken Goverder & Pratto, 1992). The same effect of automatic attitude activation was also shown in a naming task (Klauer & Musch, 2001). It has also been shown when the affective prime was drawings of inanimate 24 objects and inanimate objects themselves (Giner-Sorolla et al., 1999; Murphy et al. 1995; Murphy, 2001). In addition to differential automatic attitude activation, affective priming has been shown to have direct effects on behaviors as well. People primed with guilty words showed more self control on guilty-pleasure and grim-necessity self-control tasks than those primed with sad words (Zemack-Rugar, Bettman, & Fitzsimons, 2006). Additionally, the influence of positive affective priming increased viewing behavior for a television program (Frings & Wentura, 2003). The demonstration of the influence of affect on attitude activation and behavior makes nonconscious affect a clear bound on rationality, as the outcome in the situation is the same. It is the non-conscious affect that determines attitude activation and behavior. However, in addition to being a limitation, managers can use non-conscious affect to align attitudes and behaviors with desired outcomes, potentially leading to better results for both parties. Out-group Stereotypes. People use stereotypes to predict behaviors when they do not have prior information about the other party. Linguistic intergroup bias suggests positive in-group behavior and negative out-group behavior are described in the abstract, while negative in-group behavior and positive out-group behavior are discussed in more concrete terms (Maas, 1999). Thus, different stereotypes lead to different language use in conversations and negotiations. Additionally, group heterogeneity moderates the impact of the stereotypes. In-groups are seen as more heterogeneous than out-groups (Linville & Fischer, 1998), with the exception of minority in-groups, who are also seen as 25 homogenous (Simon & Pettigrew, 1990). So, a stereotype of a group perceived to be homogeneous allows the focal party to more accurately predict the behavior of the other party. As with expectancy violation, the expectations set by the stereotype lead to different emotional reactions when they are positively or negatively violated. So, stereotypes play a role in bounding rationality by setting expectations that may or may not be accurate. Again, however, managers can create an opportunity when stereotypes are used. If a firm contracts with a partner, with whom they do not have prior experience, the focal firm only has information about the firm based on their out-group status, which is akin to an out-group stereotype. Thus, the managers of the focal firm can use the information from the out-group stereotype to encourage or discourage the expected out-group behavior, through contract design. My Contributions to BR. My dissertation adds to the current bounded rationality literature in three ways. First, I differentiate between processing and perceptual limitations to explain why current treatments of bounded rationality in strategy research are limited. I also suggest that bounds on rationality can create an opportunity for managers to shape behaviors, emotions and relationships, which contrasts with the current view of bounded rationality as a limitation to efficient decision-making. Finally, I provide examples of new research questions possible with a more complete conception of bounded rationality and how applying it to a traditional strategy theory (transaction cost economics), provides even more prediction power. 26 MERGERS & ACQUISITIONS CONTEXT The two empirical studies in my dissertation are set in a mergers and acquisitions (M&A) context. M&A has been studied extensively in the strategic management field (see Hitt et al., 2006; Barkema & Schijven, 2008; Haleblian et al., 2009 for reviews on this and related topics). Although this literature examines such varied topics as individual-level executive compensation in M&A (for e.g. Agrawal & Walkling, 1994; Haleblian & Finkelstein, 1993; Hambrick & Finkelstein, 1987) and firm-level characteristics leading to acquisition activity (for e.g. Baum et al., 2000; Graebner & Eisenhardt, 2004), the studies of particular interest for my dissertation examine when to use particular deal structures and how the decisions affect acquisition performance. Deal structure studies have examined when to use upfront or contingent payment in an acquisition deal (Reuer et al., 2004). They have also investigated when to use cash versus stock to finance an acquisition (Reuer & Ragozzio, 2006) and the effect that the decision has on market performance (Loughran & Vijh, 1997; Hayward, 2003; King et al., 2004), shareholder performance (e.g., Carow et al., 2004; Huang & Walkling, 1987; Loughran & Vijh, 1997; Travlos, 1987), and acquirer firm-level performance (Healy et al., 1992; Heron & Li, 2002). Finally, the studies also explore whether tender offers or mergers lead to better post-combination performance (e.g. Agrawal et al., 1992; Loughran & Vijh, 1997; Rau & Vermaelen, 1998). Other deal structure studies focus specifically on one type of contingent consideration, earnout provisions, which subject entrepreneurs to performance-contingent payment for their venture. Earnouts are used in over fifty percent of all small business 27 acquisitions (Fields, 2005). Researchers suggest that earnouts are more likely to be used when there is uncertainty around the valuation of the target firm. The uncertainty can arise from the fact that the target is private (Kohers & Ang, 2000; Datar et al., 2001; Ragozzino, 2004), rapidly growing (Datar et al., 2001; Chatterjee et al., 2004) or a new venture (Kohers & Ang, 2000; Ragozzio, 2004). It can also arise when there is significant knowledge distance between the target and the acquirer because the target is outside of the parent’s industry (Datar et al. 2001; Ragozzino, 2004) or country (Datar et al., 2001). Finally earnouts are also more likely to be used when human assets are an important part of the acquisition, such as when the target is a high-tech firm (Chatterjee et al, 2004) or a service industry (Datar et al, 2001; Chatterjee et al., 2004). My Contributions to the M&A Literature The M&A literature on deal structures and earnouts has yet to examine how framing contingent consideration impacts mergers. In my dissertation, I suggest that merger value frames influence retained target management’s behaviors and perceptions of fairness. Thus, my studies suggest that managers can use merger framing to align retained target management behavior with parent merger goals, to potentially increase its likelihood of meeting its goals, and paying retained managers the earnout payment. 28 CHAPTER 2 REFERENCES Agrawal, A. Jaffe, J.F. & Mandelker, G.N. 1992. The post-merger performance of acquiring firms: A re-examination of an anomaly. The Journal of Finance, 47(4): 1605-1621. Agrawal, A. & Walking, R.A. 1994. Executive careers and compensation surrounding takeover bids. The Journal of Finance, 49(3): 985-1014. Amabile, T. M. & Glazebrook, A.H 1982. A negativity bias in interpersonal evaluation. 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The Impact of Earnout Frames on Retained Target Management Behavior and Fairness Perceptions in M&A Industry experts estimate that earnout clauses, performance-contingent consideration provisions, are present in half of all small business merger and acquisition (M&A) contracts (Fields, 2005) and are predicted to become more prevalent, due to the current tight credit market (Melazzo, 2008). Yet, according to an M&A specialist in Southern California, they are often not paid out, which headlines like “Club Penguin Founders miss $175 Million earnout in '08” (Lewis, 2009) and “Bruce Sherman's firm forgoes Earnout from Legg Mason” (Lash, 2009) demonstrate. When earnouts are not paid out, both parties generally experience negative ramifications, as the target does not receive the earnout payment and the parent’s new business unit performance is not meeting expectations. Thus, understanding how earnouts work is very important for both M&A specialists and entrepreneurs planning to use M&A as an exit strategy. How do earnouts work? Although a vast literature examines mergers and acquisitions, very few studies investigate earnouts. One line of research envisions M&A activity as the “market for lemons” (Akerlof, 1970), suggesting that parent firm inefficiencies in target valuation, coupled with target firm inefficiencies in communicating their value, prevent attractive acquisitions from occurring, while allowing less attractive ones to proceed (Reuer et al., 2004). The studies suggest earnouts are used to mitigate information asymmetry between the partners (Kohers & Ang, 2000; Datar et al., 2001; Ragozzino, 2004; Chatterjee et al., 2004). Another research stream, using agency theory (Alchian & Demsetz, 1972; Jensen & Meckling, 1976; Fama & Jensen, 37 1983), suggests earnouts align parent and target incentives, because the earnout is an outcome-based contractual element (Eisenhardt, 1989). Indeed, the studies show earnouts are used when human assets are an important part of the acquisition and the parent wishes to motivate retained target management performance (Datar et al., 2001; Chatterjee et al., 2004). However, an earnout’s influence on a merger may not be limited to such straightforward economic mechanisms. Because an earnout (contingent payment) is typically used with an upfront payment (guaranteed payment), it can be perceived as either a potential loss or gain. According to prospect theory, a loss frame induces risk seeking behavior, while a gain frame induces risk-averse behavior (Kahneman & Tversky, 1979). Other work suggests loss and gain framing also impacts perceptions of fairness (Kahneman et al., 1986), which are important in mergers as well. Thus, cognitive mechanisms may also influence how earnout frames impact mergers. THEORETICAL FRAMEWORK Researchers have studied mergers and acquisitions extensively in the strategic management field (see Hitt et al., 2006; Barkema & Schijven, 2008; Haleblian et al., 2009 for reviews on this and related topics) examining varied topics, ranging from individual-level executive compensation in M&A (for e.g. Agrawal & Walkling, 1994; Haleblian & Finkelstein, 1993; Hambrick & Finkelstein, 1987) to firm-level characteristics leading to acquisition activity (for e.g. Baum et al., 2000; Graebner & Eisenhardt, 2004). One research stream, of particular interest for this paper, examines how the deal and its structure impacts acquisitions. The studies use economic lenses to 38 predict when upfront or contingent payment should be used in acquisitions (Reuer et al., 2004). They also investigate when to use cash or stock to finance an acquisition (Reuer & Ragozzino, 2006) and the impact the decision has on market performance (Loughran & Vijh, 1997; Hayward, 2003; King et al, 2004), shareholder performance (e.g., Carow et al., 2004; Huang & Walkling, 1987; Loughran & Vijh, 1997; Travlos, 1987), and acquirer firm-level performance (Healy et al., 1992; Heron & Li, 2002). The studies also explore whether mergers or tender offers lead to better post-combination performance (e.g. Agrawal et al., 1992; Loughran & Vijh, 1997; Rau & Vermaelen, 1998). While this research vein carefully dissects antecedents to particular deal structures and the effects the structures have on post-merger performance, it has only begun to investigate the impact of earnout clauses, a particular aspect of deal structure, on mergers. An earnout clause is a contingent consideration provision, paid out only after specific performance metrics are met. The performance metrics may be based on acquiring or retaining a specific number of customers, completing the development of a technology or meeting a specific financial goal, based on revenue or profit, for example 1 . Earnout clauses are typically used in combination with an upfront payment. They also usually require existing target management to retain their positions under the parent firm, at least for a short period of time, in order for the performance metrics to be evaluated. Industry experts estimate that earnout clauses appear in half of all small business merger contracts (Fields, 2005). Earnout use is also expected to rise over the next few 1 There are many possible bases for earnout performance metrics. The specific types that I have listed here are just a few examples. 39 years. The Wall Street Journal predicts “Plain vanilla transactions, in which one company acquires another for cash, stock or a combination of the two, will be the exception” (Karnitschnig & Cimilluca, 2009). Additionally, M&A lawyers envision earnout use will rise precipitously due to the current tight credit market (Rosen, 2008). The increase is predicted because: 1) more firms will be forced to consider acquisition as an alternative to insolvency in the face of dwindling credit availability, and 2) parent firms will have less cash available for acquisitions, due to the tight credit market. So, earnout clause use is expected to increase until the credit crunch eases substantially. As a result, it is very important for both parent managers and entrepreneurs, using M&A as an exit strategy, to understand how earnouts work. Prior research on earnouts examined when they are more likely to be used in merger deals. Earnouts are used more frequently when the target is private (Kohers & Ang, 2000; Datar et al., 2001; Ragozzino, 2004), rapidly growing (Datar et al., 2001; Chatterjee et al., 2004) or a new venture (Kohers & Ang, 2000; Ragozzino, 2004). Earnouts are also used when the target is outside of the parent’s industry (Datar et al. 2001; Ragozzino 2004) or home country (Datar et al., 2001). In all such cases, information asymmetry exists between the parent and target, making it difficult for the parent to value the target correctly and the target to communicate their proper valuation. Additionally as a president of a computer reseller firm in northern California suggested, “Earnouts are used to motivate continued performance from [target] managers, after the deal is done.” Prior work demonstrates that earnouts are used more frequently when human assets are an important part of the acquisition, such as when the target is a high-tech firm (Chatterjee et al. Chatterjee et al., 2004), Thus, our current understanding of earnout clauses is agency theory and information asymmetry perspectives But, because earnouts are contingent, potential loss or gain, which is not taken into account in the economic agency theory and asymmetric information. Additionally, a lawyer points to the importance of cogniti deal is about numbers and dollars and cents, but often the thing that makes the merger successful is the way that you spin it. frame, a merger significantly impa Because an earnout conjunction with upfront payments (guaranteed consideration), potential loss or gain, depending on whether the For example, in a merger with a $2M upfront payment and a $1M earnout, the viewed as a potential loss if the merger value is presented as the value of the same merger is presented as $1M payment. See Figure 1 below. Figure 1. Loss and Gain Framing of an Earnout tech firm (Chatterjee et al., 2004) or in a service industry (Datar et al. and the parent wishes to motivate human asset performance understanding of earnout clauses is solely rooted in economics agency theory and information asymmetry perspectives. because earnouts are contingent, individuals can perceive potential loss or gain, which is not taken into account in the economic and asymmetric information. Additionally, a long-time Southern CA the importance of cognitive influences on mergers. He said, deal is about numbers and dollars and cents, but often the thing that makes the merger ful is the way that you spin it.” His insight implies that how people talk about, or frame, a merger significantly impacts its success. Because an earnout clause (contingent consideration), is typically used upfront payments (guaranteed consideration), it can be potential loss or gain, depending on whether the deal value is framed to includ For example, in a merger with a $2M upfront payment and a $1M earnout, the potential loss if the merger value is presented as $3M, and a potential gain if the value of the same merger is presented as $2M with the potential for an additional See Figure 1 below. Loss and Gain Framing of an Earnout 40 a service industry (Datar et al., 2001; and the parent wishes to motivate human asset performance. solely rooted in economics-based individuals can perceive them as either a potential loss or gain, which is not taken into account in the economic-based lenses of Southern CA M&A on mergers. He said, “An M&A deal is about numbers and dollars and cents, but often the thing that makes the merger ” His insight implies that how people talk about, or (contingent consideration), is typically used in can be framed as a to include it or not. For example, in a merger with a $2M upfront payment and a $1M earnout, the earnout is and a potential gain if al for an additional 41 Because economic lenses such as agency theory and asymmetric information rest on a limited bounded rationality assumption (only considering limitations on the quantity of information processed, not perceptual limitations that potentially distort the information), framing effects are not taken into account. Thus, in order to examine the cognitive impact of earnouts on merger, it is necessary to use a psychological lens. Prospect theory (Kahneman & Tversky, 1979) suggests that loss frames induce risk- seeking behavior while gain frames stimulate risk-averse behavior. Additionally, Kahneman and others (1986) predict that loss and gain framing also impact perceptions of fairness. So, using a psychological lens, I can examine how earnout frames impact mergers by inducing different behavioral risk profiles and perceptions of fairness in retained target management. Prospect Theory Kahneman and Tversky (1979) developed prospect theory to examine risky choice under loss and gain frames. According to the theory, individuals display risk- averse behavior when faced with gains, and risk-seeking behavior when faced with losses. The predictions are based on the classic s-curve value function mapped by Kahneman & Tversky. When outcomes fall below a particular reference point, they are encoded as a loss. The value function is convex in the loss range indicating risk-seeking behavior. In contrast, when outcomes are above the reference point, they are encoded as a gain. In the gain region, the value function is concave, indicating risk-aversion (Kahneman & Tversky, 1979). Further examination of the value function reveals that the s-curve is steeper in the loss region than the gain region, indicating that the pain of losing 42 X is greater than the joy of gaining that same X. Thus, experiencing a loss (giving up something you have) is more painful than experiencing a forgone gain (not receiving something that you may receive). Additionally, averting a loss (not giving up something you already have) feels more pleasant than gaining something (receiving something that you did not previously possess) (Kahneman et al., 1986). The variation in emotional reaction intensity occurs because losses and gains differentially move individuals towards and away from undesired and desired states, respectively (Chen Idson et al., 2000). A loss moves an individual towards an undesired state, while a foregone gain moves the person away from a desired state. Alternatively, an averted loss moves a person away from undesired state, while a gain moves the individual towards a desired state. So, higher intensity emotional reactions occur when moving towards or away from an undesired state, while lower intensity reactions result in moving towards or away from a desired state. In the face of a potential loss, a person may either experience high intensity negative emotions at losing something he or she possessed or high intensity positive emotions at keeping their possession. Because individuals prefer to experience high intensity positive emotions rather than high intensity negative emotions, they engage in risk-seeking behavior in an effort to avoid certain loss. However, in the face of a potential gain, people either experience low to medium intensity positive emotion if they receive something they did not have or low to medium intensity negative emotions at not receiving something they did not have. Again, people prefer to experience positive rather than negative emotions, so they display risk-averse behavior to preserve at least part of 43 the potential gain. Additionally, the difference in emotional intensity at losses and gains impacts perceptions of fairness. Because the negative emotional reaction due to a loss is much higher in intensity than that due to a foregone gain, individuals tend to perceive a foregone gain as much more acceptable than a loss. Three elements of prospect theory align well with earnouts, suggesting that it is particularly pertinent lens for examining the earnout frames on mergers. First, earnout clauses are almost always used in conjunction with upfront payments, so the earnout can be framed as either a potential loss or gain, depending on how the merger value is presented. Second, earnout clauses are usually tiered (See Appendix A for an example). The higher performance metric represents a significant stretch goal for retained target management, when compared to their prior performance. In contrast, the lower performance tier is usually more in line with their past performance. So, management must essentially choose a risk-averse strategy, representing the status quo, to achieve the lower performance tier, or a risk-seeking strategy, representing a significant departure from the status quo, which will either result in achievement of the higher performance metric or failure to reach even the lower one. Third, when earnout clauses are in the acquisition contract, existing target management is usually retained, for some period of time, to manage the new business unit. Thus, the parent firm actually cares about the impact of earnout frames on retained target management’s behavioral risk profile and perceptions of fairness, as it may potentially influence merger performance. 44 Loss-framed Earnouts An earnout is initially framed as a potential loss if the merger value is presented as the sum of the earnout (Y) and the guaranteed payment (Z) during the deal negotiation. For example, if the upfront payment is $4M and the earnout consideration is $1M, the value of the deal under a loss frame will be $5M. The frame is then usually propagated through additional conversations between the target managers and parent firm during negotiation and merger implementation. In such conversations, retained target management repeatedly hears that their firm is valued at Y+Z. Additionally, subsequent conversations about performance metrics and progress in meeting them further exposes retained target management to the idea that Y will be lost if particular performance metrics are not attained. Finally, friends and family will discuss the merger with retained target management, citing the Y+Z target firm value they read in the parent firm press release announcing the merger or heard on the news. Thus, the earnout loss frame is created and perpetuated in a merger. Although managers participate in the merger negotiation, and are initially aware that the earnout payment is contingent, repeated exposure to valuation of their firm as Y+Z leads them to incorporate the earnout value into their firm value. Belief migration occurs because when people are exposed to information frequently, they are more likely to believe it is true (Hawkins & Hoch, 1992). Also, if other people, such as family and friends, believe the target firm is valued at Y+Z, the retained target managers will infer their beliefs from them (Festinger, 1957; Pfeffer & Salancik, 1978). Lastly, target management overestimates their ability to meet the performance metrics in the merger 45 contract (e.g., Weinstein, 1980), which also contributes to their belief that the earnout is part of their firm’s value. So, although they initially believed the earnout was contingent payment, they come to incorporate the earnout value into their firm value, due to social and cognitive influences. Thus, not receiving the earnout payment feels like a loss, because they perceive that they have not received the full value for the sale of their firm. When an earnout is framed as a loss, target management wants to avoid a certain loss and the associated high-intensity negative emotional reactions. Under a loss frame, retained target management believes their firm is valued at Y+Z. If retained target management reaches the lower performance metric in a tiered earnout, they receive payment X, which is less than the full value of the earnout Y. Thus, retained target management perceives that they are receiving less than the value of their firm. In contrast, if they reach the higher performance metric, they receive payment Y, which means they perceive that they are receiving the full value for their firm. As a result, retained target management will choose a risk-seeking strategy to pursue the higher performance metric and avoid the certain loss, even if it means they could potentially miss the lower performance metric, resulting in a payment of $0. Because there is a chance they could avoid the high-intensity negative emotions at receiving $0, but cannot avoid them if they achieve the lower performance metric and receive X, they will take a chance of avoiding the certain loss to prevent the experience of certain negative 46 emotions. Thus, loss framed earnouts leads retained target management to display risk- seeking behavior. Hypothesis 1. A loss-framed earnout will increase the likelihood of risk-seeking behavior. Gain-framed Earnouts In contrast, the earnout is framed as a potential gain when the deal value is presented as the amount of the upfront payment, Z, plus a possible additional contingent payment, Y, which may be earned if specific performance metrics are met. For example, if the merger value is presented as $4M with the possibility of a $1M additional payment, as in the previous example, retained management perceives target firm value as the guaranteed payment amount, $4M. In contrast to the loss frame, parent and target manager conversations during the negotiation and implementation propagate the gain frame, as the target value is repeatedly referred to as Z, the upfront value. Additionally, however, both parties also refer to the potential for an additional payment, Y, which may be earned if they meet specific performance milestones. Thus the gain frame of the earnout is created and propagated. Unlike in the loss-frame situation, retained target management is consistently exposed to the value of their firm as the upfront payment value, Z, which is guaranteed. So, all conversations with the parent and their family and friends serve to support their initial belief about the value of their firm, instead of influencing it. Additionally, even though retained target management may be overconfident in their ability to meet the performance metrics, retained target management will view meeting the lower 47 performance goal and receiving payment X, or the higher performance goal and receiving payment Y, as a bonus, in addition to the value of their firm. So, they may be confident they will receive the bonus, but their confidence does not influence how they perceive the earnout. When an earnout is framed as a gain, retained target management wants to preserve at least part of the gain, and the associated low to medium intensity positive emotional reactions resulting from it. Since they view the value of their firm as the upfront payment value, Z, they perceive both X, the lower earnout payment, and Y, the higher earnout payment, as potential gains. Thus, if retained target management achieves the lower performance metric in a tiered earnout, they receive payment X, and experience low to medium intensity positive emotions. Similarly, if they reach the higher performance metric, they receive payment Y, leading to slightly higher intensity positive emotional reaction than if they received X. However, if in the pursuit of Y, they miss both the lower and higher performance metrics, they do not receive the bonus, leading them to experience medium-intensity negative emotions. Because they want to experience positive emotion while avoiding negative emotions, they display risk-averse behavior in an attempt to meet the lower performance tier to preserve part of the potential gain. As a result, retained target management will choose a risk-averse strategy to pursue the lower performance metric in an effort to preserve a portion of the earnout. Hypothesis 2. A gain-framed earnout will increase the likelihood of risk-averse behavior. 48 Fairness Kahneman et al (1986) demonstrate that individuals who do not receive loss- framed outcomes are more likely to perceive the situation as unfair, than those who do not receive gain-framed outcomes. The result stems from the idea that losses are more averse than foregone gains of the same magnitude, due to differences in value function slope in the loss and gain regions. Additionally, expectancy violation theory (Jussim et al., 1987; Jackson et al., 1993; Burgoon, 1993; Bettencourt et al., 1997; Kernahan et al., 2000) offers an explanation for the reaction. Under a loss frame, the person expects to be paid both the upfront payment and the earnout for their firm, as they perceive the value of their firm to be Y+Z. Not receiving the earnout payment is a negative violation of their expectations, which produces high-intensity negative emotions in the face of the loss that fuel feelings of unfairness. Under a gain frame, in contrast, the individual expects to receive the upfront payment, Z, in exchange for their firm, and view the earnout, Y, as a potential bonus that may or may not be attained. When the individuals do not receive the earnout payment, their expectations of receiving Z are met, so they do not experience high-intensity negative emotions, and perceive the situation as acceptable. As a result, an individual who does not receive an earnout payment will perceive the situation as more fair if the earnout was gain-framed than if it was loss-framed. Hypothesis 3. A loss-framed earnout is more likely to lead to feelings of unfairness, when the earnout consideration is not paid out, than a gain-framed earnout. 49 METHODOLOGY 195 undergraduates at a private institution on the West coast participated in the experiment as partial fulfillment of a requirement in a core organizational behavior or strategy course. There were 108 male and 88 female participants. The students were randomly assigned to one of 6 groups containing from 63 to 67 students. The students viewed the experiment on Dell desktop computers in a computer lab with dividers located between each work station. The conditions and survey questions were presented using Qualtrics software. In the experiment, participants take on the role of an entrepreneur, who sells his or her firm and stays on as a manager of the acquired business unit for one year. The acquisition deal includes a tiered earnout clause, so the entrepreneur receives a performance-contingent payment X at a pre-specified performance level, or a payment Y at a pre-specified higher performance level, in addition to an upfront payment of $Z. In the experiment, X<Y, and the ratio of X and Y to Z varied in different conditions. Participants were randomly assigned to one of six conditions and were shown to a cubicle that contained a computer. When the participant was seated in the appropriate cubicle, the experimenter instructed him or her to click on the survey icon on the computer desktop, which resulted in the presentation of a brief paragraph explaining the scenario. After reading the scenario, the participant clicked a “Next” button and was then presented with the manipulation. Following the manipulation, the participant was asked to choose a strategy for running the firm for one year, and whether they would perceive not receiving the earnout as fair or not. See Appendix B for the manipulations. 50 Experiment The experiment is a 3X2 design, resulting in 6 groups. The groups were defined as Equal Earnout/Loss, Equal Earnout/Gain, Large Earnout/Loss, Large Earnout/Gain, Small Earnout/Loss, and Small Earnout/Gain. Each of the independent variables is described below. Independent variables. The first independent variable is SIZE, indicating the size of the earnout as compared to the upfront payment. In the equal earnout condition, the earnout amount was equal to the upfront payment. In the large earnout condition, the earnout amount was 20 times larger than the upfront payment. Finally in the small earnout condition, the earnout amount was 20 times smaller than the upfront payment. The SIZE variable was included in the experiment because the impact of framing on behavioral risk profile and fairness is predicted to vary with the distance from the reference point, as the slope of the value function flattens with distance. The second independent variable is FRAME, indicating whether the earnout payment was framed as a potential loss or gain. A loss frame was defined as when the participant was told that he or she would be paid Y+Z (the sum of the earnout and the upfront payment), with the possibility of losing either X (the lower amount) or Y (the higher amount) of the upfront payment. In contrast, the gain frame was induced by telling the manager that he or she would be paid Z, with the possibility to earn an additional payment or gain of X or Y. FRAME was coded as 0 if the earnout was loss-framed, and 1 if the earnout was gain- framed. 51 Dependent variables. Two dependent variables were examined in the experiment. For the variable RISK, participants were asked to choose one of two strategies for running the business unit, with the same expected value for the earnout payment, but different risk profiles. Risk-seeking behavior was defined as choosing the strategy in which the probability of earning payment either $0 or $Y (the higher payment amount) was 50%. In contrast, risk-averse behavior was defined as choosing the strategy with a 100% probability of earning payment X (the lower payment amount). See Appendix C for the values of X, Y and Z for the loss and gain framing in each of the 3 conditions detailed below. RISK was coded as a 0 if the participants chose the risk- seeking strategy and 1 if they chose the risk-averse strategy. The second variable, FAIRNESS, captured whether the participant believed that missing the earnout was fair or not. FAIRNESS was coded as 0 if the participants stated that missing the earnout was unfair, and 1 if they stated that it was acceptable. See Appendix B for a copy of the experimental conditions, as presented to the participants. RESULTS Impact of Frame on Behavioral Profile An ANOVA analysis revealed no significant differences between the Equal, Large and Small groups for the RISK variable. As such, analysis of the FRAME variable within each group, using Fisher’s Exact Test (due to the low numbers of observations in some cells) reveals a similar pattern in all three conditions. See Table 1 below. Under the Equal condition, when the earnout was framed as a loss, 28 people displayed risky behavior, while only 10 showed risk-averse behavior. In contrast, 13 people displayed 52 Table 1. Behavioral Risk Profile Crosstabs Analysis Equal Condition Frame Loss Gain Behavioral Risk Profile Risk-seeking 28 13 Risk-averse 7 19 p<0.001 Large Condition Frame Loss Gain Behavioral Risk Profile Risk-seeking 23 9 Risk-averse 8 23 p<0.001 Small Condition Frame Loss Gain Behavioral Risk Profile Risk-seeking 27 14 Risk-averse 6 18 p<0.01 risk-seeking behavior under a gain frame, while 19 showed risk-averse behavior. The result are statistically significant at the p<0.001 level. Additionally, in the Large condition, under a loss frame, 23 people displayed risk seeking behavior, while only 8 displayed risk-averse behavior. However, the pattern reversed under gain framing, as 9 people displayed risk-seeking behavior, and 23 participants displayed risk-averse behavior. Again, the results are significant at the p<0.001 level. Finally, in the Small condition, 27 participants displayed risk-seeking behavior, while only 6 participants displayed risk-averse behavior, when the earnout was loss framed. In contrast, 18 participants showed risk-averse behavior, while 14 individuals displayed risk-seeking behavior. The results in the Small condition are significant to the p<0.01 level. Thus, hypothesis 1 and 2 are supported across all conditions. 53 Behavioral Profile Robustness Tests A logistic regression analysis was conducted on the experimental results as a robustness test. A correlation table reveals no significant correlations between the dependent variable and the control variables. See Table 2 below. Additionally, logistic regression reveals that FRAME has a significant positive impact (p<0.001) on RISK for all conditions, with p-values below 0.001, for the Equal, Large and Small conditions (Table 3 below). Table 2. Behavioral Risk Profile Analysis Correlation Statistics STRATEGY GENDER AGE MAJOR WORKEXP FRAME STRATEGY 1.00 GENDER 0.03 1.00 AGE -0.06 -0.16 1.00 MAJOR 0.01 0.12 -0.25 1.00 WORKEXP 0.08 -0.03 0.37 -0.05 1.00 FRAME 0.42 0.14 -0.06 0.06 0.03 1.00 Bold text indicates significance to the p<0.05 level Additionally, an analysis for economic impact was conducted by setting all variables at their mean, and varying FRAME from 0 to 1 . An economic impact analysis reveals the magnitude of influence that changing from a loss frame to a gain frame has on behavioral risk profiles. Table 4 below shows that a change from a loss to a gain frame results in a 35%-46% increase in probability of showing risk-averse behavior, depending on the condition. Thus, the results suggest that managers can significantly impact retained target management behavior risk profiles through earnout framing. 54 Table 3. Behavioral Risk Profile Regression Analysis Equal Large Small Model 1a Model 2a Model 1b Model 2b Model 1c Model 2c CONSTANT -0.10 -1.39 -0.06 -0.63 -1.00 -1.67 (0.77) (0.94) (0.72) (0.83) (0.67) (0.78) GENDER 0.24 -0.16 -0.53 -0.55 0.39 0.13 (0.51) (0.58) (0.54) (0.60) (0.55) (0.59) AGE 0.01 0.03 -0.57 -0.42 -1.00* -0.96 (0.52) (0.57) (0.48) (0.53) (0.59) (0.64) MAJOR -0.04 0.01 0.01 -0.07 -0.05 -0.06 (0.11) (0.12) (0.11) (0.12) (0.12) (0.13) WORKEXP -0.10 0.00 0.19 0.12 0.32** 0.29 (0.14) (0.16) (0.14) (0.16) (0.16) (0.17) FRAME 1.80*** 2.01*** 1.63*** (0.59) (0.60) (0.60) N 67 67 63 63 65 65 LogL -44.38 -39.09 42.00 -35.68 -39.83 -35.8 χ2 0.73 11.32** 3.32 15.97** 5.95 14.02* Pseudo R2 0.01 0.13 0.04 0.18 0.07 0.16 Standard errors in parentheses *** p<0.01, ** p<0.05, * p<0.1 Table 4. Behavioral Risk Profile Economic Significance Analysis Impact of Frame on Fairness Perceptions An ANOVA analysis revealed significant differences between the Equal, Large and Small groups for the FAIRNESS variable. See Table 5 below. In the Equal condition, VARIABLE LOW (0) HIGH (1) Difference FRAME (Equal) 20% 60% 40% FRAME (Large) 26% 72% 46% FRAME (Small) 18% 53% 35% 55 Table 5. Fairness Perception Crosstabs Analysis Equal Condition Frame Loss Gain Perceived Fairness Unfair 19 10 Fair 16 22 p<0.05 Large Condition Frame Loss Gain Perceived Fairness Unfair 27 12 Fair 4 20 p<0.001 Small Condition Frame Loss Gain Perceived Fairness Unfair 18 15 Fair 15 17 p=0.36 19 people felt that missing the earnout was unfair, while only 16 felt that it was acceptable. In contrast, 10 people felt that not receiving the earnout payment was acceptable, while 22 thought it was fair, under a gain frame. The result are statistically significant at the p<0.05 level. In the Large condition, 27 people thought missing the earnout payment was unfair, while only 4 thought it was acceptable, when the earnout was framed as a loss. Again, the opposite pattern was seen under gain framing, as 12 people considered missing the earnout was unfair, and 20 participants felt it was acceptable. Again, the results are significant at the p<0.001 level. Finally, in the Small condition, no significant results emerge, as 18 participants perceived missing the earnout as unfair, while 15 believed it was acceptable, when the earnout was loss framed. Additionally, when the earnout was gain-framed, 15 thought it was unfair, while 17 participants felt it was acceptable. The hypothesis was rejected because p=0.36. As a result, hypothesis 3 was supported in the Equal and Large condition, but not the Small condition. 56 Perceived Fairness Robustness Test Additionally, logistic regression analysis was conducted for the FAIRNESS variable. A correlation table reveals no significant correlations between the dependent variable and the control variables. See Table 6 below. Again, even with the control variables, the Table 6: Fairness Perception Analysis Correlation Statistics FAIRNESS GENDER AGE MAJOR WORKEXP FRAME FAIRNESS 1.00 GENDER -0.05 1.00 AGE -0.05 -0.16 1.00 MAJOR 0.02 0.12 -0.25 1.00 WORKEXP 0.09 -0.03 0.37 -0.05 1.00 FRAME 0.26 0.14 -0.06 0.06 0.03 1.00 Bold text indicates significance to the p<0.05 level results from the Fisher’s Exact Test hold. See Table 7 below. In the Equal and Large conditions, FRAME has a positive significant impact on FAIRNESS, at the p<0.05, and p<0.01 levels, respectively. Again, FRAME did not have a significant impact on FAIRNESS in the Small Condition. Additionally economic significance was determined by holding all the variables at their mean and varying FRAME from 0 to 1. The analysis reveals that changing from a loss frame to a gain frame increases the probability that individuals will view missing the earnout as acceptable by 31%, in the equal condition and 47% in the Large condition. Again, the economic significance analysis reveals that earnout framing can significantly impact perceived fairness. See Table 8 for the economic significance results. 57 Table 7. Fairness Perception Regression Analysis Equal Large Small Model 3a Model 4a Model 3b Model 4b Model 3c Model 4c CONSTANT 0.09 -0.83 -1.84** -3.03*** 0.44 0.28 (0.77) (0.89) (0.82) (1.02) (0.63) (0.65) GENDER -0.38 -0.72 0.16 0.35 -0.39 -0.50 (0.52) (0.56) (0.57) (0.64) (0.53) (0.55) AGE -0.11 -0.10 -0.55 -0.45 -0.13 -0.08 (0.52) (0.54) (0.53) (0.60) (0.49) (0.50) MAJOR -0.07 -0.04 0.14 0.08 0.04 0.04 (0.11) (0.12) (0.11) (0.13) (0.11) (0.11) WORKEXP 0.20 0.30* 0.32** 0.28* -0.13 -0.16 (0.14) (0.16) (0.15) (0.17) (0.15) (0.15) FRAME 1.36** 2.31*** 0.49 (0.58) (0.68) (0.53) N 67 67 63 63 65 65 LogL -44.22 -41.20 -38.31 -31.18 -44.01 -43.58 χ2 3.24 9.27* 7.12 21.37*** 2.07 2.93 Pseudo R2 0.04 0.10 0.09 0.26 0.03 0.03 Standard errors in parentheses *** p<0.01, ** p<0.05, * p<0.1 Table 8. Fairness Perception Economic Significance Analysis DISCUSSION AND CONCLUSIONS The experiment demonstrates that earnout framing significantly impacts individuals’ behavioral risk profiles and perceptions of fairness. Thus, earnout framing can be used to induce risk-seeking or risk-averse behavior, which may be more or less VARIABLE LOW (0) HIGH (1) Difference FRAME (Equal) 42% 73% 31% FRAME (Large) 13% 60% 47% 58 appropriate for achieving merger goals. Additionally, managers of the parent firm can potentially frame earnouts to manage perceptions of fairness, which may mitigate lawsuits that commonly arise when earnouts are not paid out. Thus, if managers understand how to appropriately frame earnouts, they increase the probability of positively impacting merger performance or limiting negative repercussions when retained target managers do not reach performance goals. My study makes four contributions to the strategy literature. First, it contributes to the M&A literature by advancing our understanding of earnouts and their impact on mergers. By linking earnouts frames to specific behavioral risk profiles and perceptions of fairness, it demonstrates that the impact of earnouts on mergers goes beyond mitigating information asymmetry and aligning incentives. Instead, my study demonstrates that earnout framing influences the merger through cognitive mechanisms, as well as economic. Thus, managers using mergers, and entrepreneurs using an acquisition exit strategy should be aware of how they present the merger value and frame the earnout. Second, my study contributes to the merger capabilities literature. Most merger capability studies examine target selection (e.g. Capron & Shen, 2007) or post merger integration management (e.g. Ranft & Lord, 2002; Zollo & Singh, 2004). Instead, my study demonstrates that the deal itself can impact merger integration. Because earnout framing can be used to influence retained target management behavior and their perceptions of fairness, managers at the parent firms who do not actively frame the earnout will have to face unintended consequences. In contrast, managers who develop a 59 deep understanding of earnout framing can actively shape the merger itself. So, my study demonstrates that managers can use elements of the deal strategically to increase their chances for merger success. Thus, earnout framing can be developed into a capability, which can serve as the basis of competitive advantage. My third contribution is demonstrating the value of laboratory experiments for examining topics in strategy. Although two prior studies have shown the value of experiments in contracting (Lazzarini et al., 2004) and strategic alliances (Agarwal et al., 2006), my study demonstrates that experiments can be used to examine even more complex business situations, such as mergers. Because a laboratory experiment allows researchers to define the variables and demonstrate causality, it offers an alternative tool for strategy researchers wishing to address natural limitations of traditional archival studies (Croson et al., 2007). However, experiments have their own limitations, in that they are conducted in simplified laboratory contexts, instead of real world situations. So, by complementing traditional archival studies that maximize realism with experiments that maximize precision of measures and allow determinations of causality, strategy researchers can develop research streams with both precision and realism. Finally, my study provides another example of how applying psychological theories to strategy expands our understanding of topics that have been previously investigated. Prior earnout studies tell us how to structure earnouts (Cain et al., 2006) and when to use them (Kohers & Ang, 2000; Datar et al., 2001; Ragozzino, 2004; Chatterjee et al., 2004), which are both very important for managers to understand. My study suggests, however, that managers should consider other aspects of earnouts when using 60 them. If managers only heed the economic influence of earnouts, and ignore the cognitive effects, their earnouts may not lead to the outcome they desire. By examining earnouts with a psychological lens, as opposed to just an economic lens, the field gains greater understanding of how to use earnouts effectively in M&A. As such, it represents a small, but significant step in incorporating psychological theories into strategy. Prospect theory examines individual effects, not impacts on firm-level activity. As such, it is necessary to outline how the influence of loss and gain framed earnouts impact the merger. When an earnout is used in the deal, target managers often negotiate the acquisition and are retained to run the newly acquired business unit. Thus, they are the key decision-makers for new business unit strategies. They also design and implement incentives for their employees, so they can reach specific performance goals. As such, although a software engineer, for example, may not develop a risk-seeking or risk-averse behavioral profile directly as a result of earnout frame; the goals, milestones, performance criteria, penalties and bonuses designed by retained target management will prompt the engineer to behave in a risk-seeking or risk-averse manner. As a result, the earnout frame will indirectly impact the engineer’s behavior, and ultimately, the merger. Finally, future work needs to be done to determine if managers actually frame earnout clauses as losses or gains in real mergers. 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The Right Frame of Mind for M&A: Framing Mergers to Get What You Pay For 2 In a recent interview, a long-time M&A lawyer in the southern California area suggested, “An M&A deal is about numbers and dollars and cents, but often the thing that makes the merger successful is the way that you spin it,” He added, “That is the thing that most MBAs and lawyers don’t get, and aren’t trained in.” In contrast, an examination of parent press releases announcing mergers with contingent consideration reveals that parent firms vary in terms of how they frame the merger value. When parent firms publically announce their acquisitions, they treat the merger value (how much the merger is worth to target shareholders) in one of three ways; they: 1) frame it as total consideration (sum of upfront payment + contingent payment), 2) frame it as guaranteed consideration (upfront value with possibility to earn contingent value) or 3) do not mention the value at all. So, it appears that firms at least vary the way they frame the value of the deal in the merger announcement, but is it intentional and strategic or just an artifact of the way the company or industry has always done business? Which theories allow us to examine the issue? Economics-based agency theory (Jensen & Meckling, 1976; Fama & Jensen, 1983) addresses why contingent consideration is used, but not why parent firms then frame the values of mergers containing contingent consideration differently. In contrast, sociology-based neo- institutional theory (Meyer & Rowan, 1977; Powell & DiMaggio, 1991) suggests that a particular merger value frame is an institutional norm in a particular industry or parent 2 This dissertation study was funded by the Grief Center Entrepreneurship Doctoral Dissertation Grant. 67 firm, so mergers within an industry or announced by a particular parent firm are always framed in the same way. However, anecdotal examination of merger value framing in the IT industry demonstrates intra-industry and even intra-firm variation. Prospect theory, a psychology perspective, offers an alternative explanation for variation in parent merger framing. It argues individuals display risk-seeking and risk-averse behavior when prospects are seen as potential losses and gains, respectively (Kahneman & Tversky, 1979). Thus, managers of parent firms could frame mergers to induce risk-seeking or risk-averse behavior in retained target managers. Interviews with various business development managers reveal parent companies often have very specific plans for the target firms acquired. For example, a business development manager in Northern California suggests, “We have specific goals in mind when we evaluate targets. It may be a strong company, but if it doesn’t meet our needs, we don’t pursue it.” In mergers involving service and high-tech firms, target managers are largely viewed as sources of knowledge required to maintain the target firm’s capabilities (Coff, 1997; Nelson & Winter, 1982; Winter, 1987), so parents often want to retain them post-merger. In an attempt to do so and to encourage effort during their tenure, parent firms often use contingent consideration in service and high-tech mergers (Datar et al., 2001: Chatterjee et al., 2004), which is consistent with agency theory. However, without intentional framing, contingent consideration induces retained target employees to display very different types of behaviors. Prospect theory argues individuals display risk-seeking and risk-averse behavior when opportunities are seen as potential losses and gains, respectively (Kahneman & Tversky, 1979). However, retained 68 target management may view contingent consideration as a potential loss or gain, leading them to display risk-seeking or risk-averse behavior post-merger, which may be more or less appropriate for accomplishing the parent firm’s goals for the target. In contrast, if the parent intentionally frames the contingent consideration in the merger as a potential loss or gain, retained target management will behave in manners more appropriate for accomplishing the parent’s acquisition goals. Thus, prospect theory suggests that managers of the acquiring firm frame mergers based on the actions they desire from managers of the acquired firm. My study makes four contributions to the strategy literature. First, unlike traditional M&A integration studies, it examines the potential for influencing effective integration during deal development, instead of only after the contract is signed. Second, it extends our understanding of earnouts in M&A, which currently have been examined through the lens of agency theory, to provide a more complete understanding of their impact on mergers. Third, because acquirers use earnouts more often when they acquire new ventures than established firms, my study provides entrepreneurs with a tool to increase their probability of meeting earnout performance goals. Finally, my study is a modest, but significant demonstration of the value of psychology theory in strategy, as psychology theory allows new questions to be examined that could not be completely explained by traditional economic and sociology-based theories. I first offer an in-depth examination of the phenomenon of merger value framing, including a discussion of earnout clauses, a common type of contingent consideration in mergers that place a premium on retaining target employees. I then offer an overview of 69 prospect theory, and its application in merger value framing, proposing two alternative merger value frames: 1) total consideration (focuses on full potential value of the deal with contingent consideration framed as a potential loss), and 2) guaranteed considerations (focuses on the guaranteed value of the deal with contingent consideration framed as a potential gain). Then, I develop and test hypotheses regarding when parent managers use each type of framing. Finally, I discuss my results and contributions, and suggested future directions for research. EARNOUT FRAMING IN MERGER ANNOUNCEMENTS A frame is a set of cognitive rules used to organize and interpret a situation (Goffman, 1974). When applied to mergers 3 , frames influence how parties interpret the business combination and provide guidelines for expected events and behaviors. A merger frame originates from discussions between the parties during the negotiation, continues with informal discussions, and is formalized in the press release. For example, a merger frame can address the combination of two firms as a merger or acquisition. In the first conception people either interpret the situation as two equal firms combining leadership and activities. In the second, they view the business combination as one firm swallowing the other. A brief examination of merger announcements reveals great variety in how several key elements are framed. However, in interviews, industry experts suggest that neither lawyers nor managers are trained in framing, and actually create unintended 3 Although mergers and acquisitions are technically different transactions, acquisitions are often referred to as mergers in practice. As such, the terms “merger” and “acquisition” will be used interchangeably throughout this paper. 70 consequences for their firms. Yet, most merger studies either use economic or sociological theories, which preclude examination of cognitive influences such as framing. While M&A researchers examine a variety of topics, work investigating the impact of deals and deal structure on mergers is particularly relevant for this paper. The studies evaluate whether tender offers or mergers lead to better merger performance (e.g. Agrawal et al., 1992; Loughran & Vijh, 1997; Rau & Vermaelen, 1998). They also examine when to use cash or stock financing (Reuer & Ragozzino, 2006), and how the decision impacts market performance (Loughran & Vijh, 1997; Hayward, 2003; King et al, 2004), shareholder performance (e.g., Carow et al., 2004; Huang & Walkling, 1987; Loughran & Vijh, 1997; Travlos, 1987), and acquirer firm-level performance (Healy et al., 1992; Heron & Li, 2002). Finally, the studies explore when to use upfront or contingent payment in acquisitions (Reuer et al., 2004). All of these studies use economic lenses to examine the impact of deals on mergers, which precludes the examination of framing effects due to incomplete bounded rationality assumptions in economic perspectives, such as agency theory and information asymmetry (Weber, 2010). Incomplete bounded rationality assumptions in economics-based strategy theory only allow for bounds on the quantity of information processed, not for perceptual limitations, such as framing effects, which potentially distort the information that is processed. Mergers containing earnout clauses provide an ideal opportunity to examine merger framing, because earnouts can be framed as either a loss or gain in a merger contract. An earnout is a contingent payment clause that requires specific performance 71 metrics to be met prior to payout. The performance metrics may be based on acquiring or retaining a specific number of customers, completing the development of a technology or a meeting a specific financial goal, based on revenue or profit, for example. Earnouts appear in half of all small business acquisition contracts (Fields, 2005). Additionally, both The Wall Street Journal (Karnitschnig & Cimilluca, 2009) and M&A lawyers (Rosen, 2008) predict that the use of these clauses will rise precipitously due to creative financing resulting from the current credit crunch. The predicted increase in earnout usage is based on two factors. First, some firms will not be able to survive declining rates of business in this recessionary period and will be looking to be acquired as an alternative to bankruptcy. Second, the potential parent firms who wish to acquire target firms may not have the available cash or credit to finance the deal. As such, the use of earnout clauses is expected to explode in 2009 and continue until the credit crunch eases substantially, so it is important for managers to understand the impact of earnouts on mergers. Earnout clauses (contingent consideration) are almost always used in combination with an upfront payment (guaranteed consideration). Thus, an earnout payment can be perceived as a potential loss or gain, depending on how the value of the deal is framed. As such, mergers containing earnout clauses provide an ideal opportunity to examine merger frames. However, traditional economics and sociology-based strategy theories do not allow researchers to examine potential cognitive influences on mergers, such as earnout frames. 72 Traditional Strategy Perspectives on Earnouts and Merger Framing Economics-based agency theory (Jensen & Meckling, 1976; Fama & Jensen, 1983) predicts when managers of parent firms should include earnout clauses in the merger, as opposed to only upfront cash payments, to align principal (parent firm) and agent (retained target management) incentives. If principle and agent incentives are aligned, agents should display behavior desired by principals (Eisenhardt, 1989). Prior research, based on agency theory, suggests earnouts are used to encourage post-merger retention of target employees, particularly when human assets are an important part of the acquisition, such as when the target is a high-tech firm (Chatterjee et al., 2004) or a service industry (Datar et al., 2001; Chatterjee et al., 2004). Other economics-based research based on an information asymmetry argument suggests earnouts should be used to bridge information gaps that occur because parents are inefficient in valuing targets correctly and target firms are inefficient at communicating their value (Kohers & Ang, 2000; Datar et al., 2001; Ragozzino, 2004; Chatterjee et al., 2004). However, both agency theory and the information asymmetry perspective incorporate an incomplete definition of bounded rationality, focusing on limitations of the quantity of information individuals can process, to the exclusion of perceptual limitations (Weber, 2010). As such, the theory does not allow researchers to examine the impact of framing or other systematic cognitive biases on agent behavior. So, agency theory addresses why contingent consideration is used, but not why parent firms then frame the values of merger containing contingent consideration differently. 73 Neo-institutional theory argues formal organizational structure arises from the institutional environment, not from task demands (Meyer & Rowan, 1977; Powell & DiMaggio, 1991). In fact, the organizations are rewarded for adopting the practices and policies, even if they are inefficient. Neo-institutional theory makes two predictions for how managers frame merger values. First, a particular frame can be an institution in the industry environment, so all merger values in a particular industry will have the same frame. Second, if the frame is an institutionalized myth within a particular firm, the firm will always frame merger values in the same way. However, examination of parent merger announcements rule out the neo-institutional explanation because firms use different merger value framing and different merger frames exist in the same industry. Additionally, managerial decision-making is largely ignored in neo-institutional perspective, as managers passively acquiesce to the institutional environment, rather than make intentional decisions (Perrow, 1986). Neo-institutional advocates suggest the theory accommodates active responses to the institutional environment in the form of acquiescence, compromise, avoidance, defiance or manipulation (Oliver, 1991). However, the extension does not offer further predictions regarding why managers in the parent firm frame mergers differently. Thus, traditional strategy theories based on economics and sociology do not allow us to understand variation in parent merger framing. However, because the field of strategy seeks to offer both a descriptive understanding and prescriptive advice on how intentional strategic behavior impacts organizational performance, researchers are encouraged to incorporate psychological theories in their studies, in addition to economic 74 and economic theories (Simon, 1997; Bromiley, 2005; Foss, 2003; Gavetti et al. 2007; Weber, 2010). As such, prospect theory is a good candidate for explaining why parent firms vary deal value framing in merger announcements. Prospect Theory & Merger Value Framing Prospect theory examines risky choice under loss versus gain frames (Kahneman & Tversky, 1979). It suggests that individuals display risk-averse behavior in the face of gains, and risk-seeking behavior in the face of losses. To understand why particular frames induce specific behavioral risk profiles, it is necessary to examine the value function. Using median values for constants derived from their experiments, Kahneman and Tversky mapped the classic s-curve value function (Bromiley, 2009). As the s-curve suggests, when outcomes fall below a particular reference point (encoded as a loss), the value function is convex, and when they fall above the reference point (encoded as a gain), the value function is concave (Kahneman & Tversky, 1979). Additionally, the value function is steeper for losses than gains, because the distance from the x-axis to the value function at X is greater in the loss domain than in the gain domain. So the pain of losing X is greater than the joy of gaining that same X. Thus, a loss (giving up something you have) is more aversive than a forgone gain (not receiving something that you thought you might receive), and an averted loss (not giving up something you have) is more pleasant than a gain (receiving something that you thought you might receive) (Kahneman et al., 1986). The proposed emotional reaction occurs because a loss moves individuals towards an undesired state, while a foregone gain moves them away from desired state; and an 75 averted loss moves you away from undesired state gain, while a gain moves you towards a desired state. That is, movement towards or away from an undesired end state leads to higher intensity emotional reactions that movement towards or away from a desired end state (Chen Idson et al., 2000). So, when people are facing a potential loss, they may either lose something they possessed (and experience high intensity negative emotions) or keep the thing they thought they were going to lose (and experience high intensity positive emotions). The desire to avoid the high intensity negative emotion and to experience the high intensity positive emotion leads to risk-seeking behavior in an effort to avoid certain loss, and potentially avert certain loss. In contrast, when people are faced with a potential gain, they may either receive something they anticipated (and experience low to medium intensity positive emotion) or not receive something they anticipated (and experience low to medium intensity negative emotion). The desire to experience positive emotion and avoid negative emotion leads to risk-averse behavior in order to preserve at least part of the potential gain. Prospect theory is particularly pertinent for examining merger value frames. First, earnout clauses (contingent amounts) are used in conjunction with upfront payments (fixed amounts), so an earnout can be perceived as a potential loss or gain, depending on the merger value frame. Second, earnout clauses are usually tiered. So, retained target management chooses between a lower payout with a much higher probability of achievement (almost a sure thing based on prior demonstrated performance), and a higher payment with a much lower probability of achievement (a significant stretch goal when compared to prior performance). See Appendix A for an example of the tiered nature of a typical earnout clause. While the lower performance goal is readily a target managers conduct business as usual, reaching the higher tier requires a completely different aggressive strategy. Thus, t link between framing and behavior risk profiles, choose one of two strategies Third, earnout clauses usually require existing target management to oversee of the new business unit, for at least a short period of time, so the impact of deal frames on their behavior is important to the parent firm. Managers can induce perceptions of earnout payments as losses or gains, by framing deal values in terms of total consi the earnout) or guaranteed consideration (the value of the upfront payment only) plus the possibility of additional contingent payment, respectively. For example, in a merger with a $2M upfront payment and a $1M under total consideration framing, with the possibility of a $1M loss if the earnout is not attained. In contrast, under a guaranteed consideration frame, the transaction is viewed as a $2M deal with the potential for a $1M gain throug on prospect theory, different management to display different behavioral risk profiles Figure 2. Total and Guaranteed Consideration Framing of typical earnout clause. While the lower performance goal is readily achievable if retained target managers conduct business as usual, reaching the higher tier requires a completely different aggressive strategy. Thus, tiered earnout clauses allow researchers to establish a link between framing and behavior risk profiles, because retained target managers two strategies, with the same expected value, but different risk profiles. Third, earnout clauses usually require existing target management to oversee new business unit, for at least a short period of time, so the impact of deal frames on their behavior is important to the parent firm. Managers can induce perceptions of earnout payments as losses or gains, by in terms of total consideration (the sum of the upfront payment and the earnout) or guaranteed consideration (the value of the upfront payment only) plus the possibility of additional contingent payment, respectively. For example, in a merger with a $2M upfront payment and a $1M earnout, the transaction is viewed as a $3M deal under total consideration framing, with the possibility of a $1M loss if the earnout is not attained. In contrast, under a guaranteed consideration frame, the transaction is viewed as tential for a $1M gain through the earnout (see Figure rospect theory, different merger value frames should lead retained target to display different behavioral risk profiles. Total and Guaranteed Consideration Framing of Merger Value 76 chievable if retained target managers conduct business as usual, reaching the higher tier requires a completely iered earnout clauses allow researchers to establish a retained target managers must he same expected value, but different risk profiles. Third, earnout clauses usually require existing target management to oversee operations new business unit, for at least a short period of time, so the impact of deal frames Managers can induce perceptions of earnout payments as losses or gains, by deration (the sum of the upfront payment and the earnout) or guaranteed consideration (the value of the upfront payment only) plus the possibility of additional contingent payment, respectively. For example, in a merger with transaction is viewed as a $3M deal under total consideration framing, with the possibility of a $1M loss if the earnout is not attained. In contrast, under a guaranteed consideration frame, the transaction is viewed as ee Figure 2). Based frames should lead retained target Merger Value 77 Total Consideration (TC) Frame. Under a total consideration frame, the merger value is presented as the sum of the upfront payment and contingent consideration. For example, if the upfront payment is $4M and the earnout consideration is $1M, the merger value is presented as $5M. Although retained target managers are fully aware the $1M earnout is contingent on performance, repeated exposure to the $5M value leads them to update their belief and now value their business at $5M. The migration of managements’ beliefs about the value of their firm can occur for three reasons. First, people are more likely to believe information that they are exposed to frequently (Hawkins & Hoch, 1992), so hearing their business valued in terms of total consideration in every conversation with the parent is likely to reinforce belief migration. Second, individuals infer their beliefs from others’ perceptions and actions (Festinger, 1957; Pfeffer & Salancik, 1978), so when target managers have conversations about the value of their business with the parent, other target management, friends, or family, their original belief about the value of their firm is often replaced with the distorted belief. Finally, target management will often overestimate their ability to meet the performance milestones in the merger contract (e.g., Weinstein, 1980), so they tend to expect that they will receive the total consideration amount in return for selling their business. Under the total compensation frame, target management perceives the $1M earnout as a potential loss. So, when faced with a decision between a risk-averse strategy to achieve the “sure-thing”, but lower performance metric (for e.g. $500,000 instead of $1M, which guarantees a loss of $500,000 of the earnout) or a risk-seeking strategy to potentially meet risky, but higher performance goal (the full $1M), retained target 78 management will choose the latter to avoid certain loss. Thus, prospect theory predicts total consideration framing leads retained target management to display risk-seeking behavior. Guaranteed Consideration (GC) Frame. In contrast, a guaranteed consideration frame presents the merger value as the upfront payment plus possible additional contingent payment. For example, in the previous deal, the deal value is presented as $4M, with the possibility of earning an additional $1M if specified performance goals are met. Under a guaranteed frame, retained management is likely to their business is worth of the value of the upfront payment, $4M in this example. But, they are also aware they may earn an additional $1M payment if specific performance milestones are reached. Because the deal value presented to target management in conversations and through the media is consistent with their own knowledge from the merger negotiation, it reinforces their initial belief that their business is worth $4M. Additionally, even though they may be overconfident in their abilities to meet the earnout performance goals, they view the additional payment as a bonus, and not part of the value of their business. Prospect theory suggests that people are risk-averse in the face of gains, because they want to preserve some part of it. Under a guaranteed consideration frame, target management perceives the $1M earnout as a potential gain. Because target management wants to protect at least a portion of the potential gain (for e.g. $500,000 of the earnout amount), they will choose a risk-averse strategy, allowing them to meet the lower performance tier of the earnout payment. So, retained target management will likely 79 display risk-averse behavior in an effort to preserve a smaller portion of the earnout payment. Parent Manager Motivation to Use TC or GC Frames. Interviews with business development professionals suggest that parent firms acquire target firms for specific purposes. They may purchase a firm to gain a specific technology or to get access to a specific customer base, for example. In order to accomplish meet the intended purpose, parent managers need retained target managers to display behavior consistent with the goal. Risk-seeking and risk-averse behavior may be beneficial in reaching some goals, while detrimental in reaching others. Prior research supports prospect theory’s predictions, demonstrating that loss and gain-framed earnouts systematically lead to risk-seeking and risk-averse behavior, respectively (Weber, 2010). Merger value framing is one essential component of earnout loss and gain framing. Managers implement perceptions of earnout clauses as losses or gains by framing the value of the merger in terms of total consideration or guaranteed consideration, respectively. For example, the following earnout is framed as a potential gain in a press release because the merger value is presented in terms of guaranteed consideration. “Under the terms of the deal, Siebel of San Mateo, Calif., initially will pay $70 million to the shareholders of Eontec of Charlotte, N.C. Depending on revenue achievement and contractual milestones, Siebel may pay up to an additional $60 million in earn-out payments during 2005. “(Siebel press release, April 20, 2004). Additionally, the following is an example of the merger value framed in terms of total consideration: 80 “The $190 million all-cash transaction is expected to close by the end of July 2005, subject to customary conditions including regulatory approval.” (Arbortext press release, July 6, 2005). The earnout in the Arbortext deal was $19M, while the upfront payment was $171M, for a total of $190M. Although acquirer managers may further emphasize the loss and gain perceptions in later conversations, framing the merger value is necessary for inducing loss and gain views of earnout payments. So, parent management can use merger value framing to induce retained target management to view earnout payments as losses or gains, which leads them to display risk-seeking or risk-averse behavior. Because risk-seeking (or risk- averse) behavior may be more appropriate for reaching a parent merger goal in one situation, and less appropriate in another, managers can use merger value framing to align retained target management behavior with parent goals for the merger. Thus, they can frame merger value to get what they paid for in the merger deal. However, prospect theory predicts individual effects on retained target management’s behavioral risk profiles, while merger success is a firm-level outcome. So, framing influences have to aggregate to the business unit level if merger value framing is to have any impact on merger success. Retained target management tends to take part in the negotiation and subsequent integration activities. After the deal is signed, they likely choose the strategy for the new business unit, and implement incentives for their employees to reach specific targets. Therefore, although a sales representative courting new customers, for example, may not have a risk-seeking or risk-averse behavioral profile as a result of the merger value frame, the goals, milestones, performance criteria, 81 penalties and bonuses designed by retained target management will prompt the sales representative to behave in a risk-seeking or risk-averse manner. Thus, merger value frame indirectly impacts the sales representative’s behavior, and ultimately, merger performance. Risk-seeking and Risk-averse Organizational Behavior In prospect theory lab studies, risk-averse behavior is displayed when a subject chooses a more certain but smaller payout over a more uncertain but potentially larger one; while risk-seeking behavior is when the opposite choice is made. But what does risk-averse and risk-seeking behavior look like in organizations? Risk-averse organizational behaviors generate certain but smaller increases in performance, tend to reinforce the status quo, and are likely to meet customer, supplier or partner expectations, derived from prior interactions or the firm’s reputation. Examples include, updating current customer support systems, conducting incremental innovation, and following regulatory guidelines or product specifications In contrast, risk-seeking behavior significantly impacts organizational performance in a positive or negative manner, topples the status quo, and tends to violate customer, supplier and partner expectations. Examples of risk-seeking behavior include, implementing an automated customer service system when it was previously handled by a dedicated sales representative, conducting radical innovation, and integrating a new technology platform into the product. Expectancy violation theory (Jussim et al., 1987; Jackson et al., 1993; Burgoon, 1993; Bettencourt et al., 1997; Kernahan et al., 2000) suggests that when expectations are met individuals experience moderate-intensity emotional reaction in the direction of the 82 expectation. So, meeting positive expectations leads to moderate-intensity positive emotion reactions, while meeting negative emotions results in moderate-intensity negative reactions). In contrast, when expectations are violated, individuals experience high-intensity emotional reactions in the direction of the violation (Burgoon, 1993; Bettencourt et al., 1997; Kernahan et al., 2000). Thus, negative violations of positive expectations result in high-intensity negative emotions, while positive violations of negative expectations leads to high-intensity positive emotions. As a result, risk-averse organizational behaviors usually lead to low-intensity positive emotions (assuming positive expectations are met), while risk-seeking behaviors lead to either high-intensity positive or negative emotions, depending on whether the expectation is positively or negatively violated. Using Merger Value Frames to Get What Managers Paid For In some mergers, risk-averse target management behavior helps the parent firm reach its goals, while risk-seeking behavior hinders the process. Other times, the opposite is true. The impact of behavioral risk profiles depends largely on parent firm’s goal for the merger, which is often captured by merger characteristics. Prior work shows two types of merger characteristics that impact M&A performance: 1) firm strategy (Haleblian et al., 2009) and technology (Puranam & Srikanth, 2007). Building on the studies, I examine the impact of intended customer strategy and technology characteristics on merger value frames. See Table 9 for an overview of the hypotheses. 83 Table 9. Matching Merger Value Frames with Parent Merger Goals Merger Characteristic Risk-averse Risk-seeking Customer strategy Retention Acquisition Technology Mission critical Exploratory Industry type Regulated Rapid technological change Customer strategy. When a parent acquires a target, they either focus on retaining the target’s current customers or acquiring new customers based on synergies between their current products and the target’s products or technology. The two strategies are impacted very differently by risk-averse and risk-seeking behavior. So, the choice of customer strategy should differentially drive the use of total consideration and guaranteed consideration frames. Retention. Retaining target customers is the primary merger goal, when parent firms want to use the merger to increase market share, access a target’s key customers or enter new markets, the primary purpose is to retain target customers. The primary path to customer retention is meeting customer expectations (Fornell & Wernerfelt, 1987). Provided that the current target customers are reasonably satisfied, behaviors that incrementally augment the status quo lead to customer retention. Risk-averse behaviors meet prior expectations, and allow for incremental augmentation. They generate low- intensity positive emotions in the customers when expectations are met (Burgoon, 1993), which are positive enough for the customer to remain in the exchange relationship with the target. Additionally because there is a finite number of target customers, risk-averse 84 behavior generates little potential downside (few customers leave) and high potential upside (satisfied customers are retained). In contrast, risk-seeking behavior leads to positive or negative violations of customer expectations. Positive violations lead to high intensity positive emotions, resulting in satisfied, committed customers (Gross & John, 2003). Negative violations, on the other hand, induce high intensity negative emotions, leading to customer defection. Because only a finite number of target customers exist, the potential downside of risk- seeking behavior is high. In contrast, the potential upside is essentially equal to that seen with risk-averse behavior, as the payoff from both very satisfied and moderately satisfied customers is retention. As a result, parent firms should frame the deal in terms of guaranteed potential consideration to induce risk-averse behavior. Hypothesis1a: When the parent firm wants to retain the target firm’s customers, merger value is more likely to be framed as guaranteed consideration than total consideration. Acquisition. In contrast, if a parent intends to use a target’s technology, service, or product to recruit new customers, customer acquisition is the primary merger goal. Unlike customer retention, customer acquisition requires target management to exceed potential customer expectations, in order to overcome inertial forces previously preventing a relationship with the potential client. That is, in order to attract new customers, target management must generate a strong positive reaction in order to get the firms, who were not previously interested in working with the firm, to sign on as buyers. So, risk-seeking behavior, which can potentially generate high intensity positive emotions, will most likely result in customer acquisition success. Even if risk-seeking 85 behavior leads to high intensity negative emotions instead, target management has more leeway to take risks when acquiring customers than retaining them, because there is a much larger supply of potential customers than current customers. So, risk-seeking behavior provides large potential upside and little potential downside when acquiring customers. In contrast, risk-averse behavior virtually guarantees that potential customer expectations will be met, but not exceeded. Additionally, it may lead to low-intensity positive emotions, which are not likely to overcome the inertial forces preventing customer conversion. Also, because there is a large supply of potential customers, target management does not reap the same benefit from risk-averse behavior as when customer retention is the primary goal. As a result, when the parent firm wants to use the target to acquire new customers, it should frame merger value in terms of total consideration. Hypothesis 1b: When the parent firm wants to acquire new target customers, merger value is more likely to be framed as total consideration than guaranteed consideration. Technological Needs. Type and stage of target technology also impacts parent firms’ merger goals. Again, the parent’s purpose for the target determines whether risk- averse behavior or risk-seeking behavior is more appropriate in accomplishing the goal. As a result, the technological needs of the parent firm influence how its managers frame merger value. Mission-critical. When a merger target produces mission critical technology, the parents wants to acquire technology that meets pre-specified standards. Following the merger, failure of the target’s technology that is mission-critical for its customers creates 86 a significant negative impact on the parent firm’s reputation and future livelihood. The damage is particularly irreparable if failure resulted from negligence by the parent or the target. So the parent wants retained target management to provide products or services conforming to strict specifications, rather than introduce new functionality that may not be well-tested. Risk-averse behavior supports conformity to standards and meets customer expectations regarding product quality. It also induces the parent to experience medium- intensity positive emotions towards the target. Additionally, because there is so much at stake when mission critical technology fails, risk-averse behavior provides little potential negative downside, as retained target managers are not likely to miss expectations. In contrast, risk-seeking behavior leads to either positive or negative violations of expectations, resulting in one of two situations. Either the parent experiences high- intensity positive emotions towards the target, if the expectations are exceeded, or the parent is forced out of business, if expectations are not met. As a result, the potential upside of risk-seeking behavior is potentially high, but the potential downside significantly outweighs it. So, framing the deal in terms of guaranteed compensation increases the likelihood of that target will meet parent merger goals. Hypothesis 2a: When the parent firm acquires a target providing mission critical products or services, merger value is more likely to be framed as guaranteed consideration than total consideration. Exploratory. In contrast, when the target is a cutting-edge technology firm, the parent wants to acquire innovative technologies or solutions. Working towards pre- 87 specified standards leads retained target management to produce incremental innovations, not the cutting edge technology the parent wants. So, the parent wants retained target management to focus on pushing the technology envelope, rather than meeting pre- specified standards. Additionally, in acquisitions of cutting edge technology firms, parent firms pay the target for the completed cutting-edge technology in the upfront payment, so any additional technology development beyond that point is viewed as a bonus. Risk-seeking behavior leads target managers to depart from the status quo, which encourages radical innovation. However, risk-seeking behavior can either meet or violate expectations, resulting in radical innovation or no additional advancement of the technology. If the technology is not advanced, the parent still has the completed target technology it purchased in the merger, it just received no additional radical innovation. So, the upside of risk-seeking behavior is considerable, while the downside is minimal. In contrast, risk-averse behavior encourages the status quo, not cutting-edge innovation. As a result, both the upside and downside are minimal, because the target will likely deliver additional innovation, but it will be incremental, not cutting-edge. Since the parent is not interested in incremental innovation, it prefers that retained target management gambles on technology development. Risk-seeking behavior will lead to the gamble strategy, while risk-averse behavior will lead to a safer approach of meeting performance metrics. As a result, it is better for the parent to frame the deal in terms of total consideration to produce risk-seeking behavior, than guaranteed consideration to produce risk-averse behavior. 88 Hypothesis 2b: When the parent firm acquires a target with exploratory or cutting edge technology, merger value is more likely to be framed as total consideration than guaranteed consideration. Early-stage. When a parent purchases a target with early-stage technology, it expects the target to develop the technology into a feasible product. Although the parent did pay for the technology, it also paid for the potential of the finished product in the upfront payment. As such, the parent expects to receive a feasible product similar to the one that it was promised in the due diligence phase. Risk-averse behavior encourages the status quo, leading the target to continue down the development path towards feasibility. Thus, the upside is positive, although there is little chance that the target will exceed the parent’s expectations and produce a feasible technology with enhanced functionality. Additionally, the downside is very small, because there is little chance of missing the parent’s expectations with the risk- averse approach. In contrast, risk-seeking behavior could potentially lead the target down one of two paths. The target may fail to reach technological feasibility, negatively violating parent’s expectations. Alternatively, the target could produce a feasible technology with additional innovation, positively violating parent expectations. However, because the parent wants to get what it paid for in the merger, a feasible technology, the risk of failing outweighs the possibility of exceeding expectations. So, when the target has early-stage technology, the deal value is more likely to be framed in terms of guaranteed consideration than total consideration. 89 Hypothesis 2c: When the parent firm acquires a target with early stage technology, merger value is more likely to be framed as guaranteed consideration than total consideration. EMPIRICAL ANALYSIS Industry Context Mergers with IT industry targets are well-suited for testing the proposed hypotheses for three reasons. First, IT firms are often acquisition targets, even if the new parent firm is not in the industry. So, there is a significant level of M&A activity with IT industry targets. Second, mergers with IT industry targets tend to use earnout provisions in their M&A contracts, because 1) it is difficult for the parent and target to agree on a value of an early-stage technology (Kohers & Ang, 2000), many of these firms are private entrepreneurial firms (Ragozzino, 2004), and parent firms usually view target human assets as key to acquisition success (Chatterjee et al., 2004). So, there is ample opportunity to frame the value of mergers with IT targets. Finally, parent merger goals are often predicated on the target firm’s technology characteristics. Thus, examining a sample of mergers with IT targets is particularly useful to investigate how parent merger goals shape deal frames. My sample includes targets specializing in hardware, software, IT services and telecommunications, which encompasses SIC codes: 3571,3661, 3663, 3669, 3671, 3674, 3679, 4225, 4724, 4813, 4899, 5044, 5045, 5199, 5734, 6162, 5999, 6162, 6719, 7311, 7335, 7371, 7372, 7373, 7374, 7379,7389, 7929, 8099, 8711, 8731, 8742, and 8748. The target firms are listed in Appendix D. 90 Data The data set for the quantitative analysis consists of 172 M&A contracts with target firms in the IT industry, containing earnout clauses, the parent 10-K filing, which reports the merger to the shareholders and the corresponding press releases announcing the deals. 1000 mergers were identified using the CapitalIQ database, using a search for mergers containing earnouts with an IT industry target. Out of the list, 175 mergers were randomly sampled from this list. Once the list of 175 mergers was compiled, the contracts and 10-K filings were collected from SEC filings in the Edgar database. Additionally, the press releases were collected from the Lexus-Nexis database. Firm-level control variables were also collected from the CapitalIQ database and 10K filings. All mergers in my sample are between public parent firms and private target firms (with the exception of three public targets in the sample). The mergers range in value from $730,000 to $330M and represent 130 buyers. The independent and some control variables were coded from a key I developed and refined based on coding four groups of 20 deals, a total of 80 mergers. The coding key was updated after each set of 20 was coded. The mergers were then put back into the sample and coded with the entire dataset based on the complete key. Once the coding key was complete a sample of 40 mergers coded by myself and a research assistant yielded inter-rater reliability of 0.9. I then coded the entire sample based on the key, which is located in Appendix E. Missing data resulted in a sample ranging from 163-169 mergers, depending on the variables in the analysis. 91 Dependent variables The dependent variable, FRAME, captures the type of M&A deal frame used in the merger. FRAME is a dummy variable. It is coded as zero if the press release does not refer to the deal value. If the press release refers to the amount of the upfront payment plus the possibility to earn additional consideration (guaranteed consideration framing), it is coded as one. Finally, if the deal value is presented as the sum of the upfront payment and the earnout provision (total consideration framing), it is coded as two. Of the 174 mergers in the sample, 46 are framed as total consideration and 88 are framed as guaranteed consideration. The remaining 40 mergers in the sample are not framed. Independent Variables In H1a and H1b, I examine how the parent’s goals for the merger concerning customer strategy impacts M&A deal frames. In H1a, I predict that if the parent wants to retain the target’s customers, it is more likely to frame the value of the deal in terms of guaranteed consideration than total consideration. To examine the prediction, the dichotomous variable RETENTION is coded as one if the text in the 10-K about the merger discusses retaining customers, highlights the importance of acquiring key target customers (for e.g. US government, specific types of firms or specific clients), notes that the target has largest share in their market or has a large number of paying subscribers or clients, or mentions an expectation of establishing the parent firm as a leader in an current or new market because of merger. The variable is coded as zero, otherwise. In H1b, I predict that if the parent wants to acquire additional customers as the result of the addition of the target’s technology or services, then it will be more likely to frame the 92 deal value in terms of total consideration than guaranteed consideration. To test this prediction, I code the dichotomous variable ACQUISITION as one if 10-K text about the merger notes a desire to increase or enhance the parent’s customer or client base using the target’s products or technologies, increase the target’s customer base, enter new product or geographic markets (beyond those of the target firm) or that the merger is a significant step in expanding sales capabilities. The variable is coded as zero, otherwise. H2a, H2b and H2c examine how parent merger goals related to target technology characteristics impact the framing of M&A deals. H2a suggests that if the target’s technology is mission critical, the parent will frame the M&A deal value in terms of guaranteed consideration as opposed to total consideration. CRITICAL, the variable of interest in H2a, is a binary categorical variable that is coded as one if the parent’s 10-K mentions that the target provides technology, products or services for critical processes relating to medical services or records, sensitive data storage, financial transactions including billing and e-commerce and the defense industry. Additionally, this variable is coded as a one if the target technology products or services ensure consistency or accuracy. The variable is coded as zero otherwise. H2b predicts that if the target’s technology is exploratory, then the deal value will be framed as total consideration instead of guaranteed consideration. To examine this hypothesis, EXPLORATORY, a dichotomous variable, is coded as 1 if the parent 10-K describes the target’s technology as state of the art, innovative or cutting-edge. The variable will be coded as zero, otherwise. Finally, in H2c, acquisition of technology in an early stage is predicted to lead to guaranteed deal frames instead of total deal frames. EARLY, the variable of interest in 93 H2c, is a binary categorical variable that is coded as one if the parent 10-K mentions that the target acquired in process R&D, technology of unproven feasibility or early technology, as a result of the merger. It is coded as zero, otherwise. Control Variables I have also included several variables in the analysis to control for other factors that might influence the framing of M&A deal values. While I control for the effect of these variables on the framing decision, I do not consider them as main theoretical drivers of duration safeguard framing decisions. However, inclusion of these factors helps control for alternative hypotheses. First, I controlled for variables specific to the firms in the deal. Framing may change over time, possibly as a result of the parent learning how to better manage mergers. YEAR captures this effect. It is coded as a dummy ranging from zero (the contract was signed in 1997) to eleven (the contract was signed in 2008). I also controlled for the parent firm’s industry to rule out the institutional theory hypothesis that framing is an industry artifact. PRNTIND captured the two digit primary SIC code for the parent firm. It was coded as a dummy variable ranging from 0 for two digit SIC code 10 and 16 for two digit SIC code 99. Additionally, I controlled for PRNTSZ, coded as the annual revenue for the parent firm in the year prior to the acquisition. It is coded in millions of dollars. Parent size may drive framing, as larger firms may have more merger resources devoted to deal management and therefore better manage their mergers. ACQEXP measures the number of acquisitions done by the acquirer in the three years prior to the focal acquisition. The three year window for acquisition experience has been use in prior 94 studies (e.g. Haunschild, 1993; Haunschild & Beckman, 1998). I also controlled for the target industry, because these industries may also have announcement norms that could influence how the parent reports the deal value. TRGTIND is coded as a dummy variable representing the two-digit SIC code of the target firm. It ranged from zero if the target industry primary SIC code was 72 to fifteen if it was 87. Additionally, I coded control variables that were specific to the merger. TOTVAL measures the total potential deal value, which is the sum of the upfront payment and the earnout payment. An alternative explanation for merger framing would be that parent firms frame merger values of large deals in one way, while framing values of small deals in another way. EOPRCNT captures the percentage of the total possible consideration constituted by the earnout. It was created by dividing the earnout amount by the total amount and multiplying by 100. Again, parent firms may frame merger values in terms to total consideration (or guaranteed consideration) when the earnout is a large portion of the total value, in an effort to report a larger (or smaller) deal to their shareholders. Additionally, three variables were coded from the 10-K filings. LITIGATION captures whether the target was involved in litigation during the merger. If the target is involved in litigation, the parent may want the target to display risk-averse behavior, maintaining the status quo, instead of pushing boundaries and potentially exacerbating the legal situation. It is coded as one if the 10-k mentions litigation involving the target firm, or zero otherwise. Additionally STRATEGY captures whether or not the acquisition is part of the parent firm’s long-term strategy. If the target acquisition is specifically mentioned in the 10-K as being consistent with or furthering the firm’s strategy, it was coded as one; 95 otherwise, it was coded as zero. If a target firm is not part of the parent’s long-term strategy, but a merger of opportunity, the parent may not be as concerned about target management behavior or even retaining the target’s human assets. INTEGRATION measures whether or not the parent plans to integrate the target into the parent firm, or whether the target will remain a stand-alone business unit. If the parent plans to integrate the firm, they may have a preference for retained target managers to display behavior consistent with that of the parent firm managers, independent of the merger characteristics. If the 10-K document mentions target integration, the variable is coded as a one; otherwise, it is coded as zero. Finally, the variable RELATED captures whether or not the target firm is in the same industry as the parent firm. Empirical Estimation To analyze my sample, it is necessary to determine how business development managers make their decisions about framing merger values. They may potentially choose a merger frame in one of three ways. First, they could just choose between a guaranteed or total consideration frame. However, given that some merger values are not framed, it is unlikely that the decision is that simplistic. This decision process would be modeled with a simple probit or logit model. Another alternative is to choose between not framing the merger value, framing it in terms of guaranteed consideration, or framing it in terms of total consideration. In this scenario, all three choices are simultaneously considered. When three options are simultaneously considered, a multinomial probit or logit analysis is most appropriate to model the decision. Finally, the managers can first choose to frame the merger value, and then choose between a guaranteed or total 96 consideration frame. This two-step process is best captured using a heckman probit analysis. To determine which model of the framing decision was most appropriate in my study, I interviewed business development managers in high technology industries to understand how they evaluate their options. When asked how they made a decision about how to frame the merger value or not, a business development professional from Northern California, responded, “I’m not sure what you mean about framing. We just say nothing about the deal amount, talk about the whole thing or about what they get at closing.” Other additional interviews support his view. Thus, framing is not an active, conscious process. Business development managers do not make a decision to frame a merger and then choose a frame. Additionally, they do not just choose between the two frames. Instead, the choice in the context examined in my paper is a simultaneous choice between three outcomes. So, given the multiple simultaneous outcomes, a multinomial probit or logit regression using the entire sample (175 projects) is most appropriate to model the decision. I present the results from a multinomial probit analysis, but also conduct a multinomial logit analysis that produces very similar results. Both of these empirical estimations recognizes that three outcomes are possible in any given contract— no frame, a guaranteed consideration frame or a total consideration frame 4 . The multinomial probit estimation approach utilizes the Huber/White/sandwich estimator of variance for robust standard errors, as well as correct the variance- 4 I also present a binomial probit estimation in Appendix F, although my interviews do not support the use of this analysis. The result are nearly the same as with the multinomial probit, with the exception that RETENTION loses statistical significance, which is not surprising given the attenuated sample size. 97 covariance matrix to account for the clustering of observations across parents (i.e., observations are independent across parents, but not necessarily within a given parent). The multinomial probit specification utilizes the following model: Probit Framing α β RETENTION β ACQUISITION +β CRITICAL β EXPLORATORY β # EARLY +β $ Z $ +. β i Z i represents the control variables in the model. Guaranteed consideration framing (GCF) serves as the base category in the specification. Model 1 compares the base case to no frame (NF), while model 2 compares it to total consideration (TCF). Additionally, I assess the marginal effects of RETENTION, ACQUISITION, CRITICAL, EXPLORATORY and EARLY on FRAME. To do this, I examine the marginal probabilities at the value of zero and one for each independent variable, with all other variables held at their means. Empirical Results Table 10 provides summary statistics of the dependent and independent variables used in the analysis, while Table 11 provides correlation statistics. Preliminary analyses of these tables provide some insight regarding the unique determinants of GC & TC framing. Table 10 indicates significant heterogeneity in the independent and control variables. Table 11 indicates FRAME varies positively with some of the independent variables and negatively with other independent variables. These results suggest that the use of different frames is driven by parent merger goals. Finally, correlations between and among the main independent and control variables in Table 12 are generally low to moderate, suggesting that multicollinearity is not a concern. 98 Table 10. Merger Value Frame Analysis Summary Statistics Variable Mean SD Min Max N FRAME 1.03 0.70 0 2 174 YEAR 7.76 2.87 0 11 174 PRNTIND 9.20 3.30 0 16 174 PRNTSZ 356.06 664.72 0 4805.5 173 ACQEXP 3.93 3.65 0 21 169 TRGTIND 10.43 3.13 0 15 174 TOTVAL 94.53 77.91 0.73 330 172 EOPRCNT 25.62 23.41 0.23 114.85 169 LITIGATION 0.06 0.25 0 1 172 STRATEGY 0.54 0.50 0 1 174 INTEGRATION 0.73 0.45 0 1 174 RELATED 0.65 0.48 0 1 173 RETENTION 0.57 0.50 0 1 174 ACQUISITION 0.30 0.46 0 1 174 CRITICAL 0.30 0.46 0 1 174 EXPLORATORY 0.13 0.33 0 1 174 EARLY 0.16 0.36 0 1 174 Table 11. Merger Value Frame Correlation Statistics Bold text indicates significance to the p<0.05 level FRAME YEAR PRNTIND PRNTSZ ACQEXP TRGTIND TOTVAL EOPRCNT LITIGATION STRATEGY INTEGRATION RELATED RETENTION ACQUISITION CRITICAL EXPLORATORY EARLY FRAME 1.00 YEAR 0.08 1.00 PRNTIND -0.04 0.05 1.00 PRNTSZ 0.04 0.11 -0.01 1.00 ACQEXP 0.01 0.04 0.09 -0.09 1.00 TRGTIND 0.03 -0.03 0.07 -0.04 -0.03 1.00 TOTVAL 0.30 0.02 -0.09 0.11 0.01 -0.66 1.00 EOPRCNT -0.12 0.00 0.05 0.28 0.03 -0.05 -0.09 1.00 LITIGATION -0.02 0.07 0.05 0.10 -0.09 -0.10 0.03 0.14 1.00 STRATEGY 0.18 0.17 0.08 0.10 0.00 0.10 -0.25 0.03 0.00 1.00 INTEGRATE -0.02 0.15 0.06 0.11 -0.14 0.08 -0.09 0.72 0.11 0.11 1.00 RELATED 0.03 -0.09 0.28 -0.09 0.04 -0.08 -0.08 0.08 -0.06 0.06 0.02 1.00 RETENTION -0.24 0.08 0.13 0.10 0.11 0.13 0.13 -0.07 0.03 -0.06 0.06 0.01 1.00 ACQUIRE 0.15 -0.04 -0.07 -0.05 -0.13 -0.04 -0.08 0.04 -0.07 0.06 -0.02 -0.04 -0.50 1.00 CRITICAL -0.16 0.08 0.10 0.12 0.10 0.14 -0.17 -0.06 -0.02 0.15 0.09 0.05 0.36 -0.24 1.00 EXPLORE 0.03 -0.08 0.01 0.01 -0.01 -0.02 -0.05 0.05 -0.02 0.14 0.11 0.06 -0.20 0.24 -0.06 1.00 EARLY 0.05 -0.03 -0.07 -0.06 0.02 0.06 0.02 -0.05 -0.04 -0.02 0.05 0.01 -0.21 0.16 -0.11 0.17 1.00 99 Table 12 presents the multinomial probit estimations. The dependent variable for the multinomial logit estimation takes on three distinct values—0 for no frame; 1 for guaranteed consideration frame; and 2 for total consideration frame. The first column of Models 1-3 presents the multinomial probit estimation results that compare mergers that are not framed to mergers that are framed in terms of guaranteed consideration. The second column of Models 1-3 compares guaranteed consideration framed mergers to total consideration framed mergers. The Table 12 models are paired for each estimation approach in terms of variable loadings. Model 1 includes the firm-specific control variables. Model 2 adds the merger-specific variables to Model 1. Model 3 adds the independent variables of interest to Model 2. We focus our attention on Model 3. The empirical results demonstrate that only the merger-specific control variable RELATED drives the use of total consideration framing as opposed to guaranteed consideration framing. In the multinomial probit estimation, mergers that involve target firms in the same industry as the parent firm increase the likelihood of using total consideration framing (p<0.1). This result is not surprising given that when the merger target is in the same industry, the parent can more easily monitor the retained target managers because they are familiar with the strategies in the industry. Thus, they may be more likely to encourage risk-seeking behavior, with a potential high return, because they can identify if the behavior is not leading to positive results and adjust the strategy to something less risky. The multinomial probit estimation indicates none of the other control variables have statistically significant effects on the use of total consideration framing versus guaranteed consideration framing. 100 Table 12. Merger Value Frame Multinomial Probit Analysis Model 1 Model 2 Model 3 YEAR -0.09* -0.02 -0.14** 0.01 -0.14** 0.02 (0.05) (0.05) (0.06) (0.06) (0.07) (0.07) PRNTIND 0.02 -0.04 0.04 -0.06 0.03 -0.03 (0.05) (0.05) (0.06) (0.05) (0.07) (0.06) PRNTSZ 0.00 0.00 0.00 0.00 0.00 0.00 (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) ACQEXP -0.03 -0.02 -0.02 -0.04 0.01 0.03 (0.05) (0.04) (0.06) (0.05) (0.07) (0.07) TRGTIND -0.085* -0.06 -0.48*** -0.09 -0.47*** 0.01 (0.05) (0.05) (0.10) (0.08) (0.10) (0.10) TOTVAL -0.02*** 0.00 -0.03*** 0.00 (0.00) (0.00) (0.01) (0.00) EOPRCNT 0.01 0.00 0.00 -0.01 (0.01) (0.01) (0.01) (0.01) LITIGATION -0.01 0.08 0.18 0.41 (0.66) (0.64) (0.73) (0.66) STRATEGY 0.58 0.28 0.56 0.38 (0.41) (0.31) (0.47) (0.35) INTEGRATION 0.37 0.30 0.52 0.30 (0.38) (0.38) (0.42) (0.45) RELATED -0.02 0.46 0.24 0.79* (0.42) (0.35) (0.49) (0.45) RETENTION 0.11 -0.94** (0.54) (0.45) ACQUISITION 1.65*** 2.28*** (0.53) (0.44) CRITICAL -0.87** -1.21*** (0.44) (0.41) EXPLORATORY 1.25* 1.49** (0.74) (0.75) EARLY -1.92** -1.42** (0.76) (0.63) Constant 0.92 0.71 6.27*** 0.68 6.05*** -1.28 (0.80) (0.79) (1.52) (1.42) (1.79) (1.60) DV NF TCF NF TCF NF TCF N 168 162 162 LogL -168.44 -132.41 -96.00 χ 2 9.72 73.81*** 203.47*** 101 NOTES: 1. *** p<0.01 ** p<0.05 * p<0.10 2. Standard errors are robust and clustered (by customer) 3. The numbers in each cell are coefficients with standard errors in parentheses. 4. The estimation compares mergers with no frames (NF) and mergers with total consideration frames (TCF) to mergers with guaranteed consideration frames (GCF). Guaranteed consideration frames (GCF) serve as the base category in both estimations. 5. Control variables are introduced in stages to establish a stripped down baseline to examine the effectiveness of the main control variables before introducing the hypothesized variables. 6. The second column in each model is the relevant comparison to the models in the probit analysis in Figure X and is used to test our hypotheses. Hypothesis 1a suggests that if the parent wants to retain the target’s customers, guaranteed consideration framing is more likely to be used than total consideration framing. Strong support is found for this hypothesis, as RETENTION is statistically significant in the predicted direction (p<0.05). Hypothesis 1b suggests that if the parent wants to acquire additional customers using the target, the deal is more likely to be framed in terms of total consideration than guaranteed consideration. Strong support is also found for this hypothesis, as ACQUISITION has the predicted impact and is statistically significant (p<0.01). Hypothesis H2a predicts that if the parent acquires a target with mission critical technology, the deal is more likely to be framed in terms of guaranteed rather than total consideration. I find strong support for this hypothesis as well. CRITICAL is statistically significant (p<0.01) in the predicted direction. I also argue in Hypothesis 2b, that if the target’s technology is exploratory, the deal value is more likely to be framed as total consideration than guaranteed consideration. Again, I find that EXPLORATORY has the hypothesized effect and is statistically significant (p<0.05). Finally Hypothesis 2c suggests that if target technology is in an early stage, guaranteed consideration framing is more likely to be used than total consideration 102 framing. Again, I find strong support for this hypothesis, as mergers concerning early technology (EARLY) have a negative and statistically significant effect on the use of total consideration framing (p<0.05). Although my empirical analysis finds strong support for all of my hypotheses, an examination of economic significance further demonstrates the importance of merger characteristics in choosing deal frames. In Table 13, I demonstrate how the absence or Table 13. Merger Value Frame Economic Significance Analysis NOTES: 1. This table holds all variables at their respective means and then varies the independent variable of interest from 0 to 1, since they are dummy variables. 2. Percentages refer to the probability of observing total consideration framing (TCF). presence of my independent variables impact the likelihood of total consideration frames versus guaranteed consideration frames. In this table, I hold all variables at their respective means and then vary the independent variables from 0 to 1. This data shows that when the parent wants to retain the target’s customers it nearly halves their probability of using a total consideration frame. Additionally, a change from “no customer acquisition” to “customer acquisition” increases the probability of total consideration framing from 22% to 74%, a nearly three-fold increase. The presence of VARIABLE LOW (0) HIGH (1) Difference RETENTION 50% 28% -22% ACQUISITION 22% 74% 52% CRITICAL 46% 20% -26% EXPLORATORY 32% 68% 36% EARLY 42%` 15% -27% 103 mission critical technology in the merger decreases the probability of total consideration framing 46% to 20%, a 26% decrease. In addition, moving from “exploratory technology” to “no exploratory technology” doubles the probability of using a total consideration deal frame, increasing the probability from 32% to 68%. Finally, if the parent acquires a target with early-stage technology, the probability of using total consideration framing decreases by over half, from 42% to 15%. Empirical Robustness In my sample of 175 mergers, 46 are framed as total consideration, 88 are framed as guaranteed consideration, and the remaining 40 are not framed. Thus, my sample is skewed towards framing the merger value instead of not framing it, which may bias the estimation. State-based sampling corrects this issue, leading to more precise parameter estimates. Under state-based sampling, an equal number of mergers are randomly sampled from the three merger groups: no frame, a guaranteed consideration frame, and a total consideration frame. This approach eliminates the framing dominance in my original sample (Manski & Lerman, 1977; Manski & McFadden, 1981). Table 14 provides the results for the robustness test for the multinomial probit estimations using state-based sampling. I randomly sampled 40 mergers from the no frame, guaranteed consideration framing and total consideration framing groups. I then conducted a multinomial probit analysis on the resulting sample. The results from the column of Model 3) with only a slight loss of statistical significance (from p<0.05 to p<0.1) in the RENTENTION and EARLY variables in the estimation, which is to be expected from the reduced sample size. 104 Table 14. Merger Value Frame Robustness Test Model 4 Model 5 Model 6 YEAR -0.11* -0.01 -0.15** 0.02 -0.11 0.08 (0.07) (0.07) (0.07) (0.08) (0.08) (0.09) PRNTIND 0.17** 0.04 0.16* -0.01 0.19 0.05 (0.08) (0.06) (0.09) (0.08) (0.12) (0.09) PRNTSZ 0.00 0.00 0.00 0.00 0.00 0.00 (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) ACQEXP 0.01 -0.03 0.02 0.04 0.08 0.13 (0.06) (0.06) (0.08) (0.07) (0.07) (0.09) TRGTIND -0.20*** -0.09 -0.08 0.08 -0.20* -0.12 (0.07) (0.06) (0.08) (0.07) (0.11) (0.09) TOTVAL -0.01*** 0.00 -0.01** 0.00 (0.00) (0.00) (0.00) (0.00) EOPRCNT 0.0139* 0.00 0.00 -0.01 (0.01) (0.01) (0.01) (0.01) LITIGATION 0.45 0.30 0.02 -0.60 (0.89) (0.78) (0.81) (0.82) STRATEGY 0.35 -0.20 0.37 -0.08 (0.44) (0.41) (0.50) (0.47) INTEGRATION 0.07 -0.27 0.45 0.52 (0.46) (0.44) (0.50) (0.59) RELATED -0.15 -0.14 0.11 0.27 (0.54) (0.47) (0.72) (0.63) RETENTION 0.57 -0.43 -0.40 -1.05* (1.14) (1.01) (0.63) (0.62) ACQUISITION 3.05*** 3.46*** (0.65) (0.57) CRITICAL -1.13** -1.48*** (0.51) (0.49) EXPLORATORY 1.49 2.33** (0.93) (0.99) EARLY -1.74** -1.52* (0.71) (0.82) Constant 1.24 0.79 0.57 -0.43 0.82 -0.61 (0.86) (0.84) (1.14) (1.01) (1.31) (1.34) DV NF TCF NF TCF NF TCF N 115 115 113 113 112 112 LogL -120.22 -104.2 -73.55 χ 2 11.83 42.84*** 111.27*** 105 NOTES: 1. *** p<0.01 ** p<0.05 * p<0.10 2. Standard errors are robust and clustered (by customer) 3. The numbers in each cell are coefficients with standard errors in parentheses. 4. The estimation compares mergers with no frames (NF) and mergers with total consideration frames (TCF) to mergers with guaranteed consideration frames (GCF). Guaranteed consideration frames (GCF) serve as the base category in both estimations. 5. Control variables are introduced in stages to establish a stripped down baseline to examine the effectiveness of the main control variables before introducing the hypothesized variables. 6. The second column in each model is the relevant comparison to the models in the probit analysis in Figure X and the second column in each model in Figure X, and is used to test our hypotheses. second column of Model 6 demonstrate are nearly equivalent to those in Table 12 (second DISCUSSION In this paper, I demonstrated how managers frame merger values to induce behavior appropriate for meeting their merger goals (to get what they paid for). If the acquisition contract stipulates a $50 M upfront payment and a $25 earnout payment, the deal value can be frame in one of two ways. First, it may be presented as a $75 M deal, which frames the transaction in terms of total consideration. In contrast, parent managers can frame deal value as a $50 M deal with the potential for additional consideration, a guaranteed consideration frame. Under a total consideration frame, retained target’s management views the earnout as a potential loss, which according to prospect theory induces risk-seeking in an effort to avoid a certain loss. Alternatively, when deal value is presented in terms of guaranteed consideration, target management views the earnout as a potential gain, leading to risk-averse behavior to preserve part of the gain. As stressed in the hypotheses, parent firms do not always want retained target management to display risk-averse behavior, as it is not always the most appropriate for every merger situation. In fact, the parent’s purpose for the merger dictates which behavioral risk profile (risk-averse or risk-seeking) is more appropriate. I suggest that 106 when parent firms plan to use target technology or products to acquire customers (in addition to target customers gained through the merger) or to attain a cutting-edge technology, risk-seeking behavior allows them to accomplish the goal more readily. I then demonstrate that parent firms attempt to induce risk-seeking behavior by framing merger value in terms of total consideration. Alternatively, I argue when the parent firm wants to retain target customers, acquire a mission-critical product or service, or attain an early-stage technology, risk-averse behavior of retained target management increases the probability it will attain the goal. I then demonstrate that parent firms indeed frame deal values in mergers with such goals in terms of guaranteed consideration. I do want to make one point clear. I am not suggesting that parent firms are consciously using prospect theory to frame merger values. Instead, I believe we see the results in this paper, because managers learn to incorporate elements that produce positive outcomes in their routines (Mayer & Argyres, 2004). Because aligning merger value frame with merger goals potentially leads to positive results, when managers at parent firms stumble on the correct framing for a particular situation, they apply it to other situations to see if it works. If it does, they incorporate it as part of their approach to a particular type of merger. As a result, managers at parent firms develop patterns of merger value framing consistent with prospect theory, without actually being aware of the theory itself. My suggestion is much like the assumption in transaction economics theory that although managers are not experts at TCE, they still apply the basic principles in choosing governance because they worked in the past. What I am suggesting, however, is that if managers could be made aware of why certain framing works better for some 107 situations than others, they can consciously use this knowledge to positively influence merger outcomes. In suggesting that parent firms strategically induce desired behavior from retained target management, I am not suggesting that parent firms behave opportunistically. Although I acknowledge that the possibility exists, in a merger containing an earnout, both parties benefit from allowing the parent to realize their merger goal. First, the parent gets what they pay for in the merger. Second, retained target management receives at least part of the earnout payment. Thus, although merger framing allows parent firms to shape target behavior, the alignment of incentives, created by the earnout clause, reduces the likelihood that opportunism will occur. My study makes three contributions to the strategy literature. First, it extends our understanding of earnouts in mergers. Because prior research was based only on agency theory, how parent firms frame values of mergers containing earnouts has not been examined in past studies. However, manager’s need for a complete understanding earnouts is quickly increasing for two reasons. First, although earnout clauses have been used traditionally used in M&A contracts with entrepreneurial firms or human-resource rich firms (IT or service firms), their usage is expected to increase exponentially over the next few years. The tightened credit market reduces parent firms’ available cash, leading them to use earnouts to finance mergers. Although prior literature has provided a clear understanding of when to use earnouts and how to structure them, parent firms also need to understand that the contingent nature of earnout clauses lead retained target management to interpret the earnout as a potential loss or gain. If managers do not 108 strategically set the frame, they have to deal with the unintended consequences. Second, a recent change in an accounting and SEC reporting rule, FAS141R, now requires that contingent consideration be recorded at fair market value on the acquisition date. Prior reporting rules allowed it to be recorded at the time of the actual payment. The change in reporting rules will likely bias parent firms to frame their deals in terms of total consideration, leading to risk-seeking behavior by retained target managers, whether it is appropriate for the merger or not. Hopefully my paper will encourage parent management to consciously choose a deal frame, rather than just follow the momentum created by the reporting rules. Second, because earnouts are more likely to appear in acquisitions of entrepreneurial ventures than established firms, my study provides entrepreneurs with a potential tool to increase their probability of meeting earnout performance goals. According to industry experts, entrepreneurs frequently do not receive earnout payments, because they rarely meet specific performance goals. My paper suggests they can actively participate in merger value framing during negotiations with the parent, in an effort to align their behavioral incentives with the parent merger goals, thus increasing the probability earnout payments. Similar to prior work demonstrates how belief differences between parent and target firms impact merger success (Graebner, 2009), my study illustrates how cognitive issues significantly impact mergers and entrepreneur payouts. Finally, I believe that my paper represents a modest but significant step towards incorporating psychological reasoning into economics-based strategy research. Previous work combining these two disciplines allowed researchers to ask novel questions, such as 109 how contract framing impacts transaction success (Weber & Mayer, 2009; Weber et al., 2009). Here, I use prospect theory, a well accepted decision-making theory used extensively in behavioral economics, to ask novel questions about mergers and earnouts. Instead of examining traditional merger integration capabilities or even when to use earnouts, both well-studied topics in M&A literature, I examine how to frame merger value when the deal contains an earnout, in order to increase the probability that parent firms meet merger goals. Thus, the incorporation of psychological theory provides the strategy field with a more nuanced understanding of mergers and earnouts. My paper suggests that managing merger perceptions can significantly impact the probability of parent firms meeting their goals for the merger. If the parent firm aligns the merger value frame with their goals, it may actually increase their probability of meeting the goals. Additionally, because it is often difficult to foresee the impact of framing in real mergers (due to their complexity) and parent firms do not always fully identify their goals in acquiring a target, successful merger framing is a complex task that is difficult to imitate, similar to alliance capabilities (Kale et al., 2002). Thus, it is possible for merger framing capabilities to serve as a basis for sustained competitive advantage. However, evidence is needed to support this conjecture. So, one area for future research is examining if firms develop merger framing capabilities. 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As a result, actors described as boundedly rational have varied cognitive capacities under different theories. Simon’s point in introducing bounded rationality was to challenge economists to incorporate more realistic human cognition in their research (Bromiley, 2005). Under most conceptions of bounded rationality, however, actors have either processing limitations (bounds on the quantity of information processed) or perceptual limitations (restrictions on how the information processed is perceived), but not both. Incorporating only one type of cognitive limitation into BR oversimplifies the decision-making process, thwarting Simon’s original objective. Bounded rationality in strategy research largely incorporates processing limitations, but fails to incorporate perceptual challenges and biases. For example, major theories, including transaction cost economics (TCE) (Williamson, 1975, 1985) and the resource-based view (RBV) (Mahoney, 2005), operationalize BR as processing limitations, leading to incomplete contracts or resource heterogeneity, respectively. While equating BR to processing biases provided a foundation for major insights from in the theories (for example, TCE predicting governance choice) 5 , I argue a conception of 5 Foss (2003) too questions the actual contribution of the current conception of BR in TCE, suggesting it is unnecessary to derive the main predictions. 118 bounded rationality incorporating both processing and perceptual bounds will expand the explanatory power of current theories and open new research avenues. Others also believe that expanding bounded rationality will augment our understanding of organizations, as both Foss (2003) and Gavetti et al. (2007) have previously called for incorporating cognitive and social psychology into bounded rationality to better model actual managerial decision-making. My paper responds to their call in three significant ways. First, it makes the distinction between processing and perceptual limitations, which clarifies what is missing from the traditional BR conceptions, and exactly how cognitive and social psychology can add value to organization research. Second, it unites three sources of perceptual limitations, which have previously been suggested in isolation, and demonstrates how perceptual limitations provide opportunities for managers to induce behaviors and emotions appropriate for organizational situation. Finally, it goes the next step by demonstrating how a more complex bounded rationality assumption expands the explanatory power of current strategy theory, leading to novel insights. In this paper, I begin discussing two common operationalizations of cognitive limitations in bounded rationality and contrast them to Simon’s original intent. Next, I propose combining both processing and perceptual limitations to create a more complete operationalization of cognitive limitations in bounded rationality, and develop propositions for perceptual bounds that are particularly applicable in strategy. Finally, I discuss how a more complex BR model augments strategy research by extending current theory, using TCE as an example. 119 CONCEPTIONS & SOURCES OF BOUNDED RATIONALITY Because researchers interpret bounded rationality (BR) in many ways, various studies imbue actors with different abilities and objectives under the same guise. Identifying and addressing shortcomings in different BR models is a good first step in creating a common conception. As such, I first examine two common bounded rationality operationalizations and then contrast them to Simon’s original notion. Common Operationalizations of Bounded Rationality A survey of BR literature reveals that different operationalizations of bounded rationality vary on three dimensions: 1) satisificing versus maximizing, and 2) myopia versus foresight, and 3) processing limitations versus perceptual limitations. The first aspect describes the actors’ objectives in decision-making. Are they optimizing on a full (or attenuated due to search costs) consideration set, or sequentially searching until they find a solution meeting predefined criteria, even though additional search may yield a superior outcome? The second dimension specifies the extent that actors are able to look ahead and plan. The final aspect addresses the types of cognitive limitations actors face during decision-making. Although all three aspects of bounded rationality are interesting, and worthy of examination, I focus exclusively on cognitive limitations in BR in this paper for two reasons. First, I believe perceptual limitations, which are largely ignored in strategy’s conception of BR, represent the field’s largest deviation from Simon’s original conceptualization of bounded rationality. Second, perceptual limitations offer a significant opportunity to influence our understanding of organizations by allowing researchers to pursue new research streams using novel theories. Some researchers, 120 including those in strategy, operationalize bounded rationality as processing limitations (e.g., Williamson, 1975, 1985; Eisenhardt, 1989), bounds on the quantity of information individuals can process, which are well-established in both psychology and neuroscience literatures (e.g. Shiffrin, 1976; Cowan, 2000). A main implication of processing limitation BR models is an individual’s inability to know all possible outcomes in a decision, resulting in limited consideration sets 6 (e.g., all complex contracts are unavoidably incomplete in TCE because negotiators cannot generate all possible contingencies (Williamson, 1975)). Under the processing limitations model, actors are still granted significant foresight and remain free from perceptual biases. So, although BR generates attenuated consideration sets, theories relying on a processing limitations model of BR assume that actors do not distort the information they do process. As a result, decision processes are modeled as less detailed versions of reality, which runs counter to Simon’s notion that the world people inhabit is much different than the one they perceive (Simon, 1982). In contrast, others camps, such as behavioral economics, operationalize bounded rationality exclusively as perceptual limitations (e.g., Camerer & Lowenstein, 2003; Thaler, 1980), or bounds on how information is perceived. Perceptual BR models focus on how cognitive biases impact actors’ perceptions and subsequent decision-making (Camerer, 2005). Thus, actors are subject to cognitive, emotional and social influences on perceptions; however, researchers utilizing perceptual BR models largely ignore 6 A subset of processing BR models further suggest actors maximize on their limited consideration sets, in essence optimizing subject to search cost constraints (Conlisk 1996). Critics of this view argue actors would need greater cognitive faculties than under strict rationality assumptions, because actors perform two complex calculations instead of one (Bromiley 2005). 121 processing limitations as their experiments are not designed to test individual’s processing limitations 7 . As a result, under perception BR models, decisions are made from full consideration sets of distorted outcomes. Simon’s Bounded Rationality Simon developed bounded rationality in response to strict rational models in neo- classical economics, and wanted economists to incorporate realistic decision-making processes into their research (Bromiley, 2005). Under Simon’s definition of BR, “human behavior is intendedly rational but only limitedly so” (Simon, 1961: xxiv) because of restricted cognitive capacities. So, bounded rationality includes all limitations arising from cognitive deficiencies, including both processing and perceptual biases. Processing limitations, deficits impacting the amount of information processed, are important bounds to rationality because they limit the individual’s options at the decision point. Without processing limitations, actors would be able to know all possible outcomes of a decision, and could optimize based on the complete consideration set. However, as suggested by psychological and neuroscience studies, human brains cannot processes large quantities of data (Cowan, 2000). Thus, a model of BR without processing limitations cannot capture actual decision-making processes 8 . 7 Experiments in behavioral economics allow researchers to determine causality. However, the simplification allowing such isolation typically prevents experiments from taxing participant processing limitations. If the subjects cannot process the stimuli, the experiment would be unsuccessful. Thus, behavioral economics studies designed to analyze perceptual limitations do not test processing limitations. 8 According to Simon, satisificing is a logical implication of processing limitations (Simon, 1957: 205). That is, actors cannot know all possible outcomes for a decision, so they sequentially search and choose the first option that meets pre-defined decision criteria (Bromiley 2005). Satisficing stands in direct contrast to the maximizing approach. 122 In contrast, perceptual limitations are cognitive bounds on how information is processed. Simon believed that under uncertainty, economic actors physically inhabit a very different world than they experience. That is, the subjective environment is not a reasonable approximation of the “real world” with some details omitted, but is a distorted view created by active perceptual and cognitive processes. Because the two worlds differ so dramatically, Simon suggested it is impossible to predict even rational behavior from objective social characteristics, as they may not influence the actor’s behavior as much as mental processes (Simon, 1982). As such, Simon proposed inclusion of perceptual biases in bounded rationality (Simon, 1997: 80), like those explored by Tversky and Kahneman (e.g., 1974). Kahneman, supporting Simon’s view, suggested, “Our research attempted to obtain a map of bounded rationality, by exploring the systematic biases that separate the beliefs that people have and the choices they make from the optimal beliefs and choices assumed in rational-agent models.“ (Kahneman, 2003: 1449). Perceptual limitations are important bounds to rationality, because perceptions, not actual outcomes, constitute the consideration set in decision-making. Thus, Simon intended bounded rationality to include both what individuals are able to process as well as how they perceive what they do process. Both issues are critically important, because they explain complexity in decision-making in organizations, which is not captured by maximization assumptions in neo-classical economics research. However, in both common conceptions of bounded rationality, only one of the two biases is incorporated. As a result, most BR models are incomplete when compared to Simon’s original intention. 123 I propose that expanding bounded rationality in strategy research to include both processing and perceptual limitations will expand the strategy field’s understanding of organizations in two significant ways. First, researchers will be able to ask novel questions, based on psychological theories not previously used in literature. The new research streams will examine both previously unidentified nuances of well-established topics, as well as aspects of organizations that could not be examined using traditional strategy theories. Second, incorporation of a more complete BR assumption, will impart increased explanatory power for traditional strategy theories. BR OPERATIONALIZATIONS IN STRATEGY RESEARCH On the surface, the strategy field seems to embrace Simon’s behavioral assumption of bounded rationality. Most traditional theories, including transaction cost economics, positive agency theory, and the resource-based view incorporate the concept as a behavioral assumption. However, it is not clear what cognitive capacities actors have under each of the theories. Transaction Cost Economics Transaction cost economics focuses on minimizing transaction costs by aligning ex post governance structure with transaction hazards (Williamson, 1975; 1985; 1996). Williamson incorporated BR as a behavioral assumption in his theory, suggesting that the “…the principal ramification of bounded rationality for the study of economic organization is that all complex contracts are unavoidably incomplete.” (Williamson, 2000: 8). That is, information processing limitations prevent actors from listing all 124 possible contingencies that may arise and potentially impact the exchange. As a result, complex contracts are always unavoidably incomplete. While Williamson’s actors experience processing biases, they are not subject to perceptual biases. So, they are still imbued with significant foresight, which some scholars argue allow them to retain some aspects of neoclassical economic (i.e., hyper- rational) man (Simon, 1997: 38). Additionally, qualitative research further suggests that managers are slower to recognize and react to issues than TCE implies (e.g., Mayer & Argyres, 2004). Thus, under its current conception of bounded rationality, TCE examines a simplified view of organizational governance decision processes; however it could provide a more complete conceptualization if augmented with a more complete BR assumption. Positive Agency Theory In contrast, positive agency theory (PAT) 9 focuses on aligning ex ante incentives to minimize agency costs (Jensen & Meckling, 1976; Fama & Jensen, 1983). The agency problem arises when a principal hires an agent, and the goals of the two parties are in conflict. If it is difficult for the principal to monitor the agent, the principal cannot be sure that the agent will display appropriate behavior. Positive agency theory focuses on identifying contractual mechanisms to align the parties’ incentives. As such, the primary implication of bounded rationality in PAT is also incomplete contracting. Again, the operationalization of bounded rationality in the theory is the application of processing limitations—individuals cannot know all possible 9 The mathematical principal-agent model of agency theory assumes perfect rationality (Mahoney, 2005), and is not included as part of this discussion. 125 outcomes. However, agency theory still imbues both the principals and the agents with significant foresight and does not subject them to perceptual biases. The Resource-based View Finally, the resource-based view suggests valuable resources that cannot be imitated, substituted or transferred, lead to sustainable competitive advantage (Barney, 1991). In RBV, bounded rationality is the key to inimitability. However, RBV holds the same narrow view of bounded rationality as both TCE and positive agency theory. The resource-based view operationalizes BR as processing deficits, and ignores perceptual limitations. So, managers cannot envision every resource available or every combination of resources. Additionally, they cannot predict every possible way that resources or resource combinations may impact firm performance. However, actors still have significant foresight and are not subject to perceptual biases. So, RBV does not examine how heuristics or framing effects impact managerial decisions, despite the potentially significant effects they may have on the process of acquiring and managing resources. Bounded Rationality in Strategy Research Closer inspection of three major strategy theories reveals bounded rationality operationalized only in terms of processing limitations. So, a large portion of the strategy literature only subjects actors to processing limitations, leaving boundedly rational actors with significant foresight and freedom from cognitive, emotional, and social influences. Because processing limitations only impact the quantity of information processed, actors are essentially making decisions from attenuated consideration sets of realistic outcomes. 126 As such, Simon concluded that the management field’s operationalization of bounded rationality is incomplete (Simon, 1997: 38), which can distort our understanding of organizations. Additionally, the impact of psychological biases on manager perceptions or conclusions is underdeveloped in the literature, and should be addressed. Because perceptual limitations often create predictable cognitive or behavioral outcomes, they can actually be used to induce specific behavior if managers understand their effect. Thus, the impetus to incorporate a more complex bounded rationality model in strategy research is two-fold: 1) model realistic decision processes to create a more complete understanding of organizations, and 2) uncover potential tools for managing intra-firm and inter-firm cognition and behavior. SOURCES OF PERCEPTUAL BIASES According to Simon, bounded rationality leads to selective perception of information, use of heuristics, and reconstruction of memory, all which contribute to systematic biases (Mahoney, 2005: 53). While it is important to understand how systematic biases impact decisions, it is also important to understand how to use them to manage employee and partner behaviors. Because biases are systematic, they produce predictable behavior, which can be induced when appropriate (e.g., managing inter-firm relationships by matching contract framing with task requirements (Weber et al., 2010)). Thus, understanding sources of bounded rationality and how they impact decisions and behaviors is fundamentally important for strategy researchers. The psychology and decision-making literatures identify many sources of perceptual limitations. Because the cognitive and social psychology literatures are so 127 vast, it is impossible to survey all potential bounds on rationality. Instead, I choose to focus on three broad classes that are particularly relevant for strategic management research, as they influence organizational decision-making and allow managers to induce specific behaviors in an effort to increase firm performance: cognitive (framing, heuristics, expectations), emotional and social. Previous calls to integrate psychological concepts into bounded rationality have taken alternate approaches to exploring sources of BR. Foss (2003) focused exclusively on cognitive biases and offered examples of the potential impact of four specific biases (availability heuristic, reference level biases, adaptive preferences and preference reversal). In contrast, Gavetti et al. (2007) offered a long list of potential candidates for bounds on rationality, but did not develop or categorize them. I take a third approach in this paper, combining elements from both papers. I incorporate cognitive biases, as Foss does, but expand beyond them to explore other sources of BR, similar to Gavetti. However, unlike Gavetti, I offer specific examples and applications of the potential bounded rationality sources. Cognitive Sources Cognitive sources of bounded rationality are mental constructs influencing how information is perceived. A variety of cognitive biases exist that lead to systematic emotional or behavioral reactions. However, examining all of them in one paper is not feasible; instead, I focus on three cognitive biases particularly applicable to strategy research: 1) frames, 2) heuristics, and 3) expectations. Frames. A frame is a set of rules used to organize and interpret situations (Goffman, 1974). It suggests what we should do and what we should expect others to do 128 in a situation. Frames can be as simple and generic as seeing an outcome as a potential loss or gain, or as complex and personal as viewing chatty neighbors in new city as intrusive or friendly. While a frame describes the same outcome in different ways, it does not fundamentally change the value of the outcome (Tversky & Kahneman, 1981). Under strict rationality, the tenet of decisions should be based only on the expected values of the outcomes and not on the description of the outcome (Tversky & Kahneman, 1981). So, changes in the frame should not have any effect on preference or behavior. However, framing has been shown repeatedly to impact decisions. For example, in prospect theory (Kahneman & Tversky, 1979), people are risk-averse when an outcome framed as a potential gain, but risk-seeking when the exact same outcome is framed as a potential loss. Additionally, in (RFT) focus theory 10 (Higgins 1997, 1998), the same goal can be framed as minimal (a goal that must be met) or maximal (a goal that would be ideal to meet). If the goal is viewed as a minimal goal, people display vigilant behavior in an effort to avoid sins of commission. However, if the same goal is framed as a maximal goal, people display creative or flexible behavior in order to avoid sins of commission. Such frame-induced behaviors or risk profiles demonstrate a predictable bias that frames impart on decision making and behavior, which are not currently accounted for in the strategy field’s conception of bounded rationality. 10 Regulatory focus theory is used widely in many fields, including marketing (e.g., Louro, Pieters & Zeelenberg 2005; Wang & Lee 2006), entrepreneurship (e.g., Baron 2004; Aidism, Mickiewicz & Sauka 2008), health care (e.g., Meyerowitz & Chaiken 1987; Keller 2006) and persuasive communications (e.g., Lee & Aaker 2004). 129 Heuristics. Heuristics are shortcuts people use to conserve information processing (Kahneman et al, 1982). Heuristics are often highly functional rules-of-thumb. For example Todd and Gigerenzer describe a 3-question evaluation analysis to determine if a heart attack patient should be treated as high-risk or low-risk (1991: 3-4). The heuristic allows doctors to quickly make decisions, with a high probability of success. However, they also produce predictable biases at times. For example, people often attribute others’ behavior to dispositional attributes instead of situational ones, resulting in the fundamental attribution error (Jones and Harris, 1967). Additionally, people tend to place greater value on an object if they already own it, than if they have to purchase it, which is referred to as the endowment effect (Thaler, 1980). People also use anchoring and adjustment heuristics (Tversky & Kahneman, 1974) when estimating values. They start from an initial value, which may be random and/or unrelated to the decision at hand, and make only small adjustments from the initial position. These heuristics, as well as others, predictably influence behavior, allowing managers to use them to generate positive outcomes, such as successful management of inter-firm relationships (Weber et al., 2010). As such, heuristics offer a fruitful area for expanding our knowledge in strategy research, and should also be included under the umbrella of bounded rationality. Expectations. Expectations are beliefs about the future that guide behavior (Roese & Sherman, 2007). They can also systematically influence decisions, if they are violated. Expectancy violation theory (Jussim et al., 1987; Jackson et al., 1993; Burgoon, 1993; Bettencourt et al., 1997; Kernahan et al., 2000) suggests that when expectations are met, initial low-intensity positive emotions are experienced, followed by medium- 130 intensity emotions in the direction of the expectation (positive or negative) (Burgoon, 1993). In contrast, if expectations are violated, an initial low-intensity negative emotional reaction is experienced (because people do not like to be surprised), followed by high- intensity emotions in the direction of the violation (Burgoon, 1993; Bettencourt et al., 1997; Kernahan et al., 2000). If managers intentionally set expectations and then willfully meet or violate them, they can manage their partner or employee’s emotional reactions, and resulting commitment levels. Additionally, when a negative violation is inadvertent, if management knows how the other party is likely to respond, they can take the most appropriate action to rectify the situation. Thus, understanding how to set, and then meet or violate, expectations is an important strategic asset. Again, expectations, as a source of BR, offer a rich opportunity for strategy researchers. Affective and Emotional Sources Emotions and affect (a pre-cognitive instinctual reaction that is a precursor to a more complex emotion) provide another potential bound on rationality (Gavetti et al., 2007). Like cognitive biases, emotions are often thought to be the antithesis of rationality. However, some emotion-based decisions actually improve judgment. For example, trustworthiness is more likely to be assessed correctly when subjects view emotions displayed on the faces of targets (Adolphs et al., 1998; Winston et al., 2002). So, once again, expanding the conception of bounded rationality in strategy research will potentially lead to new insights and more accurate models of decision making, which better capture the richness of real world processes. 131 Non-conscious affective priming can also influence decisions, without individuals actually experiencing an emotion (Zajonc, 1980). Instead, affective cues processed at an unconscious level have been shown to influence attitude activation (e.g., Bargh et al., 1992) and behaviors (e.g., Zemack-Rugar et al., 2006). So, managers are not always aware of emotional factors that influence their decisions. Thus, examining the impact of emotions and affect on decision-making will likely generate novel insights about organizations. Social Sources Finally, social factors can influence decisions, bounding rationality. For example, organizational culture can impact whether a goal is viewed as minimal or maximal (Kark & Dikj, 2007). Additionally, interactions between employees or firms can lead to systematic biases. Out-group stereotypes can be invoked with managers or firms interact with employees or partners in different companies, industries or countries. If the managers do not have additional information, the stereotype serves as a basis for predicting behaviors in the interaction. Thus, out-group stereotypes can influence contracts governing the interaction, as well as manager’s emotional reactions when the expectations are met or violated. Again, although I only touched on two examples, social sources of bounded rationality are a fruitful area for expanding our understanding of organizations. NEW QUESTIONS IN STRATEGY RESEARCH As illustrated above, three sources of perceptual bounds on rationality, not previously taken into account in strategy theories, lead to systematic emotions and 132 behaviors. Managers may be able to develop capabilities around understanding how and when to use perceptual biases to induce emotions or behaviors appropriate to the situation, which can enhance transaction or firm performance, as well as intra-firm and inter-firm relationships. Here I provide concrete examples of how in the strategy field may benefit from incorporating perceptual influences into bounded rationality. Cognitive Sources Framing: Regulatory Focus Theory in Intra-firm Incentives. Incentives have been widely studied using agency theory (e.g., Jensen & Murphy, 1990; Holmstrom & Milgrom, 1994). Many studies have examined the comparative effectiveness of “carrots” versus “sticks” (e.g., Dickinson, 2001; Andreoni et al., 2003). However, few, if any, studies examine how framing the same consequence as a penalty or a bonus elicits specific behaviors, or why a carrot is more effective than a stick in some circumstances and less effective in others. Strategy researchers can use regulatory focus theory to examine these novel topics. Additionally, firms can develop incentive capabilities if they fully understand the implications of framing. Applying regulatory focus theory (RFT) (Higgins, 1998) to incentives can address novel questions, such as those raised above. According to RFT, people view the world through a prevention focus or promotion focus, induced through loss or gain framing (Roney et al., 1995). A prevention or promotion frame influences whether people perceive the exact same goal as a minimal goal (prevention frame), which must be met, or a maximal goal (promotion frame), which would be ideal to meet (Higgins, 1998). If the goal is viewed as minimal, low-intensity contentment is experienced if it is met, while 133 missing the goal leads to high-intensity agitation. Because people wish to avoid high- intensity agitation more than they wish to experience low-intensity contentment, they display vigilant behavior in an attempt to avoid sins of commission. In contrast, if the goal is viewed as maximal, meeting the goal leads to high-intensity happiness, while missing it leads to low-intensity disappointment. Because the desire to experience high- intensity happiness at meeting an ideal goal outweighs a desire to avoid low-intensity disappointment, individuals display of flexible or creative behavior in an attempt to avoid sins of omission. Penalty. Framing an incentive as a penalty situationally-induces a prevention regulatory focus. The employee is highly motivated to avoid the high-intensity agitation upon missing the performance milestone, which is perceived as a minimal goal that must be achieved. He or she will display vigilant behavior in an effort to avoid missing this minimal goal. If the employee’s task requires vigilance, then framing the incentive as a penalty will enhance task performance; alternatively if it requires flexibility or creativity instead, then using penalties will hinder task performance. The desire to avoid triggering the negative action induces very vigilant behavior that minimizes the chances of errors (i.e., avoid sins of commission), which may be more or less appropriate for the task at hand. Proposition 1a. When an incentive is framed as a penalty, an employee is more likely to display vigilant behavior than flexible or creative behavior. Bonus. Alternatively, the same incentive can be framed as a bonus, eliciting a promotion focus. For example, the guaranteed portion of the payment could be $10K and 134 the variable portion $5K. It could be framed as a $15K payment with the potential for a $5K penalty or as a $10K payment with the potential for a $5K bonus. When framed as a bonus, the incentive induces a promotion frame, which prompts the task to be seen as a maximal goal. If a maximal goal is reached, the employee experiences high-intensity happiness. If the goal is missed, however, the employee feels medium-intensity disappointment. As a result, the employee is more likely to pursue creative and flexible behaviors in an attempt to successfully perform the task, because the consequence of not achieving it does not feel as severe as missing a minimal goal (i.e., employees are motivated to avoid sins of omission and to be more creative in trying to reach the maximal goal). Again, if the task requires flexible or creative behavior, framing incentives as bonuses instead of penalties will enhance task performance; but if vigilant behavior is more appropriate, then task performance will be hindered with the use of bonus framing. Proposition 1b. When an incentive is framed as a bonus, an employee is more likely to display flexible or creative behavior than vigilant behavior. Heuristics: Negativity Bias in Inter-firm Relationships. Inter-firm relationship studies in strategy largely examine prior experience with the partner as a proxy for trust (e.g., Gulati, 1995). However, the process of building trust or managing inter-firm relationships is rarely studied (Weber et al., 2010 is an exception). The dearth of studies is not driven by a lack of interest, but rather by a lack of appropriate tools to examine the questions. However, when heuristics are encompassed in bounded rationality, researchers are able to address such novel questions. 135 Although many heuristics exist, negativity bias is particularly pertinent for understanding inter-organizational relationships. Negativity bias is the tendency for a person to assign greater weight to negative information about a person or event than positive information of the approximately the same magnitude (Fiske, 1980; Anderson, 1974; Carlston, 1980; Dreben et al., 1979; Hodges, 1974; Oden & Anderson, 1971). Negative information provides more categorization data than positive information for two reasons. First, individuals believe both good and bad people commit minor negative acts, but only bad people commit extremely bad acts. For example, both good and bad people cheat on their diet by eating some ice cream, but only bad people commit murder. Second, individuals believe that people perceived to possess negative traits act more inconsistently than people perceived to possess positive traits, so a person who commits one impactful negative act will be perceived as a “bad apple”, even if he or she committed positive acts of similar magnitude. For example, a person who both embezzles funds from his employer and makes a large charitable donation is categorized as a bad person, even though their positive and negative acts are of similar magnitude. As a result, negative information receives more weight and attention than positive information, which is seen as less helpful for categorizing the person (Skowronski & Carlston, 1989). Although many studies examine negativity bias in the context of healthcare (Siegrist & Cvetkovich, 2001), interpersonal interactions (Amabile & Glazebrook, 1982) and political campaigns (Meffert et. al., 2006), the consequences of negativity bias on inter-firm relationships has not been examined. If two firms that have no prior history enter into an exchange, they develop impressions of each other, which may serve as the 136 basis for inter-firm trust or a more arms-length relationship (Weber et al., 2010). During impression formation, negative information may serve a categorization role. For example, a firm that is in compliance with SEC guidelines for reporting earnings, but illegally dumps toxic waste is generally seen as having negative character, which is likely not a basis for a trusting relationship. Therefore, firms will want to manage the positive or negative tone of information in their interactions with new partners, particularly if they want to develop a long-term relationship. One way to influence the tone of information presented during a transaction is to strategically choose how performance deliverables are determined in the contract. Success rate. If a supplier firm wants a new buyer to feel they are a good partner, the firm wants to avoid presenting information to the buyer in positive light. For example, a performance deliverable in the contract may be defined in terms of a success rate (percentage meeting a standard of quality) or failure rate (percentage not meeting a standard of quality). If the performance goal is couched as a success rate, the partner does not use the information to categorize the supplier as a bad partner. Since positive emotion between the parties can serve as a potential basis for higher levels of perceived personal closeness and commitment in relationships (Gross & John, 2005), firms who desire to build close, trust-based relationships are more likely to using success rates in their contracts. Proposition 2a. When a trust-based relationship is desired, contracts are more likely to contain success (or compliance) rates rather than failures (or non-compliance) rates. 137 Failure rate. However, a trust-based relationship is not always desired, as it can interfere with accountability or multiple sourcing (Uzzi, 1996), so a supplier may want a more arms-length relationship with the buyer. In this case, the supplier may want the partner to think that the firm has negative attributes, and can use negative information in the contract strategically to manage the buyer’s impression. For example, the supplier may choose to discuss performance in the contract in terms of failure rates, as opposed to success rates. Now the buyer uses the occurrence of negative events to attribute negative characteristics to the supplier firm, which disproportionately impair its impression of the supplier firm’s reliability and performance. Additionally, a focus on the negative actions in the exchange will lead the buyer to interpret ambiguous information about the supplier in a more negative light, even further impairing the buyer’s impression of the supplier. Thus, the overall impact of negative performance criteria in the contract is the development of a more arms-length relationship between the two firms. Proposition 2b. When an arms-length relationship is desired, contracts are more likely to contain failure (or non-compliance) rates rather than success (or compliance) rates. Expectations: Expectancy Violation in M&A. Although many strategy studies examines mergers and acquisitions (e.g., Chatterjee et al., 1992; Datta et al., 1992; King et al., 2004; Moeller et al., 2004; Seth et al., 2002) very little work examines the impact of expectations in M&A. Expectations can be met or violated, leading to systematic emotional reactions, which impact retained target employee commitment to the new parent, and the overall merger performance, particularly when human resources are the 138 key to merger success. Again, an expanded concept of bounded rationality allows strategy researchers to explore such novel topics in M&A. Systematic reactions to meeting and violating expectations have been well documented in psychology research. Expectancy violation theory (Jussim et al., 1987; Jackson et al., 1993; Burgoon, 1993; Bettencourt et al., 1997; Kernahan et al., 2000) addresses the consequences of confirming or violating expectations. A violation of expectations results in the initial experience of low-intensity negative emotions due to increased uncertainty of the situation, while confirmation of expectations results in the experience of low-intensity positive emotions (Olson et al., 1996). Additionally, expectancy violation theory suggests that when expectations are violated, people experience a secondary reaction of high-intensity emotions in the direction of the violation (Burgoon, 1993; Bettencourt et al., 1997; Kernahan et al., 2000). That is, if expectancies are negatively disconfirmed, then people’s initial negative emotions are augmented; however, if the violation is positive, then the secondary response will be to experience high-intensity positive emotions. Again, positive emotions act as the basis for greater commitment to relationships (Gross & John, 2005), so inducing them when a long-term, trust-based relationship is desired, increases the probability of achieving that type of relationship. Using expectancy violation theory, firms can manage target employees’ commitment level to the new parent firm in mergers. However, most firms either fail to manage expectations or set positive expectations that they are not able to meet, resulting in the generation of even more high-intensity negative emotions than if they had set and 139 confirmed negative expectations. Therefore, firms should actively consider the desired outcome, and weigh the potential costs and benefits associated with setting positive or negative expectations, rather than deal with unintended consequences. Positive expectations. If one firm acquires another and terminates a portion of target employees, the reactions of the retained target employees will depend on the expectations set during the merger negotiation. If the target employees are told their jobs were not in jeopardy, positive expectations are set. If the positive expectations are met (all target employees are retained), target employees experience an initial low-intensity positive emotion due to a confirmation of expectations, followed by medium intensity positive emotions due to the positive nature of the event. If positive expectations are violated (a portion of target employees are dismissed), the remaining employees of the acquired firm experience initial low-intensity negative emotions due to the violation, augmented by high-intensity negative emotions because their positive expectations are violated. High intensity negative emotion leads to low levels of commitment to the new parent firm, which ultimately impairs merger performance. Proposition 3a. Setting and meeting positive expectations in the merger negotiation, will lead retained target employees to experience medium-intensity positive emotions. Proposition 3b. Setting and violating positive expectations in the merger negotiation, will lead retained target employees to experience high-intensity negative emotions. Negative expectations. However, if negative expectations are set in the negotiation (a specific percentage of target employees in a particular business unit will be terminated), and then met, retained target employees will experience initial medium- 140 intensity negative emotions, tempered by a low-intensity positive reaction at having their expectations met. Alternatively, if the negative expectations are positively violated (the jobs are not cut because alternative cost-cutting is implemented), the target employees initially experience low-intensity negative emotions due to the violation of the expectations, followed by high-intensity positive emotions as a result of the positive violation. Again, if retained target employee commitment is key to merger success, the high-intensity positive emotions experienced upon the violation of negative expectations, leads to higher commitment levels to the new parent firm. Proposition 3c. Setting and meeting negative expectations in the merger negotiation, will lead retained employees to experience medium-intensity negative emotions. Proposition 3d. Setting and violating negative expectations in the merger negotiation, will lead retained employees to experience high-intensity positive emotions. Emotional Sources: Non-conscious Affect in Contract Design Similarly, although contracts have been studied extensively in the strategy field, the impact of emotions and affect on contracts has not been considered. Again, although the topic is interesting to strategy researchers, incomplete conceptions of bounded rationality previously precluded examination of them, because traditional theories could not address the issues. However, the addition of perceptual limitations to BR allows the impact of emotions on contract design to be examined. For example, affective primacy, first suggested by Zajonc (1980), suggests pre- cognitive, instinctual reactions allow people to make distinctions between positive and negative stimuli, even if they are not consciously aware of the stimuli themselves. 141 However, individuals are not able to further distinguish these stimuli into discrete emotions (Murphy, 2001), until higher order cognition occurs. The basic evaluative categorization of positive or negative occurs only 100-200 milliseconds after a non- conscious prime, as evidenced by the presence of event-related potentials in the insular cortex (Werheid et al., 2005), a brain structure related to affective processing. Then, later, the descriptive meaning of emotion is acquired (Stapel & Koomen, 2005). Non-conscious affective priming automatically activates attitudes with the same valence (positive or negative value) (Draine & Greenwald, 1998). For example, priming positive and negative words led to quicker pronunciations of target words with the same valence as opposed to words with a different valence from the affective prime (Bargh et al., 1992). The same effect is shown in naming tasks (Klauer & Musch, 2001), and when affective primes were objects (Giner-Sorrola et al., 1999) or slides of basic emotions (Murphy et al. 1995; Murphy, 2001). In addition to differential automatic attitude activation, affective priming has direct effects on behaviors as well. People primed with guilty words showed more self control on guilty-pleasure and grim-necessity self-control tasks than those primed with sad words (Zemack-Rugar et al., 2006). Additionally, positive affective priming increased viewing behavior of a positively-valenced television program (Frings & Wentura, 2003). The influence of affect on attitude activation and behavior makes non- conscious affect a particularly promising candidate for influencing both the type of clauses that are included in the contract and how they are framed. 142 Positive non-conscious affect. Exposure to positive non-conscious affect during the negotiation, such as a supplier manager’s smiling at the buyer manager , automatically activates positive-valenced attitudes about the exchange. Positive attitude activation stimulates the negotiator to focus on positive events in the exchange, which impacts how they frame the contract. Promotion framing (Higgins, 1997, 1998) induces a focus on positive events in the exchange, as well as creative and flexible behavior in an effort to ensure the positive events occur. Thus negotiators, exposed to positive non- conscious affect, are more likely to frame the contract in a promotion manner, because it is consistent with the negotiator’s view of the exchange. Proposition 4a. Contracts, negotiated by individuals exposed to positive non-conscious affect during negotiation, are more likely to be promotion-framed than those negotiated by an individual without exposure. Negative non-conscious affect. In contrast, if the buyer negotiator witnesses the supplier berating his or her assistant during the negotiation, contract design may still be systematically influenced, but in a different way. Exposure to a negative non-conscious affect prime automatically activates negative exchange attitudes, leading to a greater focus on negative events in the exchange. Prevention framing (Higgins, 1997, 1998) induces a focus on negative events, and promotes vigilant behavior in an effort to avoid them. So, the enhanced automatic activation of the negative elements of the exchange attitude leads participants to frame the contract in a prevention manner to safeguard the transaction against negative events. 143 Proposition 4b. Contracts, negotiated by individuals exposed to negative non-conscious during negotiation, are more likely to be prevention-framed than those negotiated by an individual without exposure. Social Sources: Out-group Stereotypes in Contract Design As mentioned above, contract research is well established in the strategy and economics literatures. However, the impact of social sources of bounded rationality on contracts has not been considered. Again, a more complete conception of bounded rationality, including perceptual limitations, allows researchers to ask novel questions, which creates a more nuanced understanding of the impact of contracts on transactions and relationships. Delineations of in-groups and out-groups may emerge in contract negotiation when parties are from different functional backgrounds, companies, industries or countries. Out-group stereotypes, a social source of bounded rationality, create perceptual bias in transactions, particularly when the focal party has no prior contact with the partner. When applied to contracting, they may interact with task requirements to influence clause choice. If an out-group stereotype is the only information the focal party has about its contracting partner, the focal party will expect the out-group members to perform both positive and negative stereotypic behaviors during the project. Because out- groups are perceived to be more homogeneous than in-groups (Linville and Fischer, 1998), all out-group members are expected to display the stereotypic behaviors. If the task requires non-stereotypic out-group behavior, the focal party will include 144 enforcement clauses in the contract to both prevent stereotypical behavior and promote the nom-stereotypical desired behavior. For example, if a US firm contracts with a German supplier for a task requiring very flexible, adaptive behavior, the US firm may include penalties in the contract to deter more stereotypical, rigid and structured behavior, typically associated with German firms. While the US firm does not know if the German firm will display rigid behavior, it will rely on the out-group stereotype to predict its partner’s actions in the situation, particularly if it had no prior interaction with the German firm. Thus, when the influence of the out-group stereotype is strong, more enforcement clauses will be used in the contract to prevent expected stereotypical behavior from the out-group partner, when it is not appropriate for the task under the contract. Alternatively, if the task requires stereotypical out-group behavior, the focal party will include expectation alignment clauses to ensure that the out-group understands what is required to make the task successful. If instead, the US firm hires the German supplier for a task requiring great precision and structure (again a German stereotype), the buyer wants to communicate the behavioral requirements clearly to the German firm. Here behavioral incentives are already aligned, so the biggest issue for achieving task success is overcoming misunderstanding or miscommunication. While enforcement clauses are necessary to prevent stereotypical behavior in the first example, clear definition and expectation alignment prevent misunderstandings of task requirements, allowing the German firm to accomplish task goals through stereotypic behavior. . 145 Proposition 5a: Contracts governing tasks requiring non-stereotypical out-group behavior are more likely to contain higher levels of enforcement clauses than contracts governing task requiring stereotypical out-group behavior. Proposition 5b: Contract governing tasks requiring stereotypical out-group behavior will contain are more likely to contain higher levels of expectation-alignment clauses than contracts governing tasks requiring non-stereotypical out-group behavior. IMPACT OF A MORE COMPLEX BR CONCEPTION ON TCE While the previous section explores novel strategy research topics arising from a more complex conception of bounded rationality, the current section examines how adding perceptual influences to BR augments traditional strategy theories. TCE embraces the common operationalization of bounded rationality as processing limitations. However, when perceptual biases are introduced and incorporated into the theories, new insights are derived. Williamson states that, “…the principal ramification of bounded rationality for the study of economic organization is that all complex contracts are unavoidably incomplete.” (2000: 8). He suggests that the incompleteness arose from two distinct sources: cognitive limitations and verbal limitations. The cognitive limitations did not allow humans to generate all possible contingencies to include in the contract, while verbal limitations limited the content of the contract because if an idea could not be expressed verbally, it could not be included. Together, Williamson felt that these two limitations naturally led to incomplete contracts because people could neither imagine all of the possible contingencies that should go into the contract nor articulate them. 146 While Williamson (2000) acknowledged other cognitive limitations exist, he suggests their effect on the make-or-buy decision central to TCE was relatively minor in comparison to the impact of incomplete contracts. He relegated other cognitive effects to influencing organizational design, because he believed governance should alleviate information processing issues (Williamson, 1999). As such, conceptualizations of BR in TCE have traditionally focused only on information processing and not fully embraced perceptual limitations. When a more complex bounded rationality conception is incorporated into TCE, however, the strategy field can obtain additional insights. Table 15 is a 2x2 matrix that Table 15. Impact of a More Complete BR Conception on TCE (Adapted from original table in Williamson 1985: 67.) Condition of Processing BR Absent Present Condition of Perceptual BR Absent Quadrant 1 1. No additional TCs 2. No impact of uncertainty 3. Market Transaction or simple enforcement contract Quadrant 2 1. Information management TCs 2. Environmental uncertainty 3. Hybrid (complex contracts) as information repository/categorization tool Present Quadrant 3 1. Misperception TCs 2. Interpretive uncertainty 3. Hybrid (JV) as mutual frame for interpreting transaction Quadrant 4 1. Information processing & misperceptionTCs 2. Environmental & interpretive uncertainty 3. Hierarchy as common frame for interpreting transaction & information repository/processing aid 147 examines exchanges with varying levels of processing need and perceptual needs. It provides an overview of how a more complex BR assumption refines TCE’s basic governance hypotheses. Governance Low informational-Low perceptional. Quadrant 1 contains transactions with low information processing requirements and low potential for perceptual biases, such as GM purchasing bolts from a supplier. Because information processing requirements are low, no further transaction costs are generated from bounded rationality. As such, the transaction may be governed by spot market exchanges, absent other hazards laid out by Williamson. If a contract is necessary because of other hazards, it does not need to act as an information repository to overcome information processing limitations. Additionally, contracts do not require much customization because quantity is the primary variable in the transaction. Instead, the contract governing exchanges in Quadrant 1 is largely an enforcement mechanism, with safeguards largely incorporated into standard terms and conditions. As a result, exchanges with low information processing and a low probability of perceptual bias are more likely to be conducted as market transactions or governed by standard contract templates with relatively minor modification. Proposition 6a. Exchanges characterized by low information processing requirements and a low potential for perceptual biases are more likely to be conducted as spot market transactions or governed by standard contract templates than alternative governance forms. 148 High informational-Low perceptional. In exchanges in Quadrant 2, the potential for perceptual biases is still low; however, information processing requirements are high. The projects here are complex but well defined, such as the implementation of an SAP system. High information processing requirements create additional transaction costs, in the form of information costs, in the exchange. Additionally, because partners cannot plan for all possible contingencies, environmental uncertainty plays a role in the exchange. Exchanges with high information processing limitations must be governed by complex contracts. The contract compensates for actors’ information processing deficits by capturing large quantities of detailed information specific to the transaction. Although the contract is likely based on a template, it will include extensive elaboration to capture large numbers of complex contingencies and specify extensive rules and responsibilities. As such, the contract serves as an information repository, because it codifies the unique aspects of the transaction and how the parties will interact with one another (Mayer & Argyres, 2004). It will also serve as a categorization tool easing information constraints by allowing the partners to process greater quantities of information (Daft & Weick, 1986). Proposition 6b. Exchanges characterized by high information processing requirements and a low potential for perceptual biases are more likely to be governed by complex contracts containing high levels of contingency clauses than alternative governance forms. 149 Low informational-High perceptional. In contrast, exchanges in Quadrant 3 have high probability of perceptual issues, but do not require large amounts of information processing. The project is ill-defined but not complex, such as when a Japanese and a Parisian firm collaborate on a fashion line. Each firm has a different conception of the fashion line, shaped by their local markets and experiences. As a result, the two firms may not speak the same literal or figurative language, leading to informational transaction costs. Additionally, interpretive uncertainty will play a role in Quadrant 3 exchanges, because differences in task interpretation prevent the parties from predicting their partner’s behaviors in the exchange. As a result, exchanges in Quadrant 3 need to be governed by a complex joint ventures (JVs) a form of hybrid governance. By uniting the employees from the two firms into a single legal entity and allowing it to self govern, the employees are more likely to create a unified definition of the task. It also provides an organizational culture that will support and propagate the new more unifying view. Thus, the JV may well allow even extreme perceptual limitations to be overcome in the exchange. Proposition 6c. Exchanges characterized by low information processing requirements and a high potential for perceptual biases are more likely to be governed by complex contracts, containing high levels of definitions and roles, or by joint ventures than alternative governance forms (e.g., contractual alliances or arms-length buyer-supplier exchanges). High informational-High perceptional. Finally, exchanges in Quadrant 4 are both complex and fraught with perceptual issues. When two firms from different 150 industries collaborate on a novel technology, for example, perceptual issues are high for two reasons. First, each firm views the new technology through a different lens because different industries have different language, norms and standards, and the firms have different experiences within their respective industries. Second, the project itself is ill- defined, preventing the firms from decomposing it and working separately on individual parts. Additionally, the project requires extensive information processing, as development of a new technology is a complex process. Thus, additional transaction costs result from misperceptions of limited information, allowing both environmental and interpretive uncertainty to play a role, because parties on both sides of exchange process limited quantity of task information and perceive it differently. As a result, contracts may not be sufficient for exchanges in Quadrant 4, as both perceptual and informational needs are too great to overcome with a legal document. Instead, hierarchy mitigates both processing and perceptual bounded rationality is two ways. First, it provides an overarching frame, creating common perceptions. Second, it acts as an information repository, allowing more information about the task to be processed using common categorization and organizational tools such as informational management systems. Additionally, hierarchy tempers information processing issues by removing limitations of tacit information transfer present in inter-firm exchanges (Grant, 1996). While JVs can be effective at transmitting tacit knowledge in some cases, the combination of both information processing and perceptual challenges may cause distrust between the partners, undermining tacit information transfer. 151 Proposition 6d. Exchanges characterized by high information processing requirements and a high potential for perceptual biases are more likely to be governed by hierarchy than alternative governance forms. TCE’s current bounded rationality assumption only addresses exchanges in the top half of the table. Quadrant 1 aligns with either spot market exchanges or simple contracting, while Quadrant 2 aligns with complex contracting, requiring large quantities of information processing. However, when perceptual limitations are incorporated into the BR assumption, TCE also addresses the bottom half of the table. Exchanges in Quadrants 3 and 4 also have high probabilities of perceptual biases, which generate additional transaction costs if not overcome, as firms waste time and money attempting to produce against unclear expectations. Thus, I am suggesting that incorporation of perceptual limitations into TCE can influence governance choice because it does affect transaction costs. The important extension for TCE arises from a more complex bounded rationality assumption than currently used in the theory. Opportunism In addition to bounded rationality, Williamson believed opportunism, “self- interest seeking with guile” (Williamson, 1985: 72) was necessary in TCE. He suggested that absent intentional opportunism, general contract clauses could eliminate disagreements due to contractual incompleteness, because both parties will always comply. He also noted that all people do not need to be opportunistic, under the assumption, just some of them. Because people cannot discern which individuals are opportunistic, they must act as if everyone is, in order to safeguard the exchange. 152 However, when an expanded conception of BR is incorporated into TCE, it becomes clear that behavior can be perceived as opportunistic, even when the “offending” party had not intended it to be. In Quadrant 1 exchanges, information processing and perceptual limitations are low. As a result, it is unlikely that individuals perceive their partner’s actions as opportunistic, unless they really are. Thus, Williamson’s original conception of opportunism is still required in these exchanges to predict governance choice based on transaction hazards. In contrast, however, perceptions of opportunism arise frequently in Quadrants 2-4, even without intentional opportunistic behavior. In Quadrant 2 exchanges, tasks have high information requirements, leading to constrained consideration sets for possible contingencies. As a result, perceptions of opportunism frequently arise when an unanticipated contingency occurs. Both partners have expectations about the intention of the contract under an unforeseen contingency; however, the partners’ expectations do not always align. If misalignment occurs, one partner may perceive the other’s actions as opportunistic, even if the “offending” partner did not intend them to be. As a result, a strict opportunism assumption is not necessary in Quadrant 2 exchanges. Similarly perceptions of opportunism arise in Quadrant 3 exchanges, which have a high potential for perceptual limitations. Because both parties in such exchanges have different views of task requirements and goals, partners may interpret each other’s actions as opportunistic, even though they are consistent with the focal actor’s task 153 perceptions. Thus, a strict opportunism assumption is not necessary for Quadrant 3 exchanges either, due to the high likelihood of the perception of opportunism Finally, in Quadrant 4 exchanges perceptions of opportunism arise from both limited consideration sets and perceptual limitations. Because Quadrant 4 exchanges have two forces simultaneously driving the perception of opportunism, they have the highest probability of generating such perceptions. As a result, exchanges in Quadrant 2-4 also do not require a strict assumption of intentional opportunism. Proposition 7. Quadrant 1 exchanges require Williamson’s original conception of intentional opportunism, while Quadrant 2-4 exchanges only require the perception of opportunism, arising from bounded rationality. DISCUSSION In this paper, I demonstrate the benefit of expanding the concept of bounded rationality in strategy research to include Simon’s original ideas. In strategy research, bounded rationality assumptions (e.g. TCE, positive agency theory and RBV) imply that processing limitations prevent actors from knowing all possible outcomes, leading to incomplete contracts (in TCE and agency theory) and heterogeneous resources and resource combinations (in RBV). However, in strategy’s limited operationalization of bounded rationality, perception biases, the potential for information distortion (intentional or accidental), are completely ignored. When cognitive (framing, heuristics and expectations), emotional and social sources of perceptual limitations are taken into account, not only is the actor lacking all of the information to make the decision, but the information that he or she does have may be systematically biased. By understanding 154 how perceptual limitations influence managerial decisions, strategy researchers can understand when the distortions are detrimental and when they may in fact be used strategically to improve performance, as my propositions demonstrate. My paper responds to previous calls for incorporating cognitive and social psychology into bounded rationality to better model actual managerial decision-making (Foss, 2003; Gavetti et al., 2007). However, it goes beyond suggesting possible influences on rationality (Gavetti et al., 2007) or offering examples of applications of a few cognitive limitations and offers four main contributions to the strategy literature. First, it makes the distinction between processing and perceptual limitations, which clarifies what is missing from the traditional BR conceptions, and exactly how cognitive and social psychology can add value to organization research. Second, it unites three sources of perceptual limitations (i.e., cognitive, emotional and social), which have previously been suggested in isolation. Third, it demonstrates how perceptual limitations provide opportunities for managers to induce behaviors and emotions that can improve transaction and organizational performance. Prior work has explored capabilities related to alliances (Kale et al., 2002) and contracting (Argyres & Mayer, 2007), my work suggests that managing perceptual and information processing limitations may also constitute an important firm capability. Finally, it goes the next step by exploring how a more complex conceptualization of bounded rationality can augment current strategy theories and lead to novel insights. Although Simon suggested that bounded rationality should incorporate all types of limitations from cognitive biases, BR is largely operationalized in strategy research as 155 information processing deficits limiting the quantity of information available to decision- makers. However, cognitive limitations also influence the perception of the information that individuals do process, which is not addressed by the common conceptualization of bounded rationality. In this paper, I make a distinction between the two types of cognitive limitations and explain why incorporating both types of cognitive limitations is important to our understanding of organizations. Foss (2003) and Gavetti et al. (2007) also offer suggestions of specific cognitive biases to incorporate into bounded rationality. In contrast, my paper categorizes perceptual deficits into cognitive, emotional and social sources of BR, and provides detailed examples of each one. It also serves to offer a more complete categorization of bounded rationality sources, which have only previously been suggested in isolation or included as part of a list of several factors that could influence decisions. By delineating broad categories while still providing detailed applications, I offer a guide for future researchers searching for additional bounded rationality sources. My paper also proposes that perceptual bounds on rationality provide both limitations and opportunities for managers. First, perceptual bounds on rationality potentially lead to sub-optimal decision-making, because outcomes available to decision- makers are poor approximations of reality. However, governance can be used as a tool to overcome perceptual limitations, as demonstrated in the final set of propositions. Additionally, because perceptual biases systematically impact behaviors and emotions, they offer opportunities for managers to induce behaviors and emotions from employees and partners most appropriate to the task at hand. As a result, incorporating perceptual 156 limitations into BR provides a mechanism for potentially improving exchange or firm performance, and managing intra-firm and inter-firm relationships. Finally, my paper takes the next step in incorporating psychological elements into bounded rationality by generating novel insights through the expansion of the definition of bounded rationality forming the basis of transaction cost economics. TCE currently operationalizes BR as information processing limitations. However, unlike Williamson, I argue that perceptual limitations actually create transaction costs (e.g., wasted time and effort based on different views of project requirements). When perceptual biases are taken into account in TCE, new predictions incorporating BR-related transaction costs are generated. In suggesting that parties should use perceptual biases strategically, I am not suggesting that firms use them opportunistically. That is, I am not suggesting that one party use psychological effects to manipulate the other party to their advantage. Although I acknowledge that the possibility exists, I believe two forces retard the occurrence in my specific examples. First, alignment of a frame, heuristic, expectation, emotion or stereotype with the characteristics of a particular situation benefits both parties. Second, reputational effects are also important. So, if a firm had a reputation for manipulating their employees or partners, other firms would not consider it a desirable potential partner, thus limiting its options for future business. As such, although the examples in my paper provide an opportunity to shape firm performance, or intra-organizational or inter-organizational relationships, potential for opportunistic manipulation of firm employees or partners is limited. 157 Additionally, firms can parlay an understanding of systematic influences on decisions and behaviors into capabilities, leading to improved firm performance and better management of internal and external relationships. Understanding how cognitive limitations impact decisions and behaviors is difficult. Because perceptual mechanisms are largely invisible to external firms, and difficult to develop, they can serve as the basis for sustainable competitive advantage (Barney, 1991). Finally, I believe that my paper demonstrates the idea that multidisciplinary research allows different questions to be explored than those typically examined within one of the base disciplines alone, as suggested by Agarwal and Hoetker (2007). 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An earnout can be perceived as either a potential loss or gain, which has previously been shown to impact emotions (Roney et al, 1995; Tykocinski et al., 1994) and behavioral risk profiles (Kahneman & Tversky, 1979). So, cognitive mechanisms, which play a role in earnout success, is not consciously considered in mergers. Second, it demonstrates how incorporating Simon’s complete conception of bounded rationality into strategy research allows researchers to ask new questions, and imparts greater prediction power on traditional strategy theories. Simon’s full definition of bounded rationality allows the strategy field to generate novel insights through the application of new theories to address different questions, which have been difficult to examine using only the traditional economic and sociological theories. Although others (Foss, 2003; Gavetti et al., 2009) have also called for more complete conceptions of bounded rationality, my dissertation makes four distinct contributions. First, my theory paper distinguishes between processing and perceptual limitations, which have been conflated in most discussions of bounded rationality (Williamson, 2000). By separating these two concepts, it becomes very clear what is missing from the strategy field’s current BR conception and why it is important. Second, both my theoretical and empirical work illustrates that bounded rationality can be both a limitation and an opportunity, because perceptual limitations produce systematic 166 behaviors or emotions that can be predictably induced through various techniques. Third, my two empirical studies offer specific examples of how an expanded definition of bounded rationality can address new questions in well-studied topics, like M&A. Finally, my theory paper clearly demonstrates how transaction cost economics is augmented when a more complete conception of bounded rationality is incorporated. So, in addition to calling for the inclusion of cognitive limitations in BR, I actually demonstrate how researchers can use the limitations to both ask new questions and augment current strategy theories. My empirical pieces also add to the M&A and entrepreneurship communities’ understanding of earnout clauses. Because earnouts are so prevalent in small business mergers and are predicted to increase in use in mergers at large, it is important for managers in acquiring firms and entrepreneurs considering M&A exit strategies to understand how these clauses impact mergers. Prior work using economic lenses (agency theory and information asymmetry) predicted when earnouts should be used for efficient outcomes, but it did not capture the cognitive influences of earnouts on mergers. Because earnouts are contingent payments that are almost exclusively used with guaranteed payments, they can be framed as losses or gains. As my dissertation demonstrates, the loss and gain frames significantly impact retained target management behavior and perception of fairness. Additionally, my work shows that managers actually use framing, although likely as a result of repeating successful patterns, not consciously considering framing ramifications, to get what they want out of merger targets. 167 My dissertation also identifies an entirely different type of merger capability. Previous work has suggested that target selection (e.g. Capron & Shen, 2007) and merger integration (e.g. Ranft & Lord, 2002; Zollo & Singh, 2004) are specific capabilities that augment merger performance. While traditional merger integration studies suggest that integration issues can be mitigated by choosing the right target or setting up integration routines, I suggest that merger performance can potentially be influenced through framing. Thus, even if a firm chooses an appropriate target and implements a merger integration routine, it can still negatively influence merger performance if it does not align the deal frame with its goals for the target firm. Thus, managers who are puzzled by seemingly inexplicable merger outcomes have one more tool to assess the situation, and potentially actively use in their next merger. My dissertation also augments the entrepreneurship literature by suggesting that entrepreneurs can manage the success of their M&A exit strategies through deal framing. Earnouts are found in half of all small business mergers (Fields, 2005), which suggests that entrepreneurs face earnouts more often than managers of large, established firms. Entrepreneurs often seek to use M&A as an exit strategy when they wish to retire from their business and they have no suitable successor. Earnout framing provides a tool for them to potentially increase the probability of meeting the earnout performance goals, and receiving the contingent payment. Although parent firms usually frame earnout clauses, framing is not an element of the contract that must be negotiated, so power concerns do not come into play in earnout framing. Instead, because both entrepreneurs and parent firms potentially benefit from alignment between earnout frames and parent 168 firm goals, entrepreneurs can educate parents on the value of framing, while they are positively impacting their own outcomes. My research also demonstrates the value of multidisciplinary research, as called for by Agarwal & Hoetker (2007). Looking at a strategy issue from different perspectives allows different questions to be explored than those typically examined within one of the base disciplines alone. Additionally, using a combination of lenses produces a more complete understanding of the phenomenon of interest for the strategy field. Finally, my dissertation demonstrates the benefits of using multi-method research to examine a strategy topic. My empirical approach used both an experiment and an archival dataset study to examine the influence of earnout frames on mergers. The experiment allowed precise definition of loss and gain frames, as well as the ability to infer causality, but lacked realism. The archival dataset study was limited in its precision, as the variables were defined by data availability. Additionally, the study only predicts correlations, not causation. But the archival study did allow determination of whether managers used earnout framing in real life. 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(b) If Revenues are less than or equal to $2,500,000, but more than $2,000,000, during any calendar year in the Earn Out Period, then an additional amount (an “Earn Out Payment”) shall be paid by Parent to the Shareholders with respect to such calendar year, calculated as follows: the number of validly issued, fully paid and nonassessable shares of Parent Common Stock equal to the product of (A) Revenues divided by $2,500,000 and (B) $937,500 divided by the Average Parent Common Stock Price; and cash equal to the product of (A) Revenues divided by $2,500,000 and (B) $437,500. (c) If Revenues exceed $2,500,000 (the “Revenue Hurdle”) during any calendar year in the Earn Out Period, an Earn Out Payment shall be paid by Parent to the Shareholders with respect to such calendar year, calculated as follows: the number of validly issued, fully paid and nonassessable shares of Parent Common Stock determined by dividing $937,500 by the Average Parent Common Stock Price; and cash equal to $437,500. 184 APPENDIX B. Experimental Conditions SCENARIO All conditions: You founded a small truck firm, TechCo, 2 years ago, and are selling it to another firm, Delta Corp. Your firm will be run as an independent business unit in the new firm, and you will be staying on to manage it for 1 year. PRESS RELEASES Total Consideration Frame (Small, Equal, Large): DELTA CORP TO PURCHASE TECHCO in $10.5M DEAL September 1, 2009. Delta Corp has announced that it is purchasing TechCo for $10.5. Delta Corp CEO said, "We feel that TechCo strengthens our product offerings and significantly increases our bottom line." Guaranteed Consideration Frame, Equal: DELTA CORP TO PURCHASE TECHCO in $5.25M DEAL September 1, 2009. Delta Corp has announced that it is purchasing TechCo for $5.25M plus the possibility of $5M in additional payment if specific performance milestones are met. Delta Corp CEO said, "We feel that TechCo strengthens our product offerings and significantly increases our bottom line." Guaranteed consideration Frame, Small: DELTA CORP TO PURCHASE TECHCO in $9.5M DEAL September 1, 2009. Delta Corp has announced that it is purchasing TechCo for $9.5M plus the possibility of $1M in additional payment if specific performance milestones are met. Delta Corp CEO said, "We feel that TechCo strengthens our product offerings and significantly increases our bottom line." Guaranteed consideration Frame, Large: DELTA CORP TO PURCHASE TECHCO in $500,000 DEAL September 1, 2009. Delta Corp has announced that it is purchasing TechCo for $500,000 plus the possibility of $10M in additional payment if specific performance milestones are met. Delta Corp CEO said, "We feel that TechCo strengthens our product offerings and significantly increases our bottom line." 185 STRATEGIC CHOICE & PERCEIVED FAIRNESS Total Consideration Frame, Small Delta Corp. has agreed to pay $10.5M for your firm, but you may lose part of that payment if you don't meet specific performance goals. Knowing this, which of following strategies would you pick for running the business for the one year period: Strategy A: You have a 50% chance of losing $1M of the payment, and a 50% chance of losing $0. Strategy B: You have a 100% chance of losing $500,000 of the payment If you lost $1M of the payment for your firm, you would feel that it was: Unfair Acceptable Total Consideration Frame, Equal Delta Corp. has agreed to pay $10.5M for your firm, but you may lose part of that payment if you don't meet specific performance goals. Knowing this, which of following strategies would you pick for running the business for the one year period: Strategy A: You have a 50% chance of losing $5.25M of the payment, and a 50% chance of losing $0. Strategy B: You have a 100% chance of losing $2.63M of the payment. If you lost $5.25M of the payment for your firm, you would feel that it was: Unfair Acceptable 186 Total Consideration Frame, Large Delta Corp. has agreed to pay $10.5M for your firm, but you may lose part of that payment if you don't meet specific performance goals. Knowing this, which of following strategies would you pick for running the business for the one year period: Strategy A: You have a 50% chance of losing $10M of the payment, and a 50% chance of losing $0. Strategy B: You have a 100% chance of losing $5M of the payment. If you lost $10M of the payment for your firm, you would feel that it was: Unfair Acceptable Guaranteed Consideration Frame, Small Delta Corp. has agreed to pay $9.5 for your firm, but you may gain additional payment if you meet specific performance goals. Knowing this, which of following strategies would you pick for running the business for the one year period: Strategy A: You have a 50% chance of gaining an additional $1M payment, and a 50% chance of gaining $0. Strategy B: You have a 100% chance of gaining an additional $500,000 payment. If you did not gain the $1M additional payment for your firm, you would feel that it was: Unfair Acceptable 187 Guaranteed Consideration Frame, Equal Delta Corp. has agreed to pay $5.25M for your firm, but you may gain additional payment if you meet specific performance goals. Knowing this, which of following strategies would you pick for running the business for the one year period: Strategy A: You have a 50% chance of gaining an additional $5.25M payment, and a 50% chance of gaining $0. Strategy B: You have a 100% chance of gaining an additional $2.63M payment. If did not gain the $5.25M additional payment for your firm, you would feel that it was: Unfair Acceptable Guaranteed Consideration Frame, Large Delta Corp. has agreed to pay $500,000 for your firm, but you may gain additional payment if you meet specific performance goals. Knowing this, which of following strategies would you pick for running the business for the one year period: Strategy A: You have a 50% chance of gaining an additional $10M payment, and a 50% chance of gaining $0. Strategy B: You have a 100% chance of gaining an additional $5M payment. If you did not gain the additional $10M payment for your firm, you would feel that it was: Unfair Acceptable 188 APPENDIX C. Values in Experimental Conditions Equal Earnout Condition Loss: Firm value=$10.5M Gain: Upfront payment=$5.25M Strategy A: $5.25M, and $0 Strategy B: $2.63M Large Earnout Conditions Loss: Firm value=$10.5M Gain: Upfront payment=$500,000 Strategy A: $10M, and $0 Strategy B: $5M Small Earnout Condition Loss: Firm value=$10.5M Gain: Upfront payment=$10M Strategy A: $1M, and $0 Strategy B: $500,000 189 APPENDIX D.Target Firms Target SIC Target SIC 1View Network 7372 MediaBridge Technologies 7311 AccessLine Holdings 4813 MediaDefender 7372 AccessMedia Networks 7372 Mediavast 7335 Accretive Commerce 4225 Medsite 4813 Acopia Networks 4813 MessageClick 7372 Acta Technology 7371 mindlever.com 7372 Advanced Concepts 7371 National Default Exchange 6162 Alias Systems 7372 Nationwide Card Services 7311 All Media Guide Holdings 7372 Navis Holdings 7371 Alogent 7372 Neoteris 7372 Altra Software Services 7372 NetPro Computing 7371 Arbortext 7372 NetScaler 7379 Attenex 7372 Netschools 7371 Axis Systems 7371 Network General 7373 Babycenter Inc 7379 New Edge Holding 4899 Back Bay Technologies 7372 Nusoft Solutions 7371 Best Internet Communications 7373 Oasis Siliconsystems 7371 BeVocal 7372 Oberon Associates 7379 Blackshore Properties 7372 Oberon Software 7372 Blaze Advisor 7372 Offermatica 7373 Bloodstock Research Information 7372 Optimost 7373 Brassring 7372 Outtask 4813 Bravera 7372 Pacific Consultants 8748 Calence 7373 Pantone 7372 CAS 3571 Canned Interactive 7371 Centigram Communications 3661 Pathlore Software 7371 Channel Health 7379 Pathscale 7372 CipherTrust 7371 Performance Assessment Network 4813 collegeclub.com, campus 24 7372 Performics 8742 Community Banking Systems 7372 Permeo Technologies 7372 Complient 6719 Phonetic Systems 7372 Continental Instruments 3669 PrairieWave Communications 4813 CRI Advantage 7371 Premier Technology 7372 Cyota 7379 Princeton eCom 7374 190 Data Return 7373 Procuri 5734 Datatran Network Systems 7372 Qiave Technologies 7372 Datavantage 5734 Renaissance Software 7372 Delta health Systems 7373 RVA Consulting 7372 Digital Instructor 7371 RxCrossroads 8099 Digital Systems International 7373 S2 Systems 7371 Direct Alliance 7389 Sage IT Partners 7379 DVD Mags 7929 SATO Travel Holding 4724 Ebaum's World 7929 Scala Business Solutions 5044 E-Dialog 8742 Sconex 7372 Enerwise Global Technologies 7372 SecuriMetrics 7372 Eontec 7371 Sentito Networks 4899 eStara 7372 Service Enhancement Systems 7379 Evant 7371 SFG Technologies 7373 Everest Broadband 4813 Signatures SNI 5199 Extended Care Information Network 7373 Silicon Metrics 3671 First Communications 5999 Simat, Helliesen & Eichner 7371 First USA 7372 Skye Multimedia 7371 FirstLogic 7371 SnapIn Software 5045 Foglight Software 7372 SRS Technologies 8748 Fotonation 7372 Steleus 7371 G&B Solutions 7379 Stompsoft 7372 Gain Technology 7372 Subimo 7372 Galaxy Scientific 8731 Surebridge 7373 Global Integrity 7373 Systinet 7371 Greenline Financial Technologies 7372 Tamale Software 7372 Helio Solutions 7372 Techrizon 7371 Helius 3669 Televideo 3571 Hi-Mark 7372 Tenth Floor 7371 Human Code 7372 Teralogic 3674 Hutchinson Telephone 4813 Terrascale Technologies 7372 Identify Software 7372 Total Sports 7379 Ilumin Software Services 7371 Tourmaline Networks 7372 Image Entry 7374 Transilica 4813 Imceda Software 7372 Uforce 7372 Impact Science & Technology 8748 UltraDNS 7372 191 Indigo Group 7371 U-Nav Microelectronics 3674 Info Systems 5045 Velogic 7379 Innovativ Systems Design 5045 VieCore 7371 Insight First 7379 Vintela 7372 Iridian Technologies 7372 Visual Sciences 7372 Kinexus 7379 Vocada 7371 Knowledgestorm 4813 Voyant Technologies 3661 Lasso Logic 7372 Vurv Technology 7371 LGC Wireless 3663 WebCT 5045 Logtec 8748 Webmayhem, Liberated Syndication 7372 Madison Research 8711 Whowhere? 7372 Magnet Communications 7371 Williams Communications Group 4813 Matchlogic 7372 Wirespeed Communications 7372 MATCOM International 7373 Wombat Financial Software 7372 M-Audio/Midiman 3679 World Wide Packets 3669 McClendon 7371 WOW Global 7371 McDonald Bradley 7371 Wyzdom Solutions 7372 MediaBridge Technologies 7311 192 APPENDIX E. Variables to Examine Merger Frames and Deal Characteristics Dependent Variable Variable Coding Source Coding Key FRAME None=0 GCF=1 TCF=2 Press release GCF=Deal value equal to upfront payment only with possible mention of contingent consideration TCF=Deal value equal to sum of upfront and earnout payments Independent Variable Variable Coding Source Coding Key RETENTION No=0 Yes =1 10-k Retain clients or customers, key customers (for e.g. US government, specific types of firms or specific clients, connections or clients that the merger added to the parent, reference to the client’s customer base and how to market parent products to them, target has largest share in their market or has a large number of paying subscribers or clients ACQUISITION No=0 Yes =1 10-k Merger allows firm to expand into new markets, get new customers or expand membership base CRITICAL No=0 Yes =1 10-k Target provides critical technology products or services. Medical, e-commerce, data storage, defense industry, financial/billing, sensitive data, accuracy, consistency. EXPLORATORY No=0 Yes =1 10-k State of the art, advanced, innovative projects or technology EARLY No=0 Yes=1 10-k Acquired in process R&D, technology of unproven feasibility, early technology Control Variables Variable Coding Source Coding Key YEAR From 0=1998 to 10=200 8 CAPIQ Year signed PRNTIND From 0=? to ?=? CapIQ 2 digit SIC code PRNTSZ $ CapIQ Annual revenue year prior to deal signing ACQEXP # CapIQ Number of acquisitions in the 3 years prior to the focal acquisition TRGTIND From 0=? to ?=? CapIQ 2 digit SIC code 193 TOTVAL $ CapIQ Total guaranteed deal value (upfront payment + earnout payment) EOPRCNT % Computed from CapIQ (EO/TOTVAL)*100 LITIGATION No=0 Yes =1 10-k Target firm is currently involved in litigation STRATEGY No=0 Yes =1 10-k Target firm acquisition was part of a long- term strategy INTEGRATION No=0 Yes =1 10-k Target firm will be integrated into the parent firm RELATED No=0 Yes =1 10-k Target firm and parent firm have the same 2 digit SIC code 194 APPENDIX F. Merger Value Frame Probit Analysis Model 1 Model 2 Model 3 YEAR -0.01 0.00 0.06 (0.04) (0.05) (0.05) PRNTIND -0.03 -0.02 -0.01 (0.04) (0.04) (0.05) PRNTSZ 0.00 -0.00* 0.00 (0.00) (0.00) (0.00) ACQEXP -0.01 -0.03 -0.01 (0.04) (0.04) (0.05) TRGTIND -0.04 -0.05 0.02 (0.04) (0.07) (0.09) TOTVAL 0.00 0.00 (0.00) (0.00) EOPRCNT 0.00 0.00 (0.01) (0.01) LITIGATION 0.00 0.15 (0.48) (0.50) STRATEGY 0.21 0.41 (0.24) (0.27) INTEGRATION 0.27 0.33 (0.29) (0.35) RETENTION -0.56 (0.35) ACQUISITION 1.71*** (0.35) CRITICAL -0.96*** (0.35) EXPLORATORY 1.20* (0.73) EARLY -0.94** (0.48) RELATED 0.70** (0.34) Constant 0.51 0.25 -1.73 (0.62) (1.12) (1.44) Observations 131 127 126 LogL -83.35 -80.02 -46.41 χ 2 3.49 6.61 68.77*** Pseudo-R 2 0.02 0.03 0.43 195 NOTES: 1) *** p<0.01 ** p<0.05 * p<0.10 2) Standard errors are robust and clustered (by customer) 3) The numbers in each cell are coefficients with standard errors in parentheses. 4) The estimation compares mergers with total consideration frames (TCF) to mergers with guaranteed consideration frames (GCF). 5) Control variables are introduced in stages to establish a stripped down baseline to examine the effectiveness of the main control variables before introducing the hypothesized variables.

Abstract (if available)

Abstract 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.

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Creator Weber, Libby Leann (author)

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

School Marshall School of Business

Degree Doctor of Philosophy

Degree Program Business Administration

Publication Date 06/16/2010

Defense Date 05/24/2010

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Tag acquisitions,bounded rationality,earnout clauses,framing,m,merger contracts,mergers,OAI-PMH Harvest

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Advisor Mayer, Kyle J. (committee chair), Miller, Norman (committee member), Nickerson, Jackson (committee member), Rajagopalan, Nandini (committee member)

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