Everything You Need to Know about Contingent Considerations
Contingent considerations have played a vital role in a large number of merger and acquisition (M&A) transactions in recent years. A contingent consideration or “earn-out” can help the buyer and seller come to an agreement on the purchase price. On the sell-side, it can fill the gap between the firm’s current market value and the seller’s goal for the transaction price. On the buy-side, earn-out payments can reduce the cash burden at the time of the acquisition, and at the same time, incentivize the seller to perform post-close. It allows the risks and upside to be shared between the buyer and seller. The following helps illustrate the basics of contingent considerations and its potential benefits for your company.
Earn-out payments are typically based on the acquired company’s performance post- acquisition. For example, payments could be tied to revenue in the year following acquisition. It could also be based on the performance of one or more of the company’s products. They are used often in transactions for companies that may have potential revenue streams tied up in development and testing. Earn-out payments can include milestones in the development process, such as the performance of a new software as a service (SaaS) product.
There are numerous ways to structure the earn-out to your advantage. Common used structures are described below:
- Binary: An earn-out payment could made to the seller, contingent on a specific outcome. For example, a payment of $300,000 will be paid only if revenue for a certain product exceeds $10 million.
- Linear with Two Targets: Earn-out could depend on performance within a set range. For example, a payment between $0 and $300,000 will be paid to the seller (on a sliding scale) if revenue for a certain product is between $10 and $13 million.
- Nonlinear Structure: Payment could be based on a multiple if a certain condition is satisfied. For example, a payment of 0.5 multiplied by growth in revenue plus 0.5 multiplied by growth in EBITDA between two periods minus any decline in collection efforts.
- Caps and Floors: The payments may or may not have a maximum and/or a minimum amount.
- Performance-Based: The earn-out could be a function of non-financial metrics such as clinical trials ore regulatory approvals.
- Cash or Stock: Earn-out payment could be made in the form of shares of buyer’s equity. This type of structure adds another layer of complexity, as the payment is now a function of the buyer's stock, so the seller is subject to future fluctuations in the share price.
- Promissory Notes: Earn-out payment could be made in the form of interest and principal payments over several years if the conditions are met.
An earn-out should ideally be used when there is a significant difference between what the buyer wants to pay for a company and the seller’s ideal purchase price. The party that understands the risks and benefits can make the structure work to its advantage. Structuring earn-out payments comes with some considerations, however, of which you should be aware. Complex arrangements will require some atypical accounting treatment and advanced valuation techniques.
The Accounting (Initial Measurement)
The earn-out typically has to be measured at fair value as of the acquisition date and included within the purchase consideration for financial reporting purposes. The fair value could be higher or lower than what the buyer ultimately expects to payout depending on the risks in achieving the target(s), the structure of the earn-out, and the credit risk of the buyer. The accounting literature also suggests that if the earn-out is tied to the continued employment of certain individuals, it may be accounted for as compensation expense rather than a component of purchase price.
Accounting for an earn-out also varies based on how the payments are made. Certain arrangements may result in more intensive financial reporting requirements, including re-measurement of the earn-out periodically.
The earn-out will be classified as a liability or as equity depending on how the payment is made. If it is classified as equity, it does not have to be re-measured after the transaction date and its subsequent settlement shall be accounted for within equity.
If the earn-out is classified as a liability, it needs to be is re-measured at fair value as of each reporting date until the obligation is settled. In this case, the change in fair value of the earn-out would also flow through the income statement.
If the acquired entity’s performance is better than expected, it may trigger an increase in value of the Earnout liability. This change will be included as a non-cash expense in the income statement. On the other hand, failure to meet the performance target(s) would result in the write off of some or all of the liability.
In some cases, the earn-out could be booked as an asset to the buyer. This type of asset is called “clawback”, which represents payments back to the buyer if certain conditions or targets are not met.
Valuation for Earn-Outs
Traditional valuation methods such as discounted cash flow model may not be appropriate to value the more complex earn-out structures. This is especiallly true in instances where the payment structure is nonlinear.
The two most commonly used techniques to value earn-outs include scenario approach or option pricing theory. In the scenario approach, earn-out payments are estimated for multiple scenarios, probability-weighted and present-valued. Estimating the discount rate in this approach is typically a challenge and may require subjective judgment.
The other approach is option pricing technique, which uses a risk-neutral framework. One example of this technique is to employ the Monte Carlo simulation software, which generates a random sample from a probability distribution to produce tens or hundreds of thousands of possible outcomes. Monte Carlo simulations in risk neutral frameworks have become increasingly popular, as it objectively incorporates the large majority of the scenarios and risks related to the earn-out payment.
Work with Advice You Can Trust
A valuation provider experienced with mergers and acquisitions can help you navigate the accounting and valuation considerations for navigating a deal with contingent consideration. If you have any questions please contact the author, Subramanian Parmeswaran.
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