Transactions inherently have unknowns. Sellers may be wondering if the price for which their ideal buyer is looking reflects the company’s worth. Buyers will want to know how their target company performs post-close. As we previously discussed, contingent considerations or “earn-outs” help buyers and sellers share in the risk that comes with the transaction’s unknowns. The current environment is also making them a more common feature of merger and acquisition (M&A) conversations, particularly for companies in the biotechnology sector.
Our article explores what buyers of biotech companies may want to know about contingent considerations to prepare for the impact earn-outs will have on their purchase price accounting.
What Makes Biotech Transactions Unique
Biotech companies often have potential revenue streams tied up in development, testing, and Food and Drug Administration (FDA) approval processes. Earn-out payments, generally based upon post-close performance could be structured so that they reflect the milestones in the product’s development process, such as the passing of development stages and/or final FDA approval.
Using contingent considerations may reduce the cash needed on-hand at the time of the acquisition while also incentivizing the seller’s post-close performance. Paid out to the seller, they help the seller get the ultimate value from their business while also reducing the buyer’s risk at the start of the transaction.
When biotech transactions include earn-outs however, there are additional accounting elements involved. Buyers and sellers will need to be aware of those steps so they can keep their deals flowing smoothly.
Choosing Your Earn-Out Structure
An earn-out reflects the needs of both the buyer and the seller, and as such, it can take on different structures. The structure of the earn-out informs how it’s valued for transaction reporting purposes, described briefly below:
|Type of Contingent Consideration
| Payment made if a single outcome (typically revenue amount) occurs
| ABC Biotech Company receives $300,000 earn-out if Product A’s revenue exceeds $10 million
| Linear with Two Targets
| Sliding-scale payment based on performance in a pre-set range
| ABC Biotech Company receives an earn-out between $0-300,000 if Product A’s revenue falls between $10-13 million
| Payment based on a multiple if certain condition(s) is(are) met
| ABC Biotech Company Owners receive a payment of .5x revenue growth + .5x EBTIDA growth
| Payment has a minimum and maximum
| ABC Biotech Company Owners’ minimum earn-out is $100,000 and their maximum is $300,000, based on a certain performance metric
| Payment reflects the non-financial metric
| ABC Biotech Company Owners receive $300,000 earn-out if Product A’s clinical trials are successful and it receives regulatory approval
| Stock Payments
| Payment made in shares of a buyer’s equity
| ABC Biotech Company Owners receive the equivalent of $300,000 in ABC Biotech Company’s stock post-close
How Earn-Out Structure Affects Transaction Accounting
Buyers include the value of their earn-out in their purchase price accounting. They must measure the earn-out at fair value on the acquisition date and include it in their financial statements.
It is important to note that the initial measurement may not be what the buyer expects to ultimately pay out because the fair value depends on the structure of the earn-out, the risks the acquired company faces to achieve its target metrics, and the buyer’s credit risk. Structure matters, for example, because if the earn-out is tied to a non-financial metric such as the continued employment of certain individuals, then the earn-out is included as a compensation expense rather than as part of the purchase price.
The transaction’s earn-out structure also affects whether re-measurement may be required. Earn-outs are classified as a buyer’s liability or equity depending on how the payment is made. Earn-outs structured as equity (such a stock-based payment) do not have to be re-measured after the transaction. Liabilities, however, will have to be re-measured for fair value at each reporting date until the buyer makes the payment. Changes in fair value will flow through the buyer’s income statement. Increases in fair value (stemming from stronger than expected performance) will increase the buyer’s liability and expenses, while decreases in fair value (performance targets aren’t met) can result in a write-off of the liability with corresponding income recorded.
The Challenge with Fair Value of Earn-Outs
The structure selected for your earn-outs also affects the steps involved in determining your earn-outs’ fair value. Discounted cash flow models – a traditional valuation technique for value – may not be appropriate if the transaction contains a non-linear payment structure. Buyers will want to enlist the help of an experienced valuation provider to assist with the fair value measurement because you will have to use scenario analyses or option pricing models.
Under the scenario approach, the valuation involves an estimate of the earn-out under multiple scenarios, and once estimated, the earn-out amounts are probability-weighted and present valued. Estimating the probabilities associated with the various scenarios and the discount rate for the earn-out payments present a challenge and may require subjective judgment. Buyers will want to ensure the basis for the judgement and estimation of probabilities are well-documented and can withstand scrutiny in the event of a financial statement audit.
The option pricing method is a valuation technique that uses a risk-neutral framework. Your organization will want to look for valuation analysis that involves flexibility, such as Monte Carlo simulation analysis. The Monte Carlo simulation generates a random sample from a probability distribution to produce hundreds or thousands of possible outcomes (i.e., hundreds of thousands of discrete scenarios). This analysis has become increasingly popular because it allows the valuation specialist to incorporate a wide range of inputs and assumptions associated with non-linear earn-out structures. For comparison, other option pricing techniques (such as the Black-Scholes option pricing model) do not provide such flexibility.
The most important step buyers can take in their purchase price accounting is to determine what type of earn-out they will employ in their transaction and enlist an experienced professional who can help with their earn-out valuation analysis. For more information, please contact a member of our team.