Voices

Contingent consideration: Practical pointers for earnouts in business combinations

For mergers & acquisitions professionals — and more so for their auditors — adding contingent consideration to a deal can be like replacing your injured star quarterback at the two-minute mark: It wasn’t in the original game plan and could complicate matters down the line, but sometimes it’s necessary to get the game back on track and give the team a chance to succeed.

Similarly, contingent consideration, sometimes referred to as an earnout, can salvage a transaction when the buyer and seller cannot agree on value. That is especially true in a frothy deal environment, where business owners are demanding steep valuations, while prospective acquirers are anxious about possibly overpaying.

What is contingent consideration and why is it used?

With contingent consideration, the buyer makes an initial payment of consideration for a target and then one or more subsequent payments over a stipulated period that are contingent on performance criteria being met.

For sellers, it may ultimately lead to a greater aggregate sales price because the buyer may not otherwise be prepared to offer as much due to uncertainty over the profitability — and thus the value — of the target.

In the case of a strategic buyer, it also lets sellers participate directly in the benefits of any synergies that result from the transaction to the bottom line.

As for the buyer, in addition to reducing uncertainty, contingent consideration can ensure the seller’s commitment to a successful transition/integration, and it can represent an attractive financing strategy by allowing part of the acquisition to be underwritten by the target’s future profits.

Contingent consideration can raise thorny accounting, valuation and legal issues, but it's too useful to take off the table.

Regardless of which side of the table they sit on, those contemplating a deal structure that includes contingent consideration should engage knowledgeable professionals to advise them on all aspects of the transaction.

Following is an overview of the basic accounting, valuation and legal dynamics of the approach that they will help address.

Accounting

The question that will fundamentally shape the accounting treatment of contingent payments is whether they represent additional purchase price or compensation to the seller.

A key indication that auditors will look to is whether the payments are linked to a specific post-deal period of employment of the seller, in which case they are likely to be considered compensation. Alternatively, if the payments are made regardless of the employment status of the selling party, they are likely to be regarded as an additional purchase price.

The distinction is important because, under GAAP, compensation will be treated as an expense and recorded in equity, while the additional purchase price will be recognized at fair value in the income statement and the fair value must be adjusted periodically — annually for private companies, but quarterly for publicly traded entities.

Valuation

There are different approaches for adjusting fair value when contingent consideration is an additional purchase price and must be reflected in income. The most straightforward approach is to reference the deal model.

However, in many cases contingent payment structures may include a formula tied to a standard metric such as EBITDA, but with ceilings and/or floors on payments. Alternatively, they might be tied to an event such as FDA approval of a new therapy. In these cases, option-based valuation approaches, either the Black-Scholes formula or Monte Carlo simulations, are required.

Legal

The contingent consideration that is smoothest and avoids contentious and costly disputes is when it’s meticulously documented and covers the shortest period possible — no more than three years, but preferably one or two.

When deals are structured with contingent consideration, the toughest part of the exercise is often agreeing on and then tracking reference metrics. Buyers typically focus on the bottom line and will push for a deal tied to net-income thresholds.

Sellers, for their part, typically want a deal based on revenue, since it is more straightforward to measure and there is less scope for window dressing by the buyer. Often they meet in the middle and settle on EBITDA as the key reference.

Finally, if the deal involves an aggressive integration of the target into another entity, there may be a need to track two separate sets of financials for the period of the contingent consideration.

Earnouts can be complicated to structure, tricky to value, and a headache to account for. However, when the two parties are far apart on terms, mastering the nuances of contingent consideration can keep you in the game.