Far value: how to accurately evaluate contingent consideration.

Contingent consideration, mostly in the form of earnouts, is a mechanism in which a valuation gap can be bridged emanating from the buyers’ and sellers’ different views of the deal price.

Contingent consideration puts the onus on the sellers to stay invested in the business and ensure performance parameters are met. It can also work as a retention and motivational tool for the seller’s top management to continue operating the business for the common interest of buyers and sellers.

In the US, accounting pronouncements require private as well as public companies to measure and report contingent consideration at fair value. This article discusses certain nuances that would be of importance to the buyer in the post M&A financial statements issued by them. While this article refers to US GAAP codifications the concepts discussed would be relevant even for IFRS or IND AS issued financial statements.

Introduction to contingent consideration

ASC 805: Business Combinations (“ASC 805”), Para 30-25-5 requires consideration transferred in a business combination to be measured at fair value, which is to be calculated as: the sum of the acquisition-date fair values of assets transferred by the acquirer; the liabilities incurred by the acquirer to former owners of the acquiree, and; the equity interests issued by the acquirer. Contingent consideration is one of the forms of consideration as described in ASC 805. Such consideration is to be recorded at the acquisition-date fair value as a part of the total consideration transferred.

Contingent consideration, also referred to as earn-out payment, is an obligation of the acquiring entity to transfer additional assets or equity interests to the former owners of a target company. The consideration will only be paid if specified future events occur or conditions are met. As discussed above, contingent considerations are typically employed in transactions to bridge the valuation gap between buyers’ and sellers’ differences of opinion regarding the target company’s future economic prospects. It helps to get the buyer and seller on the same page when it comes to the valuation of the target company.

Let’s examine the basic concept by way of an example: Company A intends to acquire company B. Company B has just introduced a new product line that is expected to generate significant sales. Company B’s owners have projected a significant amount of sales from the proposed product line and are considering the same to influence the deal size. The buyer, on the other hand, believes that there is a risk of uncertainty in the achievement of targets contemplated by the acquiree and hence there is a disagreement in the deal valuation. By incorporating a contingent consideration clause in the purchase agreement, the seller accepts part of the business risk along with the buyer, and also participates in any upside post-transaction.

Contingent consideration may be contingent on different events, for example on the launch of a product, on receiving regulatory approval, or reaching a revenue or income milestone. The achievement of such events often spans over more than a year. Thus, it is necessary to understand the post-acquisition treatment of such contingent consideration

Classification and measurement of contingent consideration

  • Liability v/s equity classification

The obligation to pay contingent consideration is classified as a liability or in shareholders’ equity in accordance with ASC 480: Distinguishing Liabilities from Equity, ASC 815: Derivatives and Hedging, or other applicable U.S. GAAP. The classification of such consideration is essentially driven by the mode of settlement of such consideration. Consideration settled in cash is always classified as a liability. In a scenario where the consideration is to be settled by issue of certain instruments of the buyer, we need to determine whether the number of instruments to be issued are fixed and determined at the acquisition date. In a scenario where the number of instruments is fixed, then such consideration is classified as equity and where the number of instruments to be issued is not fixed, then such consideration is to be recognised as a liability. For example, a fixed monetary amount to be settled in a variable number of shares, would be classified as a liability.

Contingent consideration classified as a liability is required to be remeasured at its fair value at each reporting period. For example, a consideration depending on revenue achieved over the next three years from acquisition, will need to be fair valued at the end of each year/quarter. Whereas a consideration classified as equity is not required to be fair valued post initial recognition, since the consideration has already been determined and locked as at the acquisition date.

Valuation of contingent consideration/ earnouts

The methods to be followed and the approach will be driven by the way the payment of such contingent consideration or earnouts is structured. The payouts are structured based on a single or more than one metric. Most commonly, contingent consideration is paid on the achievement of certain revenue or profit targets. Additionally, such payments may be spread over more than just one year. The payouts can either be linear or nonlinear payouts.

  • Linear payouts

Payouts that are dependent on a single metric and are expressed in terms of a fixed percentage or product of financial or some non-financial parameters are referred to as linear payouts. Consideration varying based on different levels of revenue or other parameters is a non-linear pay-out. For example: Target will receive a payment at some future date as follows:

  • If EBIT < $1 million, the payoff is zero
  • If EBIT ≥ $1 million, the payoff is a 10x multiple of EBIT

The valuation methods will be driven by the structure of the contingent consideration payouts. There are two broad valuation approaches used to value a contingent consideration.

  • Probably weighted expected return method, more commonly referred to as “PWERM” or Scenario Based Method (SBM); and
  • Option pricing method also referred to as the “OPM”
  • Probably weighted expected return method

The PWERM assesses the distribution of the underlying metric based on estimates of forecasts, scenarios, and probabilities. The payout computed is then discounted to the present value using a discount rate corresponding to the risk inherent in the inputs considered while computing the compensation. The steps followed are:

  • Estimate scenarios of outcomes and associated probabilities
  • Compute the expected payoffs using the scenario probabilities
  • Discount expected payoffs to present value using risk-adjusted discount rates.