With M & A activity rising and deal structures becoming more complex, accounting and valuation challenges are also increasing. The application of ASC 805 raises important questions and deal-structuring issues, particularly with respect to contingent consideration. In this issue, we look at the forms of contingent consideration and the process for valuing such arrangements.

Contingent consideration (also called an earnout) is generally a potential future obligation of the acquirer to transfer additional assets, funds or equity to the seller. There are a number of factors to consider during the valuation process to help understand the facts and circumstances driving the presence of contingent consideration, and ultimately its fair value:

• Why did the transaction use contingent consideration?
• Was it to bridge a valuation gap or to align the economic interests of the buyers and sellers after the transaction?
• What is the buyer’s expectation versus the seller’s? The parties often have different expectations.
• What is the range of potential outcomes?
• Does the business exhibit stable or volatile results? Are there extreme outcomes either on the upside or downside?

As part of purchase accounting, and the related valuation of assets acquired and liabilities assumed, there are several issues involving accounting for the contingent consideration, including:

• Whether the future payment is contingent consideration or employee compensation;
• The incorporation of ASC 820 (formerly SFAS 157) fair value and market participant considerations; and
• Methods for determining fair value.

The first issue is determining whether the future payment qualifies as contingent consideration. ASC 805 provides guidance for whether it is contingent consideration or compensation. In short, if the seller is receiving consideration for the business, the future payment is deemed contingent consideration. In contrast, if the individual is being paid for future services, the payment is deemed compensation and expensed as incurred.

In a business combination, a contingent payment can be structured in a number of ways – a revenue or earnings threshold, a percent of revenue or earnings, or milestones, among others. Based on the structure, most instances of contingent consideration are liabilities, although there are situations where it is classified as equity or even as an asset.

As part of purchase accounting under ASC 805, contingent consideration is stated at fair value, as defined in ASC 820.

Based on experience and observations, the most common approaches to valuing contingent consideration are use of a probability-adjusted income approach, an option-based model, or a Monte Carlo style analysis. In the first approach, a range of potential outcomes is determined and probabilities are assigned to each. The probability of achieving each outcome, along with the contingent payment that would occur for each, is used to determine a weighted average or expected contingent payment. An option-based model or Monte Carlo analysis is similar, but has the advantage of exploring a fuller range of possible outcomes at intermediate steps along the way from acquisition to payout, incorporating path-dependent behavior. This increases flexibility and reflects a broader range of outcomes.

It is worth noting that the presence of nonlinear payouts, in many cases based on thresholds, floors or caps, is what drives the need for more sophisticated methods. If payouts are linear, use of the base forecast in the valuation analyses would likely prove sufficient.

When determining the range of potential payment estimates, there are a variety of sources of inputs, including management expectations, historical observations and market observations. Selection of the appropriate risk-adjusted discount rate is critical when determining the fair value.

In a transaction setting, there are a number of indications, such as the internal rate of return and weighted average cost of capital. Depending upon the transaction and the structure of the contingent consideration, the appropriate risk-adjusted discount rate may reflect either of these or other factors – including the credit risk of the acquiring company.

Post transaction, ASC 805-20-35-4A requires that the acquirer’s contingent consideration arrangements be measured subsequently in accordance with ASC 805-30-35-1. Generally, contingent consideration needs to be revalued in each reporting period.

In recent years, we have seen many more transactions where contingent consideration has been present. In many cases, it is a direct outcome of differences in perspective on value. Additionally, deal structures and valuation methods continue to evolve. For more information, contact your VRC representative.