Contingent Consideration: Practical Pointers for Earnouts in Business Combinations

By: Edward Hamilton

(Estimated reading time: 4 minutes 24 seconds)

The article in brief:

  • Contingent consideration, also known as an earnout, is frequently used to bridge a valuation gap and is commonly based on achievement of technical or financial milestones.
  • Both buyers and sellers should understand important accounting, valuation, and legal issues.

Sometimes, all you need to assemble a piece of furniture is a screwdriver and a wrench.

Other times, you need a hammer to make the last part fit.

Similarly, when mergers & acquisitions professionals are putting together a deal, they can often negotiate a purchase price both parties agree on. Other times, due to differing perspectives on value or uncertainty about a future event, this proves more difficult. Contingent consideration is a useful—but also a potentially complex—tool for bridging that valuation gap.

What Is Contingent Consideration and Why Is It Used?

Most deals involving contingent consideration include an upfront payment and then one or more subsequent payments based on achieving certain milestones or financial metrics. Generally, contingent consideration is used to bridge different perspectives on value and can reduce the risk for buyers by avoiding payment for future performance or events which do not materialize.

Contingent consideration can also encourage 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. For sellers, it may ultimately lead to a greater aggregate sales price because the buyer may be willing to pay more when paying only for realized performance.

In the case of a strategic buyer, it also lets sellers share in the benefits of transaction synergies.

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

Practical Considerations

Regardless of which side of the table they sit on, those contemplating contingent consideration should understand various accounting, legal, and valuation aspects.

Accounting
The question that will fundamentally shape the accounting treatment of a contingent payment is whether it is an additional purchase price or compensation to the seller.

Accounting guidance seeks to determine whether the payment is additional payment for the business or compensation for subsequent actions of the seller. A key factor is whether the payments are linked to continuing 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 more likely to be regarded as an additional purchase price.

The distinction is important because, under GAAP, compensation is expensed when incurred while contingent consideration is recognized at fair value initially and only changes to the fair value are recognized in the income statement—typically quarterly for public companies and annually for private companies.

Sometimes counterintuitive is the impact of subsequent performance upon the earnout expense. Better than expected performance that leads to a higher payment than originally expected creates an increased liability and the increase is recognized as an expense. Alternately, lower performance may lead to a reduced liability, which is recognized as a gain.

Structure
Contingent consideration that is most successful and avoids contentious and potentially costly disputes includes metrics that are clearly and carefully defined to avoid unwanted interpretations and consequences.

In structuring deals, there are varying tradeoffs that may influence the selection of a metric. A profit-based metric, e.g., EBITDA, is most closely aligned with the value of the business. However, tracking of the acquired company’s EBITDA may limit integration as a separate P&L will be required.

Additionally, a profit metric such as EBITDA must be clearly defined. Is it before or after allocation of overhead? What level of expenses that benefit the business after the earnout period, e.g., advertising or R&D, must be maintained? For these reasons, revenue is also a common metric. It is easier to track and subject to less interpretation.

Nonetheless, attention must be paid to preventing low pricing wherein revenue is “bought.” In the course of its work, VRC came across a poorly written purchase agreement, which based the earnout on revenue but didn’t disallow sales to a related entity, which then resold the product. Contingent consideration based on achievement of a clear milestone, e.g., FDA approval or retention of a specific customer, is subject to the least interpretation.

For legal and interpretation reasons, a shorter earnout is typically preferable. Though, a longer earnout may align better with the timeline of a product launch or customer addition that was the original reason for the earnout.

Finally, if any beneficiaries of the contingent consideration will continue to be employed by the company, a payment that is below their expectations may be detrimental to morale.

Valuation
While the structure of the earnout will determine the valuation approach, most valuations start with the deal model. Many earnouts based on metrics such as revenue or EBITDA are structured such that there is no payment below a lower threshold, a sliding scale above the lower limit and no incremental payment above an upper threshold. There may be a single payment, a series of independent payments, or a series of linked payments.

In markets where there are clearly defined milestones, e.g., closing on a specific contract, or FDA approval of a new therapy, the payment may be based on achievement of the milestone. Contingent consideration based on financial metrics is normally valued using an option based approach such as Black Scholes or Monte Carlo. Structures based on milestones are normally valued using a probability adjustment.

One common valuation outcome that sometimes yields an unwelcome surprise for management is that the fair value of contingent consideration is often lower than intuitively expected. There are two reasons:

First, uncertainty about the payment, as implied by discounting, means that the anticipated payment is less than the deal model indicates.

Second, further exacerbating this phenomenon is the common asymmetric payment structure (floors, caps). Imagine revenue is close to the amount that reaches the capped payment. Volatility around the point estimate means that a downward movement in the revenue causes a reduction in value while capping the value impact of upward mobility in the metric, leading to an overall downward bias in the value.

Summary

Earnouts can be challenging to structure, value, and account for. However, when the two parties are far apart on value, they can be a handy tool.

VRC continues to see many transactions where contingent consideration has been present. Additionally, deal structures and valuation methods continue to evolve. For a more in-depth conversation about how VRC can help you understand the value implications of your contingent consideration, we invite you to contact article author Ed Hamilton or contact your VRC professional.

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