Contingent consideration: A means of mediation in acquisitions
INSIGHT ARTICLE |
Transactions are increasing their reliance on contingent consideration. This article explains why the market is doing so and why correctly valuing contingent considerations through an experienced valuation specialist is important. At RSM, we have seen a recent trend of increased use of contingent consideration as a part of purchase considerations with our clients. Overpayment, share of risk and inherent biases are just a few of the contributing factors driving this trend.
Contingent consideration, also known as an earn-out, is an obligation of the acquirer to transfer additional consideration, usually cash or equity, to the sellers if specified future events occur or conditions are met.1 Under Topic 805, “Business Combinations,” of the Accounting Standards Codification (ASC), earn-outs must be recorded at fair value at the time of acquisition with fair value measured based on the guidance in ASC 820, “Fair Value Measurement.” If the earn-out is classified as a liability for accounting purposes, it must be reported at fair value at each reporting period until the earn-out is settled.2 Given the complexities associated with valuing earn-outs, an experienced valuation specialist is often necessary to correctly determine their fair values.
The use of an earn-out allows the buyer and seller to “right-size” the purchase price and share the risk associated with the target’s future performance. As such, we have seen the number of transactions with contingent consideration increase as buyers and sellers become more sophisticated. Fortunately, new guidance is available via The Appraisal Foundation’s, Valuation of Contingent Consideration, which details valuation best practices, most of which include sophisticated models, such as Monte Carlo simulation, a series of options, etc. The guidance is currently in draft form and the finalized version is expected in early 2019. RSM’s complex financial instrument valuation team specializes in valuing earn-outs. They work alongside other RSM valuation professionals specializing in ASC 805 (tangibles, intangibles, etc.).
The table below details some of the advantages and disadvantages from the buyer’s perspective of including an earn-out as part of the purchase consideration.
As the earn-out structure, including the settlement method and payoff structures discussed below, can greatly affect the risk distribution and concluded earn-out value, we highly recommend consulting an experienced valuation specialist when structuring the earn-out in the purchase agreement, as well as when the fair value of the earn-out is required under GAAP.
Earn-out payments can be made in either cash or stock. The table below demonstrates some of the advantages for both methods; conversely, the advantages of one method are the disadvantages of the other.
Both parties involved must weigh the costs and benefits of the settlement method. Consulting with a valuation specialist can alleviate the decision-making process as hypothetical scenarios can be played out through simulation and closed-form analyses prior to finalizing the settlement method.
Earn-out payments can be structured in a multitude of ways and can be based on a variety of metrics, including, but not limited to revenue, gross profit and EBITDA. Common payment structures include all-or-nothing payments (or binary payments) and percentage of future performance payments, as illustrated below:
The selection of the payoff structure should align with the goals of the buyer and seller. Often, we see selling shareholders remain at the target as employees when the purchase consideration has an earn-out. For example, the illustrations above have identical maximum earn-out payments and are based on the same weighted average metric target ($1.0 million); however, the risk profile associated with the two structures varies for the buyer and seller as discussed below.
The all-or-nothing scenario puts the seller at risk because it is reliant on the target to reach the solitary metric threshold of $1 million, but once the threshold is reached, there is no upside to the seller if the metric improves. Due to the asymmetrical risk sharing between the buyer and seller, the amount of the payout can be limited when compared to the percentage of performance payout structures, which are described below.
Misconceptions often assume that the fair value is $0 or $500,000. It is important to note in this type of earn-out structure typically fair value is a value between the all-or-nothing payment. However, at the payment date, the actual payment is all-or-nothing, where the buyer would pay $0 or $500,000. Risk from both the seller’s and buyer’s perspectives is no payment or payment in full, respectively.
The percentage of future performance scenario shares the risk more equally amongst the buyer and seller. The gradual payment structure allows the seller to receive a linear portion of the maximum earn-out payment between the metric threshold ($500,000) and the metric cap ($1.5 million). In exchange for participating in the earn-out payment at a lower metric, a higher metric must be reached to achieve the entirety of the potential earn-out payment. From the seller’s perspective, this requires the target to continue improving the metric beyond the original $1 million mark in order to achieve the same max payment. This can be an ideal structure if the buyer is less confident in the projections of the target. From the buyer’s perspective, this structure also allows the buyer to make a payment in the range as opposed to the full payment structure noted above. This structure allows the buyer to manage the financial projection risks of a merger because both the seller and the buyer share payout risk. The earn-out limitation also allows the buyer to have scales of economy from deal synergies and (or) increases in value from the target’s operations by limiting payment levels.
Earn-outs can be tailored to a variety of buyer and seller needs, and valuation specialists can help guide the process both before and after the closing of the acquisition to ensure all needs are met. One such consideration is whether the potential earn-out has a maximum amount or ceiling. A ceiling will minimize exposure risk for a buyer (as opposed to having infinite risk). Additional contingencies can also be added. For example, a revenue metric earn-out could also be contingent on a profit margin. This example may be helpful for a buyer to encourage the target to meet revenue goals but do so in a profitable manner.
Risk of misvaluing contingent consideration
It is important to properly value an earn-out to record the appropriate goodwill and eliminate future liability volatility, if applicable. Over-valuing the earn-out could create too much goodwill, which may cause impairment issues in the future. Additionally, this could result in gains when the earn-out is recorded as a liability and remeasured downward to an appropriate fair value each reporting period. Typically, with the assumption of biases, a seller tends to be optimistic on the future performance of the target and the buyer tends to be less optimistic, or more conservative. Regardless, a buyer should be prepared for the possibility that it will pay the full amount of the earn-out and the seller should also be prepared for the possibility that it will receive none of the earn-out. At the end of day, if the target performs as intended, then the seller will be compensated through the earn-out, and if the target does not perform as intended, the buyer did not overpay. An earn-out allows the buyer to bifurcate the risk of payment and risk profile of the target’s cash flows.
Using the example above, a buyer can structure the cash payment of the purchase price through cash flows they feel are achievable. For example, the buyer feels confident the target will earn an EBITDA of $500,000 but not $1.5 million as projected by the sellers. Recall, biases are inherent on both sides of the transaction. Here, the buyer can bifurcate the purchase price, a fixed cash payment assuming target’s EBITDA at $500,000 and an earn-out payment for target’s EBITDA from $500,000 up to $1.5 million. If the target does perform as the seller intended, the seller is ultimately compensated.
Appropriately determining the fair value of an earn-out at the transaction date and in subsequent measurement periods eliminates volatility associated with an earn-out liability.
How RSM can help
Reach out to an experienced valuation specialist at RSM to ensure your contingent consideration is valued accurately and appropriately at the transaction date. In addition, when the contingent consideration is classified as a liability, we can assist your organization in establishing fair value for subsequent reporting periods, and help to avoid surprises pertaining to the fair value of the earn-out by performing upfront sensitivities. RSM engages with clients in selecting earn-out criteria based on their risk appetite and the potential payment scenarios. We can perform sensitivities on varying the earn-out criteria. Some examples include, the earn-out with a ceiling versus no ceiling, binary versus scaled payment, moving thresholds (adjusting the minimum thresholds, 5.0 EBITDA up to X, etc.), and adding thresholds (margin requirements), etc.. This type of sensitivity testing has provided our clients insight as to the fair value (and expected future payment for planning purposes) of the target company as of the transaction close date.
1. Contingent considerations can also be structured to allow the buyer to claw back value if specified future events occur or conditions are met.
2. Careful consideration should be given to earn-outs that must or may be settled in equity as liability classification of such earn-outs is often required based on their terms and the applicable generally accepted accounting principles (GAAP). If an earn-out is dependent on continued employment, it will be considered compensation expense in the post-acquisition period.