December 01, 2016

Introduction

To facilitate merger and acquisition (“M&A”) transactions, buyers and sellers commonly use contingent consideration arrangements, such as earnouts, to bridge the gap between their respective views regarding the value and/or future outlook for the target company. An earnout is a provision within (or separate agreement attached to) a purchase agreement which makes a portion of the purchase price contingent on the acquired company reaching certain financial or non-financial milestones during a specified period after closing.1

In most circumstances, Generally Accepted Accounting Principles (“GAAP”) require contingent consideration, such as an earnout, to be recorded as a liability on the opening balance sheet of the buyer.2 This liability is typically re-measured at each reporting date until the contingency is extinguished or otherwise resolved.3

As discussed in our article “Earnout: Short-Term Fix or Long-Term Problem?”, earnouts, while useful in facilitating an M&A transaction, are commonly the basis for post-acquisition disputes.4 Information used by the buyer in the initial and ongoing measurement of the contingent liabilities relating to earnouts can provide relevant information in post-acquisition disputes. However, because of key differences in the measurement of the earnout liability for financial reporting purposes and the measurement of an earnout liability in the scope of a post-acquisition dispute, care should be exercised when considering amounts disclosed in financial statements when reaching conclusions on potential damages in post-acquisition disputes involving earnouts.

Measurement of Contingent Earnout Obligations and Disclosures Required for Financial Reporting

As briefly mentioned, GAAP requires the recording of an obligation to pay contingent consideration, such as an earnout, as a liability (or in certain circumstances, as equity) at Fair Value as of the acquisition date.5 This amount is then re-measured at Fair Value at each reporting date until the liability is extinguished.6

Methods to value a buyer’s contingent earnout obligation for financial reporting can vary depending on the complexity of the earnout provision(s) and the judgment of the analyst performing the valuation. For simpler earnouts, a method such as a discounted cash flow analysis may be appropriate. More sophisticated valuation methods such as a probability weighted analysis or a Monte Carlo simulation may be appropriate for more complex earnouts.7 Whatever method is chosen, the valuation is generally based heavily on the target company’s forecasts and projections through the term of the earnout. Any projected earnout payments are then typically discounted to present value, using a discount rate deemed appropriate by the analyst to account for the time value of money in addition to the inherent risk in the earnout calculation projection.

Publicly traded companies preparing annual (Form 10-K) and quarterly (Form 10-Q) financial statements will re-measure contingent earnout obligations at least quarterly. Private companies that prepare their financial statements in accordance with GAAP will generally be required to re-measure contingent earnout obligations at least annually. Contingent earnout obligations are recorded as a liability on a company’s balance sheet as either a current liability, long-term liability or both current and long-term liabilities depending on the expected timing of the underlying earnout payments (i.e., earnout obligations expected to be due within 12 months of the financial statement date are classified as current; earnout obligations expected to be due beyond 12 months of the financial statement date are classified as long-term). If material to a company’s financial statements, additional information regarding contingent earnout obligations is typically disclosed in the contingent liabilities and commitments section (or similar section) of the footnotes to the financial statements. Additional information regarding M&A transactions and contingent earnout obligations may also be found in other sections of a company’s financial statement, such as Management’s Discussion and Analysis (for publicly traded companies), footnote disclosures relating to business acquisitions, and footnote disclosures relating to Fair Value measurements.

Earnout Obligations Disclosed for Financial Reporting versus Analyzing Earnouts in a Litigious Setting

While information obtained from the initial recording and ongoing financial reporting of obligations under earnout agreements can be useful, the valuation of an earnout for financial reporting purposes is distinctly different from analyzing and quantifying potential damages related to the same earnout. The valuation of contingent earnout obligations, as discussed previously, is prepared using one or more financial models, coupled with managements’ expectations, as of a specific measurement date.

The valuation and concluded earnout liability are likely to be different than the results obtained from evaluating and examining the same earnout in a litigious setting for the following reasons:

Valuations of Contingent Earnout Obligations for Financial Reporting Are Measurements as of a Specific Date: The valuation of a contingent earnout obligation represents a reflection of a potential future payout, or a liability, as of a specific date. For this discussion, assume a hypothetical maximum earnout of $30 million over three years, payable at a maximum level of $10 million annually upon the achievement of an EBITDA level of 10% on minimum sales per year of $80,000,000.8

The “Valuation of Earnout” column in this table reflects the estimated value of the earnout as of a specific date. As of the date of the transaction, the maximum earnout of $30 million was valued at $15 million. This illustrates that, based on information available at the time of the valuation, the contingent earnout obligation is expected to be 50% of the total possible obligation under the earnout. One year later at the next hypothetical measurement date, given the first year success and trends and other information available, the contingent earnout obligation was valued at its remaining maximum of $20,000,000, or 100% of the total possible obligation under the earnout as of the respective measurement date. At the end of year two, the remaining earnout is valued at $2.5 million, or 25% of the total possible obligation under the earnout, due to the unfavorable results experienced in year two and other information available.

In this example, the earnout and its estimated value varied significantly at the various measurement dates. At the end of year one, the acquired company had been very successful and it was expected that the success would continue. At the end of year two, the company experienced a decline in operating results and it became apparent the contingent earnout obligation had been valued too high at close. It should be noted that at any point in the course of year two, it may have become apparent that the company’s ability to achieve financial results that would require payouts under the earnout had been impaired. For example, the company may have lost a significant customer shortly following the valuation of the earnout at the end of year one. Unless updated in an interim financial report, the change in the contingent obligation would not have become apparent to a user of the financial periods until the issuance of the next financial report (measurement date). However, when analyzing an earnout in the scope of a post-transaction dispute, the loss of the customer in year two would be investigated in detail in order to examine the causes behind the failure to meet the earnout thresholds, why those occurred, how the company reacted, the related financial impacts, and other issues. In other words, the valuation is a touch point as of a specific date to consider when earnout dispute arises, but a significantly more thorough analysis is required.

Utilizes Specific Methodologies that are Different from the Transaction Measurement: As discussed previously, valuations of a contingent earnout obligation use different methodologies to derive the value. While the underpinnings of the calculation rely on the general methodology contained in the earnout or merger agreement, the actual derivation of the liability utilizes different methods. Therefore, if examining the valuation in an earnout dispute, an awareness and understanding of the methodologies used is necessary. Typically, the company will create a financial forecast that will project operating results for the duration of the earnout period. Many assumptions will underlie the forecast, and thus need to be examined, regardless of the valuation approach. Additionally, the forecast utilized may be what the buyer and/or seller envisioned moving forward, or could be reflective solely of the views of the buyer or seller, as discussed in a subsequent section. It is also important to determine if these measurements are forecast on a stand-alone basis, similar to the company pre-transaction, or are now combined with other previously existing operations of the buyer.

Additionally, each valuation methodology has its own nuances. Whether the methodology utilized is the discounted cash flow method, probability-weighted expected return method, Monte Carlo method, or option methods, each methodology and its corresponding inputs and outputs must be evaluated. Certain types of analysis, such as the Monte Carlo method, are more challenging to review. Risk and the present value measurement must also be considered, as the valuation is reflective of such a calculation by the use and application of a discount rate. The earnout, even if 100% likely based on the valuation, still represents a form of financing, so some level of credit risk is still present. If the likelihood of achieving an earnout is highly uncertain, the discount rate can be quite high and approximate a venture capital rates of return.

Management’s Discussion with the Valuation Professionals May Reflect Differing Viewpoints: The buyer and seller are both parties to the transaction. To effectively understand management’s representations considered in estimating the contingent earnout obligation valuation, it is imperative to gain an understanding of who in management provided said representations. The valuation analyst may interview the buyer’s management, the seller’s management, or both as part of the initial valuation as of the date of the transaction. Seller’s and buyer’s management may have different perspectives on the contingent earnout obligation. For example, as it is in the seller’s best interest to maximize the earnout, they may provide representations that are biased toward that viewpoint. When analyzing the initial or subsequent period valuation of the contingent earnout obligation in a dispute setting, the existence of potential bias should not be overlooked.

Additionally, doubt may exist as to whether management that made representations to the valuation professionals is actually “in the know” regarding the operations of the acquired company. If company management is hands-off in the daily operations of the company, there may be factors that others in the company are aware of that would impact the achievability of the earnout that may not have been disclosed. Possible disparities and/or shortcomings of information provided for the valuation of contingent earnout obligations cannot be overlooked when analyzing an earnout in a litigious situation.

The Parties Expectations as of the Date of the Agreement and Specific Earnout Language: In a dispute, not only are the mechanics and measurement of the earnout important, but also the parties’ viewpoints at the signing and close of the transaction. The earnout or merger agreement represents a “meeting of the minds,” but often disputes arise over the intent of the parties prior to closing and whether those intentions were fulfilled in the operation of the company post-closing. Typically, the buyer is permitted to operate the company in accordance with their business judgment or in the best interest of shareholders. The buyer may want flexibility in operating the company in order to address changing market conditions, ongoing business issues, and concerns that arise, or to effectively integrate the business into other product lines. Rarely is the buyer required to operate the company in order to maximize the earnout, and is infrequently required to operate the company consistent with past practices.9

Additionally, the personnel that negotiated the deal for either the buyer and/or seller may not be the same individuals involved in the operation of the acquired company. It is possible for disconnects in viewpoints (operational vs. legal structure vs. intent) to exist that may not be apparent in the valuation, but will be discovered in a litigious setting.

In the initial and ongoing valuations, it is not requisite to understand the nuances that occurred during negotiation, nor some of the specific “intent” provisions, as it would not necessarily impact the valuation of the contingent earnout obligation. In a dispute, however, it is important to understand these viewpoints and the specific legal language that accompanies the earnout. Simply put, typically the seller wants to maximize the earnout and the buyer agreed to the earnout in order to bridge the gap of value perspectives of the company and to minimize its risks inherent in the transaction. In order to properly understand the initial valuation of the earnout that was performed and its relevance to a dispute, it is important to be cognizant of these issues.

Differing Levels of Detail: The Valuation of the Contingent Earnout Obligation is Not Necessarily Concerned with What Happened, Just the Value. The level of detail analyzed in an earnout dispute is generally significantly greater than that analyzed in determining the value of the contingent earnout obligation as of specific points in time. Earnout disputes can involve a variety of issues. Some have been mentioned previously, such as contractual language, the intent of the parties, and the causational issues regarding financial or milestone benchmarks and their impact on the quantification of the earnout. Other factors that may need to be considered include control of the operations of the business, business decisions made during the earnout period, application of accounting principles and/or GAAP issues, and financial target measurements. Further, a post-acquisition dispute often requires the review of underlying data that may not be considered when valuing a contingent earnout liability. This data may include items such as detailed sales reports, pricing information, intercompany transaction detail, related party transaction detail, support for cost allocations, capital investment records, and other detailed support for expenses. Additionally, it is not uncommon for earnout disputes to include allegations of fraud.

In other words, in a litigious setting, the seller is trying to determine the causational factors and related financial impact that contributed to not achieving or only partially achieving the earnout, and the buyer is looking at the same set of information to explain why the earnout was not achieved. When comparing this to the valuation of the earnout, seldom is any of this information examined, and if it is, typically not at the level of detail that is necessary in a litigious setting.

Conclusion

If a party finds itself in an earnout dispute, it should be aware of the valuations of the contingent earnout obligation that may have been performed during the term of the earnout. They can be an additional source of information, and the underlying workpapers, calculations, and discussions with management can provide valuable insight to consider during an earnout dispute. These valuations, however, should not be taken at face value and, rather, warrant further investigation to understand the specifics of the valuation, the methodologies utilized, management’s participation in the valuation, and ultimately how the conclusions on value were derived.

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1 The Litigation Services Handbook, Fourth Edition
2 FASB ASC 805-30-25-6
3 FASB ASC 805-30-35-1
4 “Earnout: Short-Term Fix of Long-Term Problem?”, SRR Journal, Fall 2011 edition
5 FASB ASC 805-30-25-6
6 FASB ASC 805-30-35-1
7 For more information on valuing earnouts for financial reporting purposes, see “M&A Facilitators: The Value of Earnouts”, SRR Journal, Spring 2010
8 This example does not include the affects of discounting. Liberties were taken with this example in order to illustrate the concept discussed.
9 ABA Private Target Mergers & Acquisitions Deal Points Studies, 2007, 2009 and 2011. These studies concluded that provisions containing a covenant to run the business to maximize the earnout occur in approximately 8% of transactions, and have decreased since 2006. Covenants to run the business consistent with past practices occurred in approximately 22-29% of transactions. This study analyzes transactions of private targets by public companies over the year preceding each publication.