Contingent consideration instruments – more commonly known as “earnouts” or “clawbacks” – are frequently employed in mergers and acquisitions to bridge the valuation gap between buyer and seller and/or align the economic interests of the parties toward a successful transaction. Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 805, Business Combinations (“FASB ASC 805,” formerly known as SFAS 141R) requires that contingent consideration assets and liabilities are recorded at Fair Value on the acquisition date. Moreover, FASB ASC 805 requires the revaluation of most contingent consideration instruments at each subsequent reporting period until the final settlement of the obligation. Changes in the Fair Value of the instruments are then typically recognized in earnings.

When SFAS 141R was first introduced, many predicted that the use of earnouts would decline as acquirers would seek to avoid the time, effort, and cost associated with the accounting complexities, as well as the potential for higher earnings volatility following the transaction. The prevalence of earnouts, however, is largely unchanged. They continue to be a compelling solution in some transactions, suggesting that the real-world dynamics of deal negotiations surpass any aversion to added financial reporting requirements.

To use an earnout in a transaction is one thing, to value it is another. There exists no definitive framework for valuing contingent consideration, particularly as it relates to “diagnosing” the earnout and subsequently developing an appropriate valuation model.  We will summarize a few of the earnout nuances and challenges that are often overlooked, oversimplified, or overcomplicated in the valuation process.

Why did buyer and seller negotiate an earnout in the first place?

Earnouts are typically employed in transactions to bridge the valuation gap between buyer and seller arising from differences of opinion regarding the target company’s future economic prospects. Earnouts reduce the risk that the seller is exploiting the buyer based on the seller’s superior knowledge of the business; the seller accepts part of the business risk along with the buyer, and also participates in any upside post-transaction. In addition, earnouts are often used as a means to motivate key personnel that were retained by the acquirer and, in some cases, as a means for the seller to finance the deal. In each case, the earnout bears a different risk profile. Employing an earnout as a form of financing typically suggests a high likelihood of payout, whereas including an earnout to serve as a stretch goal for the retained management team typically suggests a lower likelihood of payout. Accordingly, the valuation inputs and assumptions should be evaluated in the context of why and how the earnout was structured

Is the condition event-related or market-related?

It is important to distinguish between two different types of “conditions” that may be present in a contingent consideration arrangement, each of which have very different risk characteristics (and thus require different valuation approaches). Event-related conditions are tied to the achievement of business objectives, such as the successful completion of a development project, receipt of regulatory approval for a new drug, or the production capacity of a mine. Event-related earnouts have risks that are unrelated to the economy and can be eliminated through diversification, and thus the substantive elements of risk can be measured through probability assessments (and do not require systematic risk premiums in the discount rate). On the other hand, market-related conditions are tied to the future performance of the acquired company’s revenue, earnings, margins, stock price targets, or other metrics. These types of contingent consideration are exposed to risks that are related to the economy, which cannot be eliminated through diversification. Consequently, the different risk elements of these two “conditions” must be taken into account when choosing the valuation methodology and when selecting an appropriate discount rate for discounting the expected cash-flows.

Is it appropriate to consider buyer-specific synergies?

The expected cash flows and underlying assumptions used to determine the Fair Value of a target’s acquired tangible and intangible assets should reflect a market-participant perspective. This includes the use of synergies that would be available to market-participant buyers of the target. In the case of contingent consideration, however, it may be appropriate to include additional benefits that are unique to the acquirer (i.e., “buyer-specific synergies”) to the extent that the revenue, earnings, or other target will be influenced by post-transaction synergies.

How complex are the earnout payment mechanics?

When valuing (or structuring) an earnout, bear in mind the nuances and complexities of the earnout payment mechanics in the purchase agreement. Various adjustments and exemptions to the revenue or income required for the earnout payment calculation (i.e., certain cost or revenues are exempt from the earnout calculation, additional acquisitions in the future might be exempt or included in calculations, etc.) can add modeling or calculation challenges. Moreover, these complexities can give rise to disputes and may require a forensic accountant to calculate the earnout amount, or to settle disputes.

Complex valuation models are necessary for most earnouts.

Two of the most common valuation frameworks seen in practice are the Probability-Weighted Expected Return Method (“PWERM”) and option pricing models (e.g., Monte Carlo simulations, binomial models, or Black-Scholes). When a payoff is more or less symmetric, discounting the most likely or expected cash flows, or using several scenarios in the PWERM approach, may be appropriate. However, most earnout payoffs are not symmetric. For example, if the seller receives a lump sum upon achieving a specific threshold, or a percentage of the amount above the threshold, and $0 below that threshold, the potential payoffs are not symmetric. Such earnouts exhibit option-like characteristics. For the same reasons that stock options require specialized models and are not valued using standard discounted cash flow techniques, non-linear earnouts with systematic / market risk require specialized valuation models based on option theory. Thus, the use of a “simple” model might not be appropriate in valuing the majority of earnouts.

But, not all earnouts require highly sophisticated models.

For event-related contingent consideration where systematic / market risk is zero, valuing contingent consideration can be as simple as estimating the cash flows that result from the event, the probability of the event occurring, and an estimate of the counterparty credit risk. Even market-related contingent consideration can be straightforward in certain circumstances, such as a scenario where the payoffs are more or less symmetric and the payoff has the same risk characteristics as the company’s equity or enterprise value. For example, if an earnout arrangement provides for the seller to receive 10% of the company’s EBITDA for the next two years, the valuation model may simply involve discounting 10% of expected EBITDA at the company’s WACC. Lastly, the materiality of the earnout estimate may influence model complexity. If the maximum earnout amount is expected to be relatively immaterial, it may be unnecessary to spend resources to construct a sophisticated model when a simplified approach (and resulting less precise answer) may suffice. Under certain conditions, the earnout could be estimated with a simpler approach.

Selecting an appropriate discount rate depends on the choice of valuation methodology and the types of risk in the payoff.

If the PWERM valuation methodology is used to value the earnout, the selected discount rate should consider three primary sources of risk: (1) the volatility in the underlying parameter (e.g., revenue or EBITDA); (2) the “shape” of the payout function (i.e., when the payout is nonlinear, the risk of the earnout is usually greater than the risk of the underlying parameter), and (3) the potential for non-payment of the earnout taking into consideration the position of the claim in the acquirer’s capital structure and the expected timing of the payout (i.e., the credit risk of the acquirer). Options models, on the other hand, are typically defined as “risk-neutral,” which means that the expected cash flows are adjusted to remove systematic risk. In such a model, the selected discount rate typically considers the risk-free rate plus a credit spread for the earnout acquirer. The selection of the valuation methodology will most likely guide the selection of the discount rate.

It can be challenging to determine an appropriate volatility factor for the underlying parameter.

One of the challenges in using option pricing models to value earnouts is the estimation of an appropriate volatility factor for the specific earnout parameter (i.e., revenue or EBITDA). In contrast to common stock options, financial instruments with similar earnout parameters typically do not trade in the public markets. In the absence of observable, market-based volatilities, it is possible to indirectly estimate volatility for the underlying parameter (such as revenue or EBITDA) based on common stock volatilities, as adjusted for the effects of financial, operating leverage, and other factors. Alternatively, volatility can be inferred from scenarios provided by management for the underlying parameter(s) using various statistical methods.

Consider the implication of the current valuation on future reporting periods; not all earnouts are accounted for the same way.

The accounting for contingent consideration depends on the classification of the contract, which might not be obvious. Most frequently, contingent consideration is classified as an asset or a liability, which requires revaluation at each subsequent reporting period, with the changes in Fair Value being recognized in earnings. Accordingly, it is important to understand and consider the potential impact on earnings under alternative future scenarios. The contingent consideration liability may also affect debt covenants unless the earnout is defined to be excluded from covenant calculations. However, if the contingent consideration arrangement meets certain criteria such that it is classified as equity, subsequent revaluation is not required since the settlement is accounted for within equity. If the earnout payments are tied to continued employment of key management, then the contract is accounted for as “compensation,” and the guidance in FASB ASC Topic 718, Compensation – Stock Compensation applies (e.g., the payments are expensed and not recorded on the balance sheet). In addition, if the earnout is classified as a derivative, hedge accounting may be required under FASB ASC Topic 815, Derivatives and Hedging and the changes in Fair Value are recognized in other comprehensive income until the contingency is resolved. Understanding the future accounting and valuation implications of earnout arrangements prior to the transaction can be critical to evaluating alternative transaction terms in order to support negotiations, and can avoid unnecessary surprises down the road.