These provisions may benefit M&A buyers and sellers, but they also bring significant accounting complexity to the transaction.

January 02, 2020

Earn-outs are common in mergers and acquisitions (M&A), aligning future incentives between buyer and seller. Earn-outs provide buyers with protection relative to projections prepared by sellers, upon which purchase price is often predicated. In addition, these mechanisms can serve as a bridge between disparate buyer and seller valuations. Earn-outs can be tied to a variety of financial metrics, most often revenue and/or earnings growth.

While earn-outs are a practical solution for buyers and sellers in M&A transactions, they can create significant accounting complexity, both with regard to purchase and post-transaction accounting. Earn-outs generally require an (often complex) valuation and, depending on structure, may create post-transaction earnings volatility due to ongoing mark-to-market accounting. Additionally, questions often arise as to whether earn-outs constitute a portion of the purchase price (i.e., purchase consideration) or reflect post-transaction compensation expense. This determination is nuanced and should consider a variety of facts and circumstances, along with the overall economics of the transaction. The fundamental question is: Does the earn-out consideration relate to services provided pre- or post-transaction?

Let’s start with the straightforward scenarios. Contingent consideration that is explicitly tied to the continued employment of the sellers is generally considered post-transaction compensation expense. Conversely, contingent consideration provided to sellers that do not remain with the company post-transaction is generally considered to be purchase consideration. Anything between these two scenarios sits firmly in the gray.

The following scenarios may indicate that the contingent consideration should be recorded as post-transaction compensation expense:

  • The sellers are subject to an employment agreement and the period of required employment is equal to or longer than the contingent payment period
  • The sellers’ compensation (other than contingent payments) is low relative to other key employees in the combined entity
  • The contingent payments, combined with other consideration transferred, exceed the established valuation range for the business
  • The contingent payment formula is consistent with prior compensation or profit-sharing arrangements
  • The contingent payments are based on a specified percentage of earnings

On the other hand, the following scenarios may indicate that the contingent consideration should be included in purchase consideration:

  • The sellers’ compensation (other than contingent payments) is at a reasonable level relative to other key employees in the combined entity
  • The contingent payments, combined with other consideration transferred, are in line with the established valuation range
  • The contingent payments are based on a multiple of earnings

Because earn-outs often represent a significant portion of the overall transaction value, it is important that companies understand the accounting impacts of earn-outs early to avoid post-transaction surprises. To that end, accounting teams should work closely with their corporate development counterparts to understand the accounting impacts of earn-outs before purchase agreements are finalized.