How do earnouts, including contingent consideration, affect the financial results of an acquired business?

Over the last decade or so, the process of valuing and purchasing a business in a merger or acquisition has evolved significantly in terms of complexity as the motivations and intentions of buyers and sellers have changed. For instance, some buyers want to encourage the sellers to remain active in the business in order to leverage legacy knowledge and relationships to increase value, while some sellers may want to retain some interest to get subsequent upside. Additionally, buyers and sellers may have differing views on the value of the company. Incorporating an earnout allows a price to be set today that can adjust as uncertainty about future performance is resolved.

What is an earnout?

Pricing in today’s transactions is affected significantly by concepts related to future performance. Rather than setting a price, paying the seller, and continuing forward on their own, many buyers are setting performance targets on the future business activities that will govern the final amount that the sellers get paid. These additional payments related to achieving performance targets are commonly known as earnouts.

These additional payments related to achieving performance targets are commonly known as earnouts.

Traditional earnout arrangements typically include a future payment in cash based on a certain future metric being achieved, such as revenue exceeding a specified target during a relatively short period of time. However, earnouts can be settled in other assets or equity, and the contingency can be based on any metric. Many recent earnouts we’ve seen include settlement in equity units of the acquirer, contingencies based on a longer period of time, or based on targets related to value provided to the acquirer (for example, based on EBITDA or return to acquirer achieved upon a future change in control).

In addition, many buyers hire top executives and sellers to continue to work for the business post-acquisition. Given that, among these executives, work performed occurs after the sale agreement is reached, there can be significant debate about whether additional payments to them in the form of an earnout should be considered compensation or contingent consideration related to the sale of the business. This conclusion can have a material impact on the financial results of the acquired company beyond the year of acquisition.

Earnouts: Compensation versus consideration 

In some cases, buyers don’t look for sellers to remain with the business after the acquisition. In these instances, it’s relatively straightforward to recognize the fair value of the potential earnout amounts as part of the consideration paid for the acquisition. Frequently, though, earnouts are used as a way to keep former owners/executives on board and engaged in the early stages of the acquired entity and to give them an incentive to optimize the performance of the post-acquisition business. When these individuals continue to work for the post-acquisition entity, it can raise many questions and concerns about whether amounts paid as part of the earnout agreement are compensation for employment services or consideration for the sale of the business. Compensation costs will affect operating expenses during the periods while the sellers continue to work, while payments initially recognized as consideration for the sale will impact the overall valuation and the calculation of goodwill in the acquisition accounting.

Earnouts are used as a way to keep former owners/executives on board and engaged in the early stages of the acquired entity.

The earnout conundrum: Defining the line between compensation and consideration

It can be easy to underestimate the complexity involved in classifying earnout payments as compensation or consideration. In fact, the terms that buyers and sellers negotiate are becoming increasingly more complicated, making it that much more difficult to determine the line between compensation and consideration.

Here are some factors that can help parties determine if potential payments should be classified as compensation or consideration.

• Continuing employment: If a seller automatically loses the right to any of the payouts when employment terminates before the performance target dates, the payments should be recognized as compensation, not consideration.

If the earnout payments are not affected by termination, then additional factors should be considered, including:

• Required duration of continuing employment: If someone agrees to stay for the contingency period of the earnout or longer, that may be an indicator that some or all of the payments are compensation. If the duration of required employment is short, or the nature of the required services are trivial, that may be an indicator that the requirement to provide service after the transaction is not substantive.
• Level of compensation compared to others in the same position: If someone qualified for the buyout at the end of the earnout period is paid a salary that’s reasonable compared to others in key positions, that may be an indicator that the earnout is consideration.

Other factors that can play into the determination include:

• Incremental payments to employees.
• Number of shares owed.
• Linkage of payments to the value of the business.
• Components of the formula that the parties used to determine contingent consideration.

Overall, accounting standards create a “rebuttable presumption” that any payments based on some type of future performance will amount to future compensation. At the same time, there could be situations where most of the purchase price is contingent on future employment. In that case, if 100% of the earnout was recognized as compensation, the deal wouldn’t make sense. This situation could result in an allocation of the contingent consideration between compensation and consideration.

Accounting for business combination earnouts

With so many variables in play, the accounting in this area can get very challenging. For those amounts that qualify as compensation, the buyer would follow other U.S. GAAP guidance that specifies when and how such amounts are recognized. On the other hand, contingent consideration needs to be measured initially at fair value on the purchase date and, for a liability classified as contingent consideration, remeasured at every reporting date until the earnout period ends and the final amounts have been determined. Additionally, there is a step to determine if contingent consideration is classified as equity or liability, which can further increase the complexity. Changes in the fair value throughout the earnout period are recorded through net income. This involves valuation of the projected earnout liability in each reporting period during the span of the earnout period.

The complexity of contingent consideration and earnouts

Each acquisition is as unique as the businesses that enter into the deal, so it’s important to remember that results in this area depend heavily on the specific facts and circumstances of the transaction.