Contingent consideration, often referred to as earnouts, is a strategic component frequently utilized in merger and acquisition (M&A) transactions. It is a financial arrangement wherein a portion of the purchase price is contingent upon the achievement of specific future performance metrics by the acquired company. In the dynamic landscape of business acquisitions, contingent consideration acts as a flexible financial arrangement that links future payments to the performance of the acquired company.
Reasons Behind the Use of Earnouts:
Risk Mitigation: Earnouts are commonly employed when there is uncertainty regarding the future performance of the acquired company. Sellers might opt for earnouts to share the risk with the buyer and ensure that the full purchase price is commensurate with the actual performance achieved.
Valuation Misalignment: In cases where the buyer and seller have differing opinions on the current value of the target company, contingent consideration allows both parties to compromise by tying a portion of the payment to future performance.
Alignment of Interests: Earnouts align the interests of the buyer and seller, as both parties have a vested interest in the success of the acquired business post-transaction. Sellers remain involved in the company’s performance, aiming to maximize the contingent payments.
Characterizing Contingent Considerations:
While contingent consideration arrangements are often used to achieve similar purposes and exhibit certain common characteristics, contingent consideration structures observed in practice come in many different forms that are designed to address the unique risks associated with each specific transaction. An earnout may be broadly characterized by the choice of the underlying metric or event which triggers the payment, the structure or payoff of the earnout, and the means by which the earnout is ultimately settled.
1-Underlying Metrics:
Underlying metrics refer to a measurement unit defined in the contingent consideration agreement, the value of which will determine the amount of the contingent consideration to be paid.
Typical Metrics Include:
Financial metrics: Revenue (in some cases in conjunction with minimum gross margin conditions), EBITDA, net income, and business metrics such as number of units sold, rental occupancy rates, etc.
Non-financial milestone events: regulatory approvals, resolution of legal disputes, execution of certain commercial contracts or retention of customers, closing of a future transaction, achievement of technical milestones (such as completion of a product launch, a stage of product development, certain software integration tasks, or a construction project), etc.
The choice of the underlying metric will affect the riskiness of the contingent consideration payoff cash flow and therefore the relevant discount rate. For example, the risk associated with certain nonfinancial milestone events (such as an earnout contingent on regulatory approval of a pharmaceutical drug) might typically not be influenced by movements in the markets and therefore such risks are diversifiable, leading to the use of a discount rate similar to the cost of debt of the obligor over the appropriate time horizon. In contrast, the risk associated with a financial metric will generally not be fully diversifiable, leading to the use of a discount rate that includes a risk premium for that financial metric’s exposure to systematic risk.
2-Payoff Structures
At one extreme, contingent consideration may be structured in a simple way as a fixed percentage of an underlying metric such as earnings or revenue (i.e., a linear payoff structure). At the other extreme, contingent consideration payoff structures may be complex, nonlinear functions of the underlying metric, including minimum thresholds below which no payment is made, a maximum payment cap, tiers with differing rates of payment per unit of improved performance, and/or carry-forward provisions that link payment in one time period to performance in other time periods.
The contingent consideration structure can have a substantial impact on the risk, degree of leverage, and discount rate to use in the valuation. Furthermore, similar to the distinction between diversifiable and non-diversifiable risk, the distinction between linear and nonlinear payoff structures is a key consideration when selecting the contingent consideration valuation methodology.
Examples of Payoff Structure:
While most earnouts are settled in cash, there are cases where settlement involves the transfer of other assets, equity, and/or liabilities. The way an earnout is settled may or may not have an impact on its fair value.
If the earnout payment is specified in monetary terms but settled through the transfer of other assets. Such an earnout is economically equivalent to an earnout settled in cash.
Eg: An earnout payment equal to 500 worth of the acquirer’s common shares if EBITDA earned in the first year exceeds 5,000.
However, specifying an earnout as a fixed number of the acquirer’s shares will impact the fair value of the earnout, and the valuation of such an earnout generally requires consideration of the fair value of the shares being transferred, the impact on the counterparty credit risk and the correlation between the value of the shares and the underlying metric.
Eg: An earnout payment equal to 500 common shares of the acquirer if EBITDA earned in the first year exceeds 5,000.
Valuation Methodologies
At the acquisition date, IND AS 103 – Business Combinations requires an acquiring company to report the contingent consideration at fair value as part of the purchase price in an M&A transaction. The three generally accepted valuation approaches to estimate the value of an asset or liability include the income approach, the market approach and the cost approach. Given that the income approach incorporates future expectations, it is typically the approach used to value contingent consideration. Within the income approach, there are two commonly used methods to value contingent consideration.
1.The scenario-based method (“SBM”)
The scenario-based method requires the identification of a set of outcomes (or scenarios) for the underlying metric or event and the payoffs associated with each outcome. The payoffs are then probability-weighted according to an assessment of the likelihood of each scenario. The probability-weighted payoffs are then discounted at the appropriate rate to calculate the expected present value of the contingent consideration.
2. The option pricing method (“OPM”)
Option-pricing models are mathematical tools used to estimate the value of options – financial contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specific period. The three most widely used option-pricing models for valuing contingent consideration are the Black-Scholes-Merton model, the binomial option pricing model, and the Monte Carlo simulation.
Selecting a Valuation Methodology
The SBM is appropriate for pricing contingent consideration when the risk of the underlying metric is largely diversifiable and there is linear payoff structure. In the case of a metric with only diversifiable risk, estimating, the SBM discount rate need to only address the time value of money (risk free rate) over the relevant time horizon and any counterparty credit risk.
In the case of a linear payoff structure, the structure does not change the risk of the underlying metric. In this case the discount rate must incorporate the required metric risk premium as well as the time value of money over the relevant time horizon and any counterparty credit risk.
In the case of a nonlinear payoff structure (for example, a structure with tiers, thresholds, caps, or path dependencies such as carry-forwards, roll-backs or cumulative targets) involving a contingent consideration metric with non-diversifiable risk, estimating the discount rate for the SBM cannot be easily intuited by the valuation specialist as the SBM discount rate must be adjusted for the risk of that nonlinear payoff structure. In such cases OPM methodology is appropriate for valuing contingent consideration. In such cases the OPM provides a framework by which the impact of the payoff structure on the non-diversifiable risk of the metric can be easily modelled.
Conclusion:
Earnouts can be challenging to structure, value, and account for. However, when the two parties are far apart on value, they can be a handy tool to bridge the gap. By aligning the interests of buyers and sellers and addressing uncertainties in post-acquisition performance, earnouts contribute to the success of strategic deals. As the landscape of M&A continues to evolve, contingent consideration is likely to remain a significant component in structuring deals and fostering collaboration between acquiring and selling entities. Understanding the characterizations and valuation methodologies associated with contingent considerations is crucial for both parties to navigate these complex financial arrangements successfully.