Companies often use contingent consideration when structuring M&A transactions to bridge differing perceptions of value between a buyer and seller, to share risk related to uncertainty of future events, to create an incentive for sellers who will remain active in the business post-acquisition, and other reasons. Starting when SFAS 141R (now ASC 805) became effective in 2009, acquiring entities are now required to record the fair value of earn-outs and other contingent payments as part of the total purchase price at the acquisition date. This rule came into effect in the aftermath of the financial crisis when M&A activity slowed to a stand-still. Given the recent experience and continued expectation of increases in M&A activity, a refresher on the new rules may be helpful for CFOs and controllers of companies contemplating acquisitions in 2011.

The Rules

ASC 805, the section of the FASB codification that addresses business combinations, requires that:

  • The fair value of contingent consideration be recognized and measured at fair value at the acquisition date. In most cases, recognition of a liability for contingent consideration will increase the amount of goodwill recognized in the transaction.
  • Fair value must be re-measured for each subsequent reporting date until resolution of the contingency, and any increases or decreases in fair value will show up on the income statement as an operating loss or gain.

What Is Fair Value?

In the case of contingent consideration, fair value represents the amount the reporting entity would have to pay a hypothetical counter-party to transfer responsibility for paying the contingent liability. This amount is basically the present value of the probability-weighted expected amount of the future payment.

Valuation Procedures

The complexity of the procedures necessary to estimate the future payment ultimately depends on the structure of the earn-out.

  • For an earn-out structured as a straight multiple of revenue or EBITDA, it may be reasonable in many cases to estimate the expected payment using a single-scenario model by applying that multiple directly to the measure of performance in the financial forecast.
  • For a fixed amount payable upon achieving a particular milestone or event, estimating probabilities of various scenarios in a multi-scenario model will be necessary.
  • For more complicated earn-outs including thresholds, caps, or tiers, a more complicated modeling technique such as a Monte Carlo simulation or real options analysis will be required. Preparing these analyses generally requires specialized training and software.

Valuation Inputs

For earn-out structures including milestone payments or tiered schedules, the fair value of the contingent payment is generally most sensitive to the estimate of the probability-weighted expected payment (rather than other inputs such as duration of contingency or discount rate). Developing reasonable estimates of the probability of future events is inherently difficult, but the use of decomposition and cross-checks will help improve the quality of these estimates. Decomposition is the process of breaking down a big event (such as commercialization of a development-stage product) into a series of smaller, more familiar pieces to make the probability estimate process easier. Cross-checks using aggregate industry information (such as the average length of time to receive regulatory approval from the FDA) can be helpful to validate assumptions that by nature rely on judgment. Industry expertise can be extremely valuable when selecting a valuation specialist to help with estimating the fair value of contingent consideration. An expert will be able to decompose common pathways into a series of managable steps to estimate, will have familiarity with available industry data that can be used to help support assumptions, and will be able to effectively explain and defend the assumptions.

Role of a Valuation Specialist

In most cases, you or someone else in your company will likely be the individual most knowledgeable of the potential outcomes. The role of the valuation specialist is to integrate this information into the appropriate valuation model, test it for reasonableness, and to articulate the nuances of the inputs and valuation model in such a way that is clear for auditors and other third-party reviewers to understand. For simple situations it may not be necessary to bring in the outside help of a valuation specialist. For more complicated situations requiring multiple scenarios or Monte Carlo analysis, however, outside support may be necessary. If you have any questions regarding the valuation of contingent consideration or the impact of particular structures on financial reporting procedures, feel free to contact us in confidence.

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