How do you get buyers and sellers to execute an M&A transaction when the prospects of an industry are extremely uncertain? Part of the answer may be to structure the deal in a way that defers payment of a (significant) portion of the purchase price in the form of contingent consideration. The golf industry has had to endure a sustained period of decline as sales have swooned on the back of unenthusiastic all-around consumption (falling number of rounds played, fewer people playing, and slower equipment refresh cycles). Still, might things be finally looking up? Against this unpredictable backdrop, Adidas announced earlier this month that it would sell parts of its golf division (including the TaylorMade brand) to PE firm KPS Capital Partners. Approximately half of the purchase price would be delivered in the form of cash, with the balance to be paid with a combination of secured note and contingent considerations.
How should a valuation analyst measure the fair value of contingent considerations structured as part of a corporate transaction? We received some new guidance on the topic earlier this year.
The first exposure draft of Valuation of Contingent Consideration developed by the Valuation in Financial Reporting Working Group 4 of the Appraisal Foundation was released at the end of February 2017. The comment period ended in April 2017, and either another draft or the final guidance is expected next.
In today’s blog post, we catch up with Travis Harms, who leads our valuation for financial reporting practice, to get his thoughts on the new valuation guidance.
Travis, let’s start with some context for the readers. What is contingent consideration (or earnouts)?
Contingent consideration is a common feature in many corporate transactions. Earnouts are essentially agreements between the parties to the transaction to defer a portion of the purchase price. The amount of consideration ultimately paid is determined with reference to events occurring subsequent to the transaction date, either some measure of financial performance such as revenue or EBITDA, stock market returns, or a specific milestone or gating event, such as regulatory approval of a new product.
If the parties were not able to use earnouts to “punt” on elements of consideration, some transactions probably would just not occur. Contingent consideration agreements can be an efficient risk-sharing mechanism for the parties. Deferral of the purchase price mitigates the risk of subsequent performance failing to meet expectations, while simultaneously providing the prospect of additional upside for the seller. Furthermore, contingent consideration agreements can influence post-transaction behavior. If it is important for the selling shareholders to continue operating the business following the sale, the presence of contingent consideration can incentivize the freshly-endowed sellers not to call in rich, but continue to expend full effort in support of the business.
We have previously talked a bit about your background and practice at Mercer Capital. When or why do you value contingent consideration? How has the practice of measuring fair value of these earnouts changed over time?
We measure the fair value of contingent consideration as a component of the purchase price allocation when the deal closes and at subsequent balance sheet dates as the agreements are re-measured in accordance with GAAP.
Techniques for measuring fair value have certainly evolved over the past two decades. Analytically crude approaches focused on consideration of most-likely outcomes or a small set of potential outcomes have been displaced by more sophisticated approaches requiring analysts to construct replicating portfolios of derivative securities and/or develop complex simulation models. Despite the general adoption of more sophisticated techniques, considerable diversity in practice remains. The recent exposure draft advocates wider application of so-called options-based methods.
Now, the basic options-based method, or OPM, is not necessarily new. We use similar tools to value a variety of financial instruments from stock options (of course) to VC/PE investments in startups or private companies. Since option pricing models assume a risk-neutral framework, how does the new guidance reconcile a tool developed for a risk-neutral universe with the riskiness of reality?
That is an interesting question. Put simply, risky metrics have to be restated to a risk-neutral equivalent basis for use in the options-based techniques, and the exposure draft includes guidance on how to do so. In general, doing so requires estimating discount rates for specific financial metrics (revenue, EBITDA, etc.) using either a top-down approach or a bottom-up approach.
So, in reviewing the guidance, two (almost instinctive) criticisms are that a) the approach does not reflect how market participants view contingent consideration, and b) it is not appropriate to assume lognormal distributions for financial metrics or normal distributions for corresponding growth rates. Does the guidance address these concerns?
The exposure draft acknowledges these criticisms and addresses them directly.
In response to the first objection, the exposure draft states that the availability of observable market participant trading behavior in the options market supports extending application of the broadly-accepted option pricing models to contingent consideration: “The OPM [option pricing model] is widely used by market participants and valuation specialists to price traded options and other derivatives with nonlinear structures, even though more simple models may just look at the intrinsic value of options.”
With regard to the second, and more technical, objection, the exposure draft acknowledges that while a lognormal distribution may not be appropriate in all circumstances, the impact on fair value measurements is likely to be modest: “In any event, the Working Group believes that the choice of distribution for a financial (non-diversifiable) metric does not often materially affect the valuation. In the rare cases where the risk associated with the metric is non-diversifiable and the metric’s distribution is known to be far from lognormally distributed in a manner that could materially affect the valuation, an adjustment may be appropriate.”
Taking a step back, what do you like about the new guidance? What do you not like about it?
I think the guidance, like those previously issued by the Appraisal Foundation and the AICPA, is an important step in advancing the valuation profession. The SEC and others have lamented the diversity of practice among practitioners, and the exposure draft addresses that concern in a constructive manner. The detailed discussions and examples should promote broad and consistent adoption of techniques that, frankly, have to date been applied only sporadically and inconsistently. The techniques advocated in the exposure draft should promote the “auditability” of what can be very tricky and subjective fair value measurements.
That said, the stark differences between the recommended techniques in the exposure draft and the analysis performed by actual market participants do give us some pause. For the exposure draft to accomplish its goal, financial statement preparers and users will need to accept the reliability and relevance of the recommended techniques, and that process may take a while. In the meantime, I know the Appraisal Foundation is collecting comments from informed stakeholders and will carefully weigh such comments and incorporate them into the document as appropriate. Given the complexity of the issues, it wouldn’t surprise me to see this initial guidance continue to evolve and expand even after final issuance of the Advisory.
- Contingent Consideration: 5 Things to Remember
- Valuation of Contingent Consideration in M&A Transactions
- The Complications of Contingent Consideration: “It Depends”