Contingent Consideration in a Business Combination

Contingent consideration is a common element of a business combination transaction. These provisions are commonly referred to as “earnouts” and are typically based on revenue or earnings targets that must be reached after the acquisition date. They serve a valid purpose in reducing the uncertainty and risk related to post-transaction performance. Properly structured, earnouts create a win-win situation, reducing risk for the buyer and allowing for the seller to participate in the ongoing success of the business.

Topic ASC 805 requires the fair value of contingent consideration be recognized and measured at the acquisition date. The accounting treatment of contingent consideration can trip up the unwary. Depending on the accounting classification, the fair value of the contingent consideration will be recorded as either a liability or as equity. Therefore, prior to finalizing the deal structure, an evaluation of contingent consideration provisions should be made to determine the potential impact on the Company’s post-transaction financial position and subsequent earnings. If treated as a liability, it may adversely affect an entity’s debt covenants. Contingent consideration treated as a liability must also be remeasured at fair value at each reporting period and any adjustment to fair value will be reflected in earnings. If it is determined that contingent consideration is treated as equity, there is no requirement for remeasurement and no effect on subsequent earnings. Any gain or loss at settlement is recorded as an adjustment to equity through other comprehensive income.

Generally, contingent consideration will be classified as a liability if it requires the buyer to pay cash or transfer other assets upon meeting specific conditions. For example, Company A agrees to purchase Company B for $50 million, and will pay an additional $5 million if total revenues in the year following the acquisition exceed $200 million. This is a clear case of liability treatment.

When the contingent consideration agreement requires the issuance of the acquirer’s own equity shares, you must look to ASC 480 to distinguish between a liability and equity, and potentially review the guidance in ASC 815 to determine if it is to be treated as a derivative.

ASC 480-10 requires a financial instrument to be classified as a liability if it has any of the following characteristics:

It will or may be settled by the issuance of a variable number of the issuer’s (buyer’s) shares, and at inception, the monetary value is based on any one of the following:

A fixed monetary amount known at inception. For example, a provision that includes a fixed $1 million earnout payable in the issuer’s shares, the number of shares determined based on the fair market value of the those shares at a certain date;

Derived from something other than the fair value of the issuer’s shares. For example, requiring the buyer to deliver a variable number of the equity shares based on the movement of the S&P 500 index;

Value varies inversely to the changes in fair value of the buyer’s equity shares in the opposite direction of the value of the issuer’s equity shares. For example, Company A purchases Company B by issuing 1 million shares of its common stock which is trading at $25 per share. They also agree that if the share price of Company A trades below $25 one year from the acquisition date, Company A will issue additional shares to protect against any price decline from the acquisition date value of $25 million.

If the earnout provisions are not within the scope of ASC 480, consideration must be given to ASC 815, Derivatives and Hedging, to determine if the provision should be accounted for as a derivative at fair value. A contingent consideration provision that is a derivative is classified as a liability unless it meets the scope exception that allows equity classification. ASC 815-10-15-74(a) provides a scope exception for instruments that are both (1) indexed to the entity’s own shares, and (2) classified as stockholders equity in the entity’s statement of financial position. If the provision is not indexed to the acquirer’s own equity, it must be classified as a liability (or an asset in the case of a clawback).

The steps in this process can be complex and involve a significant level of judgment. Additional guidance in determining if a financial instrument is indexed to an entity’s own stock can be found in EITF Issue 07-5.
The complexity of contingent compensation agreements combined with the evaluation process under ASC 815-10-15 presents a challenging environment for management. Buyers who are not aware of these requirements may be in for a surprise by the impact earnouts may have on reported earnings in periods subsequent to the acquisition. Let us know if we can help.

John M. Byrne, CPA/ABV
Mallah Furman, Certified Public Accountants
954-475-3199