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

Government Regulation and Business Value

It its simples form, the value of any business is a function of its cash flows and the risks of realizing those cash flows. Generally speaking, the lower the perceived risk, the higher the value of the business. The converse also holds true.

In the process of estimating the value of an existing business, the risk assessment process is a key factor. Every company is exposed to risk. For example, a company with a high debt level is generally more risky than companies with low or no debt. Companies that have only a few customers that represent a high percentage of total sales are generally deemed more risky than companies that have many customers that generate the same sales volume. Companies that are highly regulated by government agencies may also face high risk levels due to frequent legislation that effects their operations and future cash flows. The auto industry, airline industry, and healthcare, are examples of highly regulated industries.

Successful business owners identify risks and proactively adopt strategies to reduce and minimize risks. Cultivating a diverse customer base is a deliberate action to reduce business risk. Hedging is a strategy often used to reduce risk. The purchase of insurance policies reduces risk of loss through casualty or otherwise.

Government regulations, for most business owners, can present uncontrollable risks. They can appear suddenly, the result of current events and the political pressure to “do something”.

From a valuation perspective, the recent announcement on the prospect of increasing the minimum wage could decrease the value of businesses that rely on low skill employees, those that are earning at or near the minimum wage. The decrease in business value is a result of potentially lower cash flows due to higher labor costs. In today’s fragile economy, a business owner would be hesitant to automatically increase prices based on a forced increase in labor costs. This could result in loss sales to competitors. Most likely, the business owner would cut back in total labor employed so that overall costs remain the same. What happens in this scenario is that fewer people are employed under the guise of helping the low skilled worker earn more.

There have been numerous studies that contradict the politically popular thinking that mandating minimum wage law is good for the economy and good for the low skilled worker.

A more effective approach is for policymakers to focus on policies that generate faster economic growth. A growing economy benefits all workers, while minimum wage policies disproportionately affect low-skilled workers. While I understand that politicians and policy makers believe they are helping workers, research shows the opposite is true. (1)




(1)Richard V. Burkhauser and Joseph J. Sabia, “The Effectiveness of Minimum Wage Increases in Reducing Poverty: Past, Present, and Future, Contemporary Economic Policy 25, no. 2 (April 2007).
Richard V. Burkhauser and Joseph J. Sabia, “Minimum Wages and Poverty: Will a $9.50 Federal Minimum Wage Really Help the Working Poor?” Southern Economic Journal 77, no. 3 (January 2010).

When The Time Is Right, Will You Be Ready?

You’ve heard the line, “When the time is right, will you be ready?” As a business owner, maximizing the sales price of your company may be the most important process that you undertake. It will probably represent the bulk of your retirement nest egg and provide you with the means for a secure retirement. This article addresses key areas that effect business value and what you should focus on to position the company for sale.

The Numbers

An accrual based balance sheet and income statement will be at the top of the list of any serious buyer. The balance sheet is a snapshot of your financial position at a point in time. The trends in your balance sheet offer important clues about your business. It could indicate collection problems with accounts receivable, slow moving or obsolete inventory items, or a shortage of working capital. Adverse trends can indicate to buyers that there is weak or ineffective management, resulting in higher risk and lower value. Identify the key ratios that are relevant in your industry. Typically, working capital, inventory turnover, and debt to equity ratios are significant balance sheet ratios for most businesses. Work at improving your ratios so that they meet or exceed industry standards.

The income statement is a fundamental value driver. Since revenues drive the income statement, make sure that your company’s revenue recognition policies are in accordance with generally accepted accounting principles (GAAP). There are complex rules regarding revenue recognition for firms engaged in construction activities, software sales and support, and contracts with contingent consideration. The income statement will reveal trends on revenues, gross profit percentage, and other operating costs. For a potential buyer, companies with strong or stable growth in revenues are more attractive than businesses that are stagnant or declining. Equally important is the gross margin. Be prepared to explain any significant trends that might be the result of a different product mix or class of customers. When selling your business, one of the components of value is future growth. For a potential buyer, future growth is more believable if the company has a track record of consistent growth in sales and earnings.

People

One of the most valuable assets of your company isn’t even visible on your financial statements, your employees. A well trained workforce, committed to the company and its vision, can be a valuable asset. A well-run company invests in its people, providing them with adequate training, a compensation package that rewards their efforts, and open communication about the company’s direction and their future.

Your customers are also part of the value equation. Are your customers repeat buyers with a history of prompt payment or are they at risk of walking to the competition? A loyal customer base provides comfort to the potential buyer that reduces risk and increases value. All things being equal, a customer base that is relatively homogeneous in sales volume is less risky than a customer base in which one or two customers represent a large percentage of sales. The loss of a single high volume customer can cripple growth and hence, would be considered a higher risk factor.

Often a business owner is so involved in the operations that his absence creates a dangerous void. Successful companies don’t rely on one individual. Owner dominance only increases risk and reduces value. Successful companies have systems and procedures in place and a trained workforce that can handle the normal and unusual situations. Training subordinates and delegating responsibility should be an ongoing process to ensure continuity which increases value.
A strong management team is never satisfied with the status quo. Current operations are scrutinized and evaluated on a regular basis. Budgets and cash flow forecasts are prepared and evaluated against actual results. Proper internal controls are in place and monitored for effectiveness. Improvements to products and services are studied and evaluated.

Processes and Improvements

In the technology age, information is vital. A company’s IT system, tracking information such as inventory levels and product costs, customer sales history, and financial performance, is a critical factor in managing your business. Often the investment in new technology pays for itself in a relatively short period of time.
Capital expenditures for your facility and equipment are necessary to maintain efficiencies in your operations and stay competitive. Any business that doesn’t have a plan for replacing outdated equipment will find itself penalized by potential buyers. Keeping your infrastructure up to date also places your company in a position to handle future growth.

Risk is abundant in any business venture. Managing risk is on-going process. Too often, risk management is often performed by small business owners after the fact. A pro-active approach to identifying external and internal risks to your operations keeps you one step ahead of your competition. The risk assessment process identifies areas where the risk of the dollar value of loss and the probability of loss is above your defined threshold. Some risks are transferred to third parties, for example, by the purchase of insurance policies. Other risks can be addressed by strengthening internal controls, instituting formal policies and procedures, and creating a contingency plan.

Conclusion

Maximizing the value of the sale of your business is an ongoing process that doesn’t happen overnight. A structured approach focuses on the attributes that potential buyers can identify and quantify. Your actions now can pay big dividends when the time is right.

Please contact me for additional information.


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

Celebrity Brand Value and Estate Planning

Forbes magazine’s publishes an annual list of the Top-Earning Dead Celebrities, or “Delebs”, as they are referred to by industry executives. At the top of the 2012 listing is Elizabeth Taylor at $210 million, followed by Michael Jackson at $145 million, and in third place, Elvis Presley, at $55 million. A celebrity’s image and “persona” can be extremely valuable intellectual property. With today’s technology, images and sounds can be captured and transmitted globally, with a minimum of effort.

Anyone can register their name, nicknames, poses, slogans, and signatures, as trademarks. Even without a registered trademark, celebrities have “publicity rights” to prevent unauthorized use of their name, likeness or other personal attributes. However, the right to publicity is not protected by federal law; rather it is a matter of state law. A range of U.S. states have devised legislation aimed at preventing unauthorized commercial use of an individual's name or likeness, giving that person (or their estate) an exclusive right to license the use of the identity for commercial purposes

Some states treat publicity rights as transferable property that survives a celebrity’s death. Other states treat publicity rights as personal rights that terminate at death. Of the states with post-mortem rights, some only apply to celebrities that pass away after the enactment of such states laws. Other states retroactively apply their laws to any celebrity who passes after a specified date, sometimes decades before the enactment of the law. California law covers a person’s lifespan plus 70 years, Oklahoma has enacted legislation that covers 100 years after death. The comedian Bill Cosby, a resident of Massachusetts, put his support behind a recently proposed law that would protect a celebrity’s publicity rights for 70 years after death.

Until the Estate of Andrews v. United States in 1994, the value of a decedent’s right of publicity was commonly ignored for purposes of calculating federal estate taxes due on death. Virginia C. Andrews was, at the time of her death, an internationally known, best-selling author. The Estate did not list Andrews’ name as among its assets. In 1990, the IRS issued a tax deficiency of $649,201.77 based on their valuation of the intangible asset at $1,244,910.84. Ultimately the court concluded on a value of approximately $700,000.

Estate planners would be well served in determining the value of the right to publicity as a component of the overall estate planning strategy of their celebrity client.

Personal Goodwill and Why It Matters

For many businesses, the value of intangible assets dwarfs the value of their tangible assets. Ocean Tomo, an intellectual property consulting firm, released their 2010 annual study of intangible asset market value, which concluded that the implied intangible asset value of the S&P 500 reached 80% of total market capitalization, which was down slightly from the previous year.(a) Intangible assets represent the excess market value of a business beyond the value of its tangible assets.

Goodwill is an intangible asset that cannot be traced to an identifiable source, such as patents or trademarks. Firms that provide professional services frequently have two categories of goodwill; personal goodwill and enterprise goodwill. Personal goodwill attaches to a particular individual rather than to the operating business. Enterprise goodwill results from characteristics of a particular business, for example a high-traffic location.

Family law courts in many states operate under the principal that personal goodwill is not a marital asset subject to distribution, but represents future earnings potential associated with an individual’s personal characteristics. Hence, the component of personal goodwill may need to be identified and segregated from any enterprise goodwill.

Personal goodwill generally can be traced to two main sources:

1. Contacts and Relationships:

The landmark 1998 Tax Court case of Martin Ice Cream v. Commissioner noted the existence of personal goodwill due to the ice cream distributor’s relationships with customers. (b) Customers continued patronage due to an individual’s personal relationships are a primary source of personal goodwill. Relationships with suppliers and employees can also contribute to personal goodwill, providing a loyal, motivated workforce and a reliable source of inventory at or below market price.

2. Skill, Knowledge, and Reputation:

Skill may be in the form of either intellectual, physical, or both. Surgeons are an example who may have both qualities, gaining customer referrals and patronage due to innovative techniques (intellectual) as well as manual dexterity (physical). A practitioner’s skill level is often the source of the related reputation. For a firm that produces highly technical products or services, an individual’s knowledge and education may be unique to the industry, providing a superior competitive edge.

Segregating the intangible value of a business between personal and enterprise goodwill is challenging and there is no single method that will fit all situations. The quantification of personal goodwill is dependent upon the facts of each case and is often approached by estimating the financial impact the departing employee or owner will have on the business.

Personal and enterprise goodwill are elements of value that are relevant in divorce, tax, bankruptcy and other settings. Segregating the values into their separate components is difficult and a subjective task. Courts and valuation experts have yet to agree on a consistent method of bifurcating goodwill. By using evidence from the existing facts and circumstances, the valuation analysts can estimate the degree of personal and enterprise goodwill to help ensure equitable outcomes in marital dissolution cases.


(a) “Ocean Tomo Announces Results of Annual Intangible Asset Market Value Study”, http://www.oceantomo.com/media/publications. April 4, 2011.

(b) Martin Ice Cream Company v. Commissioner of Internal Revenue, 110 TC 189 (1998).

Groupon, Inc. and Value

In its simplest form, value is a function of cash flows and risk. For any business, its value is dependent on the level and timing of future cash flows and the perceived risks in realizing those future cash flows. Therefore, the valuation process is primarily a forward looking concept although the past can provide clues to the markets’ perception of value. Generally speaking, higher growth rates translate into higher values, although beware if growth doesn’t translate into increased profits.

Groupon, Inc. (Nasdaq GRPN) priced its IPO at $20 share and debuted in November 2011 with an implied value of $13 billion. In May 2012, after a series of financial reporting blunders, its market value was reduced 50% as its stock price fell to just under $10 per share. The company’s stock has been in a free fall since July 2012, falling from $9.51 per share on July 2, 2012 to $4.44 at the close of trading on August 24, 2012. This is despite the fact that year over year revenues and earnings have improved.

The lesson, investors’ perceptions changed dramatically when Groupon’s financial restatements lowered revenues and earnings. In addition, investors are recognizing there are low barriers to entry and rising competition (Living Social). The result, lower stock value as perceived risk moved higher and future cash flows moved lower.

Tax Court Upholds Defined Value Gift Formula Clause in Wandry v. Commissioner, T.C. Memo 2012-88 (March 26, 2012)

Formula clauses are used by taxpayers to avoid unintended gift, estate and generation-skipping transfer (GST) tax consequences when transferring property. There are two general types of formula clauses: A definition clause defines a transfer by reference to the value of a possibly larger, identified property interest; and a savings clause retroactively adjusts the value of a transfer due to a subsequent valuation determination.

The IRS has been successful challenging savings clauses for gift, estate and GST tax purposes, arguing that they are against public policy because they prevent the IRS from properly administering the Code. The definition clause is a relatively new type of clause that has generally been respected by courts for gift, estate and GST tax purposes.

In Wandry, a couple established an FLP and embarked on an annual program of gifting interests to a FLP. Their estate planning attorney advised them that (1) the number of FLP units equal to the desired value of their gifts on any given date could not be known until a later date when a valuation of the FLP's assets could be made; (2) all gifts should be given as specific dollar amounts rather than specific numbers of membership units; and (3) all gifts should be given on Dec. 31 or Jan. 1 of a given year, so that a midyear closing of the books would not be required.

Consistent with the transfer documents, the gift tax returns reported total gifts of $1,099,000, and the schedules supporting the gift tax returns reported net transfers from each spouse of $261,000 and $11,000 to their children and grandchildren, respectively. However, the schedules describe the gifts to the children and grandchildren as percentage interests in the FLP (not specific dollar amounts). The couple's accountant had derived these percentage interests based on an appraisal valuing a 1 percent interest in the FLP. The IRS audited the couple's 2004 gift tax returns and determined a deficiency based on the percentage interests listed in the schedules to each spouse's gift tax returns.

At trial, the IRS alleged the couple was liable for the deficiency amount because (1) the gift descriptions, as part of the gift tax returns, are admissions that petitioners transferred fixed FLP percentage interests to the donees; (2) the FLP's capital accounts control the nature of the gifts, and the FLP's capital accounts were adjusted to reflect the gift descriptions; and (3) the gift documents themselves transferred fixed FLP percentage interests to the donees. The IRS further argued that the formula clause created a condition subsequent to the completed gifts and was void for federal tax purposes as contrary to public policy, citing the 1944 case Commissioner v. Procter (142 F.2d 824).

The Tax Court quickly dispensed with the first two arguments by the IRS. Regarding the descriptions of the gifts on the gift tax returns as percentages of the FLP as opposed to a specific dollar amount, the court noted that the description of the gifts on the gift tax return was consistent with the gift tax documents transferring a specific dollar amount of FLP interests. Regarding capital accounts being adjusted related to specific percentages, the court determined that the adjustments in the capital accounts were "tentative" and subject to change once final values were determined. Therefore, it determined that the capital accounts do not control the nature of the gifts by the couple.

The Tax Court next addressed the validity of the valuation clause. The court first took note that other federal courts have held that formula clauses were valid to limit the value of a completed transfer, citing Estate of Christiansen v. Commissioner (130 T.C. 1, aff'd 586 F.3d 1061); Estate of Petter v. Commissioner (T.C. Memo. 2009-280, aff'd 653 F.3d 1012); and McCord v. Commissioner (461 F.3d 614). The court then noted that a savings clause is void because it creates a scenario in which the taxpayer tries to take property back. On the other hand, a formula clause is valid because it merely transfers a fixed set of rights with uncertain value. It further noted that in Petter, it ruled the formula clauses were valid because the ascertainable dollar value of stock transferred was a fixed set of rights even though the units had an unknown value. It also noted that on appeal the Ninth Circuit agreed with the holding that although the value of each membership unit in the limited liability company (LLC) was unknown on the date of the gift, the value of a membership unit on any given date was constant. Therefore, under terms of the formula clauses at issue, the donees received a fixed number of membership units and no contingencies existed in order to render the transfers otherwise ineffective on the date of transfer.

The Tax Court reasoned that it was inconsequential that the formula clause reallocates membership units among petitioners and the donees rather than a charitable organization because the reallocations do not alter the transfers. As of the date of the transfer, each donee was entitled to a predefined FLP percentage interest expressed through a formula. The court concluded that the transfer documents do not allow the petitioners to take property back. Instead, the documents correct the allocation of FLP membership units among the taxpayers and the donees because the appraisal of the FLP understates the FLP's value. Therefore, the court ruled that the formula clauses were valid.

This case is significant because under the formula clause, the reallocation of FLP units in the event of an understatement or overstatement of the amount transferred occurs between the donors and the donees. The previous cases validating formula clauses (i.e., Petter, Christiansen, and Hendrix v. Commissioner, T.C. Memo. 2011-133) contain formula clauses that reallocated closely held interests among the donees. Once the donors parted with the transfers, the formula clauses did not operate to reallocate any interest back to the donor. Charities were among the donees in these cases, so that any excess transfers over and above the specified dollar amount would be reallocated to the charity, making the excess transfer eligible for the gift tax charitable deduction under Section 2522. Thus, no unintended gift tax consequences were produced. The Tax Court's ruling in Wandry would alleviate the need to use a charity as a donee when using a formula clause.