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Rich and Co.

Earnouts as Part of Total M and A Transaction Value

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An earnout is a form of contingent consideration that is often included as part of the purchase price of a company in which there is a valuation gap between the buyer and seller.

Prior to the new accounting standards, earnouts were not included in the purchase price and any subsequent cash payment would simply increase the goodwill account. In the new fair value world, the manner in which earnouts are valued and initially recorded will have a direct effect on a company’s income statement. Therefore, it’s important for all involved to have an understanding of how earnouts are valued.

The earnout serves to bridge this gap by rewarding the seller upon achievement of performance metrics, milestones, etc.In accordance with GAAP, the acquirer must value the earnout, include it as part of the purchase price, and record the value of the earnout as a contingent liability on the balance sheet.This liability needs to be revalued every period until the earnout period has ended and all changes in the value flow through the income statement.  This new requirement, effective as of December 15, 2008, has increased the complexity of the purchase price allocation process.

How Do You Value An Earnout?
Typically, earnouts are structured based on achievement of revenue, gross profit, or EBITDA targets.

Therefore, a natural starting point is to look at the acquired company’s forecasted financial metric(s) and compare it to the earnout target(s).

In the example of an earnout based on achieving an EBITDA target, if the forecasted EBITDA is above the target for the earnout, it is likely that the earnout will be paid. There may be an inclination to value the earnout by simply discounting the earnout payment using a present value technique. However, this may potentially overstate or understate the value of the earnout because it’s not taking into account the various potential scenarios for EBITDA. It is often more appropriate to use a scenario analysis in which multiple EBITDA scenarios are developed and then probability-weighted. This is especially useful when the earnout is based on different tranches. For example: $5MM would be paid if EBITDA is between $1MM – $3MM, $7.5MM would be paid if EBITDA is between $3MM – $5MM, and $10MM would be paid if EBITDA is above $5MM. In this example, if EBITDA was forecasted to be $4.5MM, simply taking the $7.5MM payment for that EBITDA tranche and present valuing it would understate the value of the earnout. The scenario analysis would be more appropriate in this example because the earnout payment would be $10MM if the acquired firm exceeds its forecasted EBITDA by only $500K. In addition, there are other valuation techniques such as option pricing models and simulations which can be particularly helpful when dealing with more complex earnout structures. One such option pricing model is a binomial (or lattice) model. A binomial model is depicted in a tree in which there are two movements (up and down) from a starting point. Its advantages include its flexibility and ease of interpretation. A Monte Carlo simulation uses stochastic techniques that allow even greater flexibility. However, the Monte Carlo simulation is complex and requires high level statistical analysis and often is difficult to understand and interpret.

Prior to the new accounting standards, earnouts were not included in the purchase price and any subsequent cash payment would simply increase the goodwill account. In the new fair value world, the manner in which earnouts are valued and initially recorded will have a direct effect on a company’s income statement. Therefore, it’s important for all involved to have an understanding of how earnouts are valued. 

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Written by Rich and Co.

December 27, 2011 at 9:02 pm

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