Published on April 1, 2021 by Abhishek Gupta
M&A strategies are driven by the desire to enhance market position, expand into new markets, reduce costs and gain talented management or staff. These strategic drivers may lead to purchase agreement terms that are more complex than the cash payment of the asking price on the acquisition date. From a buyer’s perspective, the buyer may not want to pay the entire price upfront if there are significant uncertainties associated with the acquired business or the value of the acquired business depends on key management personnel. Upfront payment of cash may transfer too much risk to the buyer. In contrast, the seller would want to get the full benefit of selling the company and would not want to discount the purchase price even if the buyer is uncertain. The seller could get the full benefit by contributing to and participating in the growth of the company and, thereby, earning an agreed pay-out once targets are achieved within the stipulated timeframe.
When negotiating the purchase price of a business, contingent considerations are often used to bridge the price gap between what the seller would like to receive and what the buyer would like to pay.
What is an Earn-out and why does it exist?
ASC 805 and IFRS 3R define contingent consideration usually as being an obligation of the buyer to transfer additional assets or equity interests to the former owners of the seller as part of the exchange for control of the seller if specified future events occur or conditions are met (an “Earn-out”).
More generally, an Earn-out can be defined as a portion of the purchase consideration based on the outcome of future events. These events are usually based on a performance metric of the target company, resulting in a mechanism for adjusting the initial consideration for future performance. For example, additional consideration may be paid if the acquired business meets certain targets (such as future revenue, margin and profit targets), passes regulatory reviews, has successful litigation outcomes, meets covenants or completes product development.
Earn-outs have always been and will likely remain an indispensable component of M&A transactions. One of the major challenges for buyers and sellers in an M&A transaction is overcoming the price gap, primarily due to the difference in the buyer’s and the seller’s growth-/expansion-related expectations, more so for start-ups and early-stage companies. As a result, buyers expect lower valuations, while sellers lean on recent performance and expected recovery as the baseline. This gap in expectations has clouded current M&A activity, compressing the price for sellers and creating uncertainty for buyers. A key mechanism to address this gap is the Earn-out.
Earn-outs include performance metrics – financial metrics such as net income, EBITDA, revenue and equity value – or certain metrics independent of broader market risks such as passing a clinical drug trial.
If used properly, Earn-outs can be very successful for buyers and sellers, enabling deals that may otherwise fail, allowing buyers to calculate the price paid for a business based upon its actual performance after completion, and allowing sellers to maximise the price achievable on a sale.
M&A and Earn-outs in the current environment:
The worst health crisis in more than a century, according to Dr Ghebreyesus, Director of the World Health Organization, and a sudden, deep economic recession have created a volatile environment for businesses across industries and the most uncertain M&A landscape in decades. Companies are facing uncharted waters in these uncertain times that have presented increased M&A opportunities as companies seek both stability, by restructuring or right-sizing their organisations, and growth, as customer and market landscapes continue to shift. Compared to organic efforts, deals can be a faster and more efficient way to bring change, especially in an unstable environment. This strategic imperative to change and adapt quickly in this new environment means M&A activity could potentially recover more quickly than the overall economy in the months ahead. Interest in Earn-outs as part of M&A has increased since mid-June 2020 and is expected to grow, with Earn-outs increasing over the next several months as buyers and sellers navigate the post-pandemic M&A landscape.
The pandemic era has seen a huge shift from the more common revenue-based Earn-outs to EBITDA-based Earn-outs, driven by a buyer’s concern over the target’s ability to achieve overall profitability in the future. Another shift has been seen in terms of the length of the Earn-out period. Given that we do not know how long the current uncertainty will last, most parties are pushing for longer-duration Earn-outs. On one hand, these allow more time to manage the impact of the pandemic; on the other, they make it more difficult to measure the upfront amount to be paid by the buyer and increase the desire for more flexible terms to accommodate unpredictable changes.
Both these factors could increase the risk of dispute and should be considered. Interim reporting of Earn-out results to sellers can sometimes help expedite the resolution of issues/questions, but could also increase the administrative burden on buyers and cause further questions if subsequent adjustments are needed to the interim results.
Earn-out valuations – challenges:
“As part of the initial recognition and measurement requirements under Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 805 – Business Combinations (ASC 805) and International Financial Reporting Standards (IFRS) Standard 3 Business Combinations (Revised) (IFRS 3R), contingent consideration included in a business combination must be measured at fair value as of the acquisition date.”
The valuation of an Earn-out is inherently challenging due to (a) estimation of future scenarios and corresponding probabilities relating to the underlying performance metric, i.e., the probability distribution, and (b) dependence on the occurrence of future events and the often non-linear/complex structure of the payoff functions.
It has also been an area for which limited guidance exists, and special attention is required in terms of valuation methodologies to be used, calculations of performance metrics, volatility, credit spread, and discount rate, etc., and treatment of non-recurring/one-time adjustments. Amid the uncertainty, valuation needs to be treated with care because Earn-outs could be a recipe for significant disagreement and dispute after completion.
Author’s insights on best practices for Earn-out valuations and key inputs:
We rely on scenario-based valuation models in scenarios where either the performance metric is independent of the broad economy/market risks, e.g., regulatory or non-financial milestones, or when the pay-off is strictly linear, e.g., percentages of revenue or EBITDA
A number of valuation professionals use scenario-based models for non-linear/asymmetric pay-offs based on a single performance metric and period. We rely on adjusted option pricing models, as they correctly capture the pay-off structure and also eliminate subjective decisions related to probabilities and forecasts
We rely on stochastic models such as Monte Carlo simulations for complex path-dependent scenarios with multiple performance metrics/periods where the pay-off for one performance metric/period changes based on the occurrence of others, e.g., aggregate caps/floors, threshold catch-up amount in the final year for amounts not earned in prior years
Valuation techniques that rely on option pricing models or Monte Carlo simulation require the volatility of the performance metric. Amid this high level of uncertainty, it becomes really important to correctly identify the peer companies. We at Acuity Knowledge Partners use the most recently available financial data for re-levering volatility, which is adjusted for the term due to the short-term nature of Earn-outs
Using a correct volatility measure is very important for valuations depending on performance metrics, as it can impact the fair value to a large extent. We take this into account in our analyses and use equity volatility for equity value-/net income-based Earn-outs, asset volatility for enterprise value-/EBITDA-/EBIT-based Earn-outs and asset volatility adjusted for operational leverage for revenue-based Earn-outs
While there are multiple approaches to estimating the discount rate applied on the risk of the performance metrics (i.e., forecasts), we rely on either a top-down or bottom-up approach
In the top-down approach, the discount rate is the deal’s rate of return adjusted for the difference in market risk between the performance metric and the overall enterprise value. Adjustments reflect many factors, such as the general risk of the performance metric, leverage, term, size premium, and company-specific risk. In the bottom-up approach, the discount rate is the performance metric adjusted for the term, size, company-specific risk and other relevant valuation factors. Since the bottom-up approach relies on a statistical analysis of the performance metric from the company or its peers, we use statistical tools to estimate this
We make sure the discount rate applied on the risk of the performance metrics is adjusted for the term of the Earn-out and is applied using a mid-period convention, as it captures the actual risk with the underlying variable, which is typically achieved over the whole period. The mid-period convention essentially assumes uniform earnings of financial metrics and fixes a particular point during the year when the entire value of the yearly metric is assumed to be realised
Earn-out pay-offs are typically a junior subordinated, unsecured obligation of the company. As such, they should be discounted based on a rate that would be applied for such an obligation. There are, however, a few noteworthy exceptions. One is if the payment is held in an escrow account, guaranteed or provided through a senior security
We estimate the discount rate to be used for Earn-out pay-offs as the sum of the risk-free rate and the credit spread (reflecting the credit risk of the buyer)
Credit spread estimation becomes really complex when the companies are not rated. In such cases, use of an appropriate shadow credit rating model is recommended. Credit spread can be estimated from multiple sources such as Bloomberg or Reuters, using the credit spread data for publically traded companies for all credit ratings
We make sure the credit spreads are adjusted for the term of the Earn-out and, most importantly, for seniority (a junior subordinated, unsecured obligation). We prefer to use a statistical risk-neutral valuation model for adjustment of credit spread for seniority. However, many valuation professionals use an approximation, i.e., a credit rating notch-down approach, for this
We at Acuity Knowledge Partners make sure the Earn-out valuations are aligned with the broader valuation for purchase price allocation. For example, the average projection used is the same as that used in the deal model. The discount rate, likewise, is consistent with the company as a whole, adjusting for metric and time differences. Similar adjustments are made for size, and company- and country-specific risk
How Acuity Knowledge Partners can help
With the continuously evolving M&A transaction structures and valuation methodologies, our dedicated team of experienced professionals with deep domain knowledge and extensive financial modelling and valuation capabilities help clients derive the fair value of Earn-outs associated with M&A transactions across multiple industries and sectors. We also support clients on multiple business combinations/purchase price allocation engagements under ASC 805 and goodwill impairment engagements under ASC 350 for tax and financial reporting purposes. Additional key services we offer include valuation of complex financial instruments, Section 409A, fair value measurements, stock-based compensation, legal entity valuations, and portfolio valuations.
Our years of experience in valuing instruments using comprehensive financial modelling and up-to-date valuation techniques have helped us develop best practices and consider all scenarios.
For more details, please visit our Valuations page.
1) Guide to Business Combinations: AICPA's Guide to Business Combinations, Goodwill, and Other Consolidation Issues
2) The Appraisal Foundation Financial Reporting Valuation Advisory for Contingent Consideration
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About the Author
Assistant Director, Investment Banking
Abhishek holds over 10 years’ total experience, leading and supervising a wide range of valuation projects in compliance with various accounting standards, such as ASC 820 (loan portfolios, debt and related embedded derivatives and convertible notes), IRC 409A (preferred stocks, common stocks, options, warrants, incentive units, etc.), ASC718/IFRS2 (PSUs, MIUs, profit interests and ESOPs) and ASC805/IFRS 3 (contingent considerations).
Prior to joining Acuity Knowledge Partners, Abhishek worked at higher managerial levels with Ernst and Young and Credit Suisse, and assisted alternative asset managers and corporates on various valuation-related assignments. He has significant experience in developing complex statistical and probabilistic valuation models, such as Black-Scholes, Binomial Lattice, Hull-White, Longstaff-Schwartz and Monte Carlo simulations. He is proficient in different pricing valuation techniques used for complex financial securities, minority and controlling interest equity valuations, and OTC products (exotic options, cross-currency/interest-rate swaps, etc.)
Abhishek has also carried out Structured Trade Reviews (STRs) and Independent Price Verification (review of complex trades using risk-based testing processes, such as yield curve testing, OPA analysis for FX and rate products).
He holds a Bachelor of Technology (Mechanical and Automotive Engineering) from Thapar University.
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