Accountants and Business Advisers
Posted 20 Jul 12 by Allan Farrar
In these times of economic uncertainty, "earn-outs" are becoming more common in structuring of the purchase consideration for acquisitions. Clearly, one of the most significant risks for any potential acquirer is assessing how well a business will operate without its previous owner or founder.
To help mitigate this risk the acquirer, when possible, includes an "earn-out" as part of the acquisition agreement which, in turn, shifts a portion of the acquisition risk back to the vendor.
"Earn-outs" are also used as a means of bridging the valuation gap between vendor and purchaser and generally result in a deferral of part of the consideration pending achievement of performance targets.
Such earn-outs are typically based on earnings targets to be met by the acquired company post acquisition and are a strong incentive for vendors to ensure the continued performance of the business post their divestment. In many business combinations, the acquisition price is therefore not completely fixed at the time of the sale, but is instead dependent on the outcome of future events.
Under Accounting Standards, earn-outs are defined as a contingent consideration which must be measured and recognised at acquisition date and at fair value if any contingency is probable and can be reliably measured. If the contingent consideration includes a future payment obligation, that obligation is to be classified as either a liability or equity.
This classification between liability and equity can, in theory, significantly impact the buyer's post acquisition earnings. In practice, since most earn-outs are likely to be classified as a liability, any fair value adjustment will have to be recognised in earnings at each reporting period after the acquisition date until the arrangement is settled.
The uncertainty of the earn-out payment will therefore have to be assessed and accounted for by the acquirer at each reporting date. The implied earnings volatility technically re-introduces part of the acquisition risk initially mitigated via the earn-out back to the acquirer.
The adequate use of sound valuation methods and processes together with a flexible and adaptable valuation model will ascertain the fair value recognition of the contingency but also help to estimate earnings fluctuation. Accurately assessing, modelling, predicting and eventually recognising the earn-out risks in fair value from an early stage is the best defence against any earnings volatility.
The choice of valuation methods is therefore central. This choice ultimately depends on the complexity of the earn-out components and the availability of reliable financial information. The methods to be used may range from a market- based actualisation of estimated cash flows up to the use of "Monte Carlo" simulations.
A commonly used approach, in the case of cash settled earn-outs, is to develop a scenario analysis for future revenues above and below the target negotiated in the earn-out arrangement. Each scenario is assigned a probability and a weighted average earn-out is derived. Then the amount of earn-out is discounted based on market assumptions. This method is commonly adopted when performance outcomes of the target are uncertain.
When a discounted cash flow methodology is used, specific work also needs to be performed around risk, particularly the risk of achieving the revenue and the risk that the buyer may not be able to make the payment.
In the case of a share settled earn-out, deriving a probability-weighted average earn-out is usually not sufficient and the modelling of the share price will be needed to derive an adequate discount rate. This requirement is mainly due to the importance and quantity of factors affecting the outcomes of the share price returns such as the impact of future financial results, distributions and stock market volatility as a whole. Due to the multiplicity of uncertainties, this type of earn-out usually requires a valuation approach incorporating option pricing techniques to address the risks and evaluate the earn-out payment probability.
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