Healthcare and Basic Concepts on Valuing Earn-Outs – Part I
Given how common Healthcare merger and acquisition performance-based payouts are, we thought it’d be interesting to describe some of the features of an earn-out in the context of a healthcare provider acquisition. The valuation concepts will apply across all industries, however.
There is a baseline conceptual difference as to how valuation specialists think of contingent consideration versus how actual Buyers and Sellers approach the matter.
The accounting definition of contingent consideration under ASC 805, Business Combinations, is, “Usually an obligation of the acquirer to transfer additional assets or equity interests to the former owners of an acquiree as part of the exchange for control of the acquiree if specified future events occur or conditions are met. However, contingent consideration also may give the acquirer the right to the return of previously transferred consideration if specified conditions are met.”1 The accounting definition leads the valuation specialist to quantify the value of the earn-out or contingent liability using guidance provided in ASC 820, Fair Value Measurements.
From a Buyer/Seller perspective, earn-outs are typically part of a merger transaction whereby the Buyer initially only acquires a portion of the Seller with the remainder left in the hands of the Sellers or in virtual escrow by means of legal arrangement. These arrangements could include Put and Call provisions, which may require or allow parties to put or call the remaining interest at a later date for a price tied to a key-performance indicator (or KPI). For instance, a physician’s business may be purchased with some promise of additional consideration should the acquired practice’s total wRVUs post-transaction exceed some contractually stated threshold.
These arrangements generally form from one of two scenarios. One, both the eventual full acquisition of the Seller is a foregone conclusion and the earn-out provides additional upside to the Seller while the Seller helps the Buyer through the transition. Or two, there is trepidation on either the Buyer or Seller’s part, and the contingent liability may allow for a ripcord that unwinds the deal altogether. In either case, the thought processes Buyers and Sellers go through to calculate how much the contingent consideration is “worth” in real dollars is likely much different than how valuation specialists would estimate the liability’s Fair Value. As a result, and in extreme circumstances, the Fair Value of the contingent liability may be significantly more or less than that total contemplated transaction consideration estimated by Buyers and Sellers. These circumstances include poorly defined earn-outs, or terms that fail to contemplate the volatile nature of the target’s business.
But let’s start with a simple example demonstrating the basic disconnect. Let’s assume two healthcare providers are to complete a transaction. Company A buys Company T with the following terms:
- Company A receives 80 percent of Company T’s equity for 80 dollars; and
- If Company T earns more than $100 in sales in the next year, then Company A will pay Company T an amount equal to any revenue received over $100 with a maximum payment of $20.
For the purposes of this example, let’s make the following assumptions:
- Both entities have similar practices, in non-competing locations and are relatively the same size;
- Company T earned $125 in revenue last year; and
- Company T’s revenue was expected to be flat year-over-year.
To the layperson, it would appear that both Buyer and Seller felt it reasonable that Company T would make about as much money next year as this year, and the final 20 percent of the equity would be purchased for $20. This arrangement may be to entice certain physician owners or management to stay onboard through the transition. In this frame of mind, the CFO for Company A would simply think the liability is ‘worth’ $20.
However, a valuation specialist will likely take some probabilistic approach to Company T’s forecast including some consideration around the practice shake-up the acquisition causes, healthcare industry challenges, competitive forces and other matters which jeopardize the relatively benign assessment of Company T’s flat revenue predication. Additionally, the valuation specialist will adjust for risks to Company A’s expected payment including some default probability and the fact that this payment would likely be lower in priority to other obligations of Company A in the event of bankruptcy. Once applied in some sort of valuation framework, all these considerations may generate an expected liability in the low-teens depending on volatility and risk of the payer defaulting.
As a result, there is a conflict between the common-sense approach business people use to guess at the real future obligation (or income depending on who you are in the transaction), and the accountants seeking to report a liability consistent with the guidance.
Unfortunately, there is no easy resolution, and mergers in the Healthcare space are only increasing. We recommend that parties involved in the establishment of a contingent liability or earn-out as part of a merger or acquisition involve the proper accounting and valuation professionals upfront to avoid surprises. Further, once the TAF WG4 guides are available, we believe the wide-spread adoption of standard practices for valuing earn-outs and contingent liabilities will make the calculation and auditing process easier for everyone involved.
In our next article, we will dive into the valuation components of contingent liabilities, and further down the road walk-through some of the observed practice diversity.
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The information contained herein is not necessarily all inclusive, does not constitute legal or any other advice, and should not be relied upon without first consulting with appropriate qualified professionals for your individual facts and circumstances.
