Contingent consideration earnouts are a common mechanism used in private equity transactions to bridge valuation gaps between buyers and sellers. They involve additional payments to the seller based on the future performance of the acquired business. This approach helps manage uncertainty and aligns the interests of both parties.
What Are Contingent Consideration Earnouts?
Earnouts are typically structured as a part of the purchase price in a merger and acquisition transaction. They stipulate that the seller may receive additional compensation if certain performance targets are met post-acquisition. These targets can be based on various metrics such as revenue, EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) or other financial indicators.
The primary purpose of earnouts is to address differing expectations about the future performance of the business. Sellers may believe the business will perform exceptionally well, while buyers might be more conservative in their estimates. Earnouts allow the final purchase price to be adjusted based on actual performance, thus mitigating risk for both parties.
Fair Value Considerations
In the overwhelming majority of cases, earnouts are liability classified. Liability classified earnouts must initially be recognized at fair value on the date of the transaction and subsequently remeasured each reporting period. Subsequent remeasurements of liability classified earnouts are run through a Company’s income statement. The ASC 820 fair value hierarchy categorizes inputs into three levels: Level 1 includes observable inputs like quoted prices in active markets, Level 2 includes inputs other than quoted prices that are observable and Level 3 includes unobservable inputs that rely on the entity’s own assumptions. Earnouts are typically classified as Level 3 because they depend on future performance metrics and other unobservable inputs, making them inherently subjective and less reliable. It is common practice for a Company to engage a valuation specialist to initially provide a fair value estimate of the liability an acquirer will assume as part of the purchase accounting process. Finally, contingent consideration liabilities are recognized on the books of the acquirer and not pushed down to the acquired company during the application of push-down accounting. However, in rare cases where the acquiree has the legal obligation to repay the consideration, such as compensation earn-outs, the contingent consideration will reside on the books of the acquiree.
Auditing Earnouts: Preparing for Your Annual Financial Statement Audit
Auditing earnout valuations is a complex process that requires a thorough understanding of the agreement and the business’s historic and projected financial performance. As part of the financial statement audit process, your auditor will aim to ensure that earnout valuation calculations are accurate and comply with applicable accounting standards by doing the following:
- Reviewing Agreements: Document retention is key. An audit firm will start by reviewing the earnout section and clauses of the purchase agreement to understand the performance targets, measurement period and payment structure. It's recommended that management maintain all documents associated with an acquisition in a centrally located finance folder. A lack of easily accessible agreements, including amendments, can lead to audit delays.
- Assessing Underlying Performance Metric Assumptions: The audit firm will assess underlying historical financial data for completeness and accuracy and projected financial data for reasonableness. Management can expect various inquiries from auditors surrounding growth factors utilized to calculate projections used as the underlying basis of the projection model by the Company’s valuation specialist. This may include inquiring of management regarding the attainment of new contracts to support revenue growth factors, or asking management of a Company to substantiate an EBITDA growth factor through providing examples of cost cutting measures put into place by the Company. Management should ensure that the underlying assumptions are developed accurately and not rely purely on the outcome of results as they may be caused by other factors.
- Assessing Guideline Public Companies: The audit firm will verify the guideline public companies utilized in the valuation are in the same industry and share similar characteristics with the Company. Management should first review the guidelines public companies utilize by their specialist to ensure they are comparable to their Company, as the underlying data of these guideline public companies will be utilized in the valuation.
Contingent consideration earnouts are a valuable tool in private equity transactions, helping to align the interests of buyers and sellers and manage uncertainty about the future performance of the acquired company. Navigating the audit of an earnout requires careful attention to detail and a thorough understanding of the agreement and underlying financial metrics and company forecasts utilized. It is important for management to be both prepared and organized when navigating acquisitions, as it will best prepare them for subsequent audit scrutiny.
Author: Michael Tiplady, CPA | [email protected]
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For more information on this topic, reach out to Withum’s Private Equity Portfolio Services Team.
