Best practices for valuing contingent consideration

Contingent consideration, also referred to as an earnout, is commonly used to bridge a valuation gap, provide continuing incentive to business sellers or account for the achievement of technical or other milestones.

Under Statement of Financial Accounting Standards 141, the value wasn’t recognized until paid. Beginning with SFAS 141R and now under Accounting Standards Codification Topic 805, contingent consideration is recognized at fair value as of the transaction date, and subsequent changes to fair value are accounted for via the income statement. The recent exposure draft, Valuation of Contingent Consideration, developed by the Valuation in Financial Reporting Working Group 4 of the Appraisal Foundation, expands and crystalizes valuation best practices.

Background

Historically, many earnouts were valued using the amount implied by the deal model. However for earnouts where the payment is “asymmetric,” meaning there are ceilings and floors to the payments, the expected forecast may not yield the expected earnout payment.

Consider the following example where the contingent payment is year 1 earnings before interest, tax, depreciation and amortization times 6 minus $240 million with no payment occurring below EBITDA of $40 million and a payment cap of $150 million, which occurs at EBITDA of $65 million. Assuming the probabilities below are estimated accurately, the expected payment is $110 million while the payment implied by the expected EBITDA is $120 million. In practice, the divergence may be even greater.

Asymmetric Payment Structures and an Option-Based Approach

To accommodate asymmetric payment structures, practice evolved into use of multiple forecast scenarios which were probability weighted. However, developing multiple forecasts with appropriate weighting is incrementally challenging and subjective. Additionally, it is difficult to estimate an appropriate risk adjusted discount rate for leveraged payouts because there isn’t a simple and accepted approach like CAPM. Moreover, the implied discount rates may be counterintuitive, such as greater than 100 percent. For the reasons above, the current best practice is use of an option-based approach for earnouts that are based on financial metrics such as revenue or EBITDA (referred to by the document as “non-diversifiable” because they are exposed to market risks). An important exception is contingent consideration based on technical milestones or other non-market (“diversifiable”) risks, such as a new drug passing a clinical trial. Such contingent consideration has no market risk exposure. In order to estimate the fair value of such an earnout, one needs to estimate the expected earnout payment by adjusting for probabilities, and then discount the expected payment with a discount factor that only accounts for the ability to pay and the time value of money. Where applicable, there is often historical data appropriate to estimate the probability, such as the likelihood of a given drug passing Stage 2 clinical trials.

In revisiting the previous example, notice that the earnout’s payment structure is similar to the payment from the purchase of a call option with a $40 million strike price and the sale of a call option with a $65 million strike price. Use of an option based approach, in this case a Black Scholes formula, is appropriate.

The following calculation estimates the value of the earnout as the aggregate value of a long call with a strike price of $40m and a short call with a strike price of $65. Though beyond the scope of this alert, any option valuation method assumes a risk neutral framework, which is a means of accounting for the market risk of non-linear payout structures and removing the need for a direct estimate of the risk adjusted discount rate.

In this case, the expected payment under the option based approach is lower than that implied by the deal model. This typically occurs when the forecast metric is closer to the cap than the floor and thus for any variation in the forecast, there is more downside to the payment than upside. The inverse can also occur.

More complex earnout structures are also possible, for instance a payment that is based on EBITDA in each of three years with a catch up in the final year for amounts not earned in prior years. In these cases, referred to as path dependent because the payment in the final year depends upon financial performance in prior years, a more complex Monte Carlo simulation is required.