Earnouts are often used in transactions to bridge the gap between what a buyer is willing to pay up front and what a seller wants in the way of total compensation to complete a deal. Therefore, earnouts are typically constructed to allow the seller to enjoy additional upside if the acquired company reaches certain performance targets after the sale while providing the buyer with downside protection if the projected performance after the deal closes does not materialize. That said, practitioners must understand accounting rules that could result in an earnout not being deemed an earnout. The author discusses valuing and structuring earnouts.
I am pretty sure my first experience with earnouts came when sitting at the lunch table with my buddies in grade school.
“I bet you I can throw my sandwich wrapper into the trash can from here.”
“Yeah. I bet you a dollar.”
While transaction earnouts involve many more dollars than my story, as well as much more complex terms, the concept is generally the same— an earnout is a payment based on performance (akin to a “bet”). For example, a deal may include a $20 million cash payment and an earnout that calls for an additional five million dollars to be paid over the next two years if certain earnings before interest, taxes, depreciation and amortization (EBITDA) targets are met. Earnouts are often used in transactions to bridge the gap between what a buyer is willing to pay up front and what a seller wants in the way of total compensation to complete a deal. Therefore, earnouts are typically constructed to allow the seller to enjoy additional upside if the acquired company reaches certain performance targets after the sale while providing the buyer with downside protection if the projected performance after the deal closes does not materialize.
Valuing and Accounting for Earnouts
While earnouts are commonly used in transactions, many buyers are not aware that when they purchase a company in a deal that includes an earnout, Generally Accepted Accounting Principles (GAAP) require a liability for the earnout to be recorded on the balance sheet (GAAP often refers to earnouts as “contingent consideration”). To value the earnout, the likelihood of the earnout being achieved needs to be considered. For earnouts with high likelihoods of being realized and short payout periods, the recorded liability will generally be close to the maximum payment amount (albeit slightly lower than the maximum to account for the time value of money). For riskier earnouts that stretch over longer periods, consideration needs to be given to the risk of the earnout being achieved and the related amounts that could be paid. In these cases, the recorded earnout liability is typically much lower than the maximum amount that could be paid under the agreement.
Subsequent Accounting for Earnouts
Once an earnout liability is recorded on a company’s books, it must be adjusted to fair value as of each financial statement date (typically annually for privately-held companies and quarterly for publicly-traded companies) until the earnout period is complete. The difference between the actual payments and the earnout liability recorded as of the transaction date is run through the income statement as a gain or loss. This may bias acquirers to overstate earnout liabilities since they will be able to record a gain if the actual payments are less than those estimated when originally valuing the earnout liability.
When is an Earnout Not an Earnout?
We have had several clients who have recently been surprised to find out that there are certain instances in which what looks like an earnout is not treated as an earnout for accounting purposes. Let’s go back to our original example—a deal that includes a $20 million cash payment and an “earnout” that calls for an additional five million dollars to be paid over the next two years if certain EBITDA targets are met. If we throw in one additional wrinkle—the fact that the sellers must still be employed by the acquirer for a certain period (typically until the earnout payments are made)—GAAP precludes earnout treatment for these payments. Instead, the payments must be recorded as compensation expense, which can have a significant impact on earnings. It is important to keep this in mind when structuring earnouts and balance the benefits and drawbacks of this unique rule. Otherwise, the acquirer may end up having to record a much higher amount of future compensation expense for payments that would have otherwise been recorded as goodwill on the purchase date.
What to Remember
Earnouts often help buyers and sellers reach agreements that protect the interests of both parties. When an earnout is present in a deal, companies must be aware that they will likely need to record a liability equal to the fair value of the projected earnout payments. They must also keep in mind, however, that if the earnout payments are contingent on the seller’s future employment with the acquirer, traditional earnout treatment is typically thrown out the window for accounting purposes and the contingent payments are generally treated as a post-transaction expense.
About the AuthorSean R. Saari is a partner in Skoda Minotti’s Valuation and Litigation Advisory Services Group and is responsible for helping clients address their valuation, litigation support, tax, financial reporting, strategic planning and business advisory needs. He joined Skoda Minotti over 10 years ago and assists a diverse client base. He has authored more than 75 articles, e-books, blogs and whitepapers and is a regular speaker, both locally and nationally, on valuation, litigation support, accounting and tax issues. [This article was previously posted in QuickRead by NACVA (National Association of Certified Valuators and Analysts) in September, 2018.]