Active deferred consideration: Meaning, Criticisms & Real-World Uses

What Is Active Deferred Consideration?

Active deferred consideration refers to a payment obligation in a business acquisition that is contingent upon the acquired entity or business achieving specific future performance targets or milestones. It is a key component within the broader field of Mergers and Acquisitions (M&A) accounting and corporate finance, particularly in complex business combinations. This type of payment, often structured as an "earnout," incentivizes sellers to remain involved and ensures that the buyer's ultimate purchase price aligns with the future success of the acquired assets. Active deferred consideration is initially recognized at its fair value on the acquisition date.

History and Origin

The concept of contingent payments, including what is now known as active deferred consideration or earnouts, gained prominence in mergers and acquisitions as a mechanism to bridge valuation gaps between buyers and sellers. When there is uncertainty about the future performance or true worth of a target company, especially in industries with long development cycles (like pharmaceuticals) or volatile market conditions, earnouts provide a flexible solution. Parties to M&A transactions often agree to make payments to target shareholders contingent upon post-closing measures, such as earnings, net income, or gross revenue⁴. This approach allows the buyer to mitigate risk by deferring a portion of the payment until the acquired entity demonstrates the expected performance, while offering the seller the potential for a higher overall consideration if the targets are met.

Key Takeaways

Active deferred consideration is a contingent payment in an acquisition, typically based on future performance or milestones of the acquired entity.
It serves to align the interests of the buyer and seller and to mitigate valuation uncertainties in complex deals.
These payments are initially recognized at fair value as a liability on the acquisition date.
Subsequent changes in the fair value of active deferred consideration are generally recognized in profit or loss.
Often referred to as earnouts, these arrangements can be tied to financial metrics like revenue or EBITDA, or specific non-financial milestones.

Formula and Calculation

The calculation of active deferred consideration typically involves a pre-defined formula outlined in the acquisition agreement. While the specific formula varies widely depending on the deal, it often looks like this:

P_C = f(M_1, M_2, ..., M_n)

Where:

(P_C) = The contingent payment amount (active deferred consideration)
(f) = A function or formula, often involving percentages, multiples, or tiered thresholds
(M_1, M_2, ..., M_n) = Specific performance metrics (e.g., Revenue, EBITDA, regulatory approvals, customer retention) over a defined earnout period.

For instance, if the earnout is based on achieving a certain revenue target, the formula might be:

P_C = \text{Percentage} \times (\text{Achieved Revenue} - \text{Base Revenue Target})

Or, for a milestone-based payment, the formula might be simpler:

P_C = \text{Fixed Amount if Milestone Achieved}

The initial fair value of this contingent payment at the acquisition date is determined by estimating the probability of achieving the performance targets and discounting the expected future payments back to the present.

Interpreting Active Deferred Consideration

Interpreting active deferred consideration involves understanding its implications for both the buyer and the seller. For the buyer, it represents a commitment to pay a potentially significant sum in the future, subject to the acquired business performing as expected. This aligns with the buyer's initial valuation assumptions. If the targets are not met, the buyer's total outlay for the acquisition is reduced, serving as a risk mitigation tool. Conversely, if the targets are exceeded, the buyer pays more but presumably benefits from a more successful acquisition.

For the seller, active deferred consideration offers the opportunity to realize a higher sale price than a fixed upfront payment might provide, particularly if they have strong confidence in the future performance of the business. However, it also introduces uncertainty; the seller's ultimate proceeds depend on post-acquisition factors, some of which may be outside their direct control if they no longer manage the business. The accounting treatment also requires careful attention, as it directly impacts the acquiring company's financial statements.

Hypothetical Example

Imagine Company A acquires Company B for an initial payment of $50 million. As part of the deal, they agree to an active deferred consideration clause: Company A will pay an additional $10 million if Company B's net profit reaches $5 million in the first full fiscal year post-acquisition.

Initial Recognition: On the acquisition date, Company A's accountants assess the probability of Company B achieving the $5 million net profit target. Based on a detailed analysis and projections, they determine there's an 80% chance of reaching this target. The fair value of the active deferred consideration at acquisition date might be estimated as ( $10 \text{ million} \times 0.80 = $8 \text{ million}). This $8 million is recognized as a liability on Company A's balance sheet.
Post-Acquisition: One year later, Company B's net profit hits $6 million, exceeding the $5 million target.
Payment and Adjustment: Company A now owes the full $10 million. The initial recognized liability of $8 million is adjusted to $10 million, with the $2 million increase typically recognized as an expense or loss in the current period's income statement. Company A then pays the $10 million, settling the active deferred consideration obligation.

Practical Applications

Active deferred consideration, primarily in the form of earnouts, is widely used in Mergers and Acquisitions (M&A) transactions to bridge gaps in valuation and align stakeholder interests. These provisions are particularly common when:

Valuation Uncertainty: The acquired business is new, rapidly growing, or operates in a volatile market where traditional valuation methods may be insufficient. Life sciences and technology companies often use earnouts due to the uncertain nature of product development and regulatory approvals. For example, Biogen's acquisition of Reata Pharmaceuticals for approximately $7.3 billion included contingent elements related to the acquired company's drug development pipeline³.
Performance Incentives: The seller's management team is crucial to the continued success of the acquired business and will remain involved post-acquisition. The earnout structure incentivizes them to achieve specific performance metrics, such as reaching certain revenue or profitability goals.
Funding Gaps: Buyers may use active deferred consideration to reduce the initial cash outlay required for an acquisition, making larger deals more feasible.
Regulatory Milestones: In industries like pharmaceuticals, payments may be contingent on achieving specific regulatory milestones, such as drug approval by bodies like the FDA.

Under accounting standards such as IFRS 3, "Business Combinations," contingent consideration is recognized at its fair value at the acquisition date². Subsequent changes in this fair value are generally recognized in profit or loss, impacting the acquiring company's financial statements.

Limitations and Criticisms

Despite their utility in M&A transactions, active deferred consideration arrangements present several limitations and are subject to criticism. One primary concern is the potential for disputes between the buyer and seller over the calculation and achievement of performance targets. The buyer, now in control of the acquired business, may have incentives to manage the operations in a way that minimizes the earnout payment, for instance, by accelerating costs or delaying revenue recognition¹. Conversely, sellers, particularly if they remain involved, might prioritize short-term gains to trigger earnout payments, potentially at the expense of the long-term health or strategic objectives of the business.

Another limitation is the complexity involved in drafting clear and comprehensive earnout clauses. Ambiguities can lead to disagreements over accounting policies, operational control, and access to information required for verifying performance metrics. For example, the interplay between the buyer's ongoing operational decisions and the seller's earnout expectations can create tension. Furthermore, the valuation and subsequent remeasurement of active deferred consideration can be complex, requiring significant judgment and potentially impacting reported goodwill and earnings.

Active Deferred Consideration vs. Purchase Price Adjustment

Active deferred consideration and a purchase price adjustment are both mechanisms that modify the final amount paid in a business acquisition, but they differ significantly in their nature and purpose.

Active Deferred Consideration (Earnout): This involves future payments contingent on the acquired business achieving specific performance targets or milestones after the closing of the deal. Its primary purpose is to bridge valuation gaps and incentivize future performance. The amount of the payment is uncertain at the time of closing and depends on future events. For instance, an additional payment if the company hits a certain EBITDA target in the next two years is active deferred consideration.

Purchase Price Adjustment (PPA): This is an adjustment to the initial purchase price based on a review of the target company's financial metrics (such as working capital, cash, or debt) as of the closing date (or a specified date shortly before or after closing). The purpose of a PPA is to ensure that the buyer receives a business with the expected level of assets and liabilities, based on an agreed-upon balance sheet target. It's a true-up mechanism, not an incentive for future performance. For example, if the actual working capital at closing is less than the target, the purchase price might be reduced accordingly.

In essence, active deferred consideration looks forward to future performance, while a purchase price adjustment looks backward to verify the state of the business at or around the closing.

FAQs

What is the main purpose of active deferred consideration?

The main purpose of active deferred consideration is to align the interests of the buyer and seller in an acquisition and to manage valuation risk. It allows the buyer to pay a portion of the purchase price only if the acquired business meets certain predefined future performance goals or milestones.

How is active deferred consideration accounted for?

Active deferred consideration is recognized as a liability or, in some cases, equity interests, at its fair value on the acquisition date. Subsequent changes in its fair value are generally recognized in the income statement as profit or loss, unless classified as equity.

Is an earnout the same as active deferred consideration?

Yes, "earnout" is a common term used to describe active deferred consideration. Both refer to contingent payments made by an acquirer to former owners based on the future performance of the acquired business.

What types of metrics are typically used for active deferred consideration?

Common metrics include financial targets such as Revenue, Gross Profit, EBITDA, or Net Income. Non-financial milestones, like regulatory approvals for new products, successful integration of technologies, or specific project completions, can also be used, particularly in specialized industries.