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Contingent consideration

What Is Contingent Consideration?

Contingent consideration refers to an obligation of an 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. This financial arrangement is a common feature in mergers and acquisitions (M&A) and falls under the broader category of corporate finance, particularly within business combinations. Contingent consideration can also represent the acquirer's right to receive a return of previously transferred consideration if certain conditions are not fulfilled.

History and Origin

The use of contingent consideration in M&A transactions gained prominence as a mechanism to bridge valuation gaps between buyers and sellers, particularly in situations involving significant uncertainties about the future performance or value of the target company. As M&A activity grew, especially in industries with unpredictable revenue streams or regulatory hurdles, such as biotechnology or technology startups, buyers sought ways to mitigate risk. Sellers, on the other hand, aimed to secure a higher ultimate sale price if their projections materialized.

Accounting standards have evolved to provide guidance on how to recognize and measure contingent consideration. For instance, International Financial Reporting Standard (IFRS) 3, Business Combinations, outlines specific requirements for its accounting treatment. IFRS 3 generally mandates that contingent consideration be recognized at its fair value at the acquisition date, consistent with the valuation of other forms of consideration in a business combination.4

Key Takeaways

  • Contingent consideration is an additional payment or receipt in M&A deals, dependent on future events or performance metrics.
  • It is recognized at fair value on the acquisition date and subsequently remeasured if classified as a financial liability, impacting profit or loss.
  • These arrangements help bridge valuation gaps between buyers and sellers, especially when there are uncertainties about the acquired business's future.
  • Common payment triggers include revenue, EBITDA, or specific non-financial milestones.
  • Proper accounting and legal structuring are crucial due to the complexities involved.

Interpreting the Contingent Consideration

Interpreting contingent consideration involves understanding both its initial recognition and subsequent measurement. At the time of a business combination, contingent consideration is initially measured at its fair value. This fair value estimate incorporates the probability of achieving the specified conditions and the potential payout amounts.

After the acquisition, the accounting treatment depends on whether the contingent consideration is classified as an asset, a liability, or equity interests. If it is a financial liability, its fair value is typically remeasured at each reporting date, with any changes recognized in profit or loss. This means that future financial results of the acquiring company can be impacted by fluctuations in the estimated fair value of the contingent consideration, reflecting changes in the likelihood or magnitude of the future payment. Conversely, if classified as equity, it is not subsequently remeasured, and its settlement is accounted for within equity.

Hypothetical Example

Imagine TechInnovate, a large software company, acquires StartupX, a small AI firm, for an upfront payment of $50 million. As part of the deal, TechInnovate agrees to pay an additional contingent consideration of up to $20 million if StartupX's flagship AI product achieves 1 million active users within two years of the acquisition. This earn-out clause serves as contingent consideration.

At the acquisition date, TechInnovate's accountants, in conjunction with valuation experts, assess the probability of StartupX reaching the 1 million user milestone. They estimate a 60% chance of success and determine the present value of the potential $20 million payout, discounted for the two-year period, to be $10 million. This $10 million is recognized as a liability on TechInnovate's balance sheet and factored into the overall cost of the acquisition, impacting the calculation of goodwill.

One year later, StartupX's user growth significantly exceeds expectations, and it appears almost certain to hit the target. TechInnovate reassesses the contingent consideration. The fair value of the potential payout might increase to $15 million due to the higher probability and shorter time to payment. This $5 million increase in the liability would be recognized as an expense in TechInnovate's financial statements for that period.

Practical Applications

Contingent consideration is widely applied across various sectors, most notably in private mergers and acquisitions. It is particularly prevalent in situations where there is high uncertainty regarding the target company's future performance or where buyers and sellers have differing views on the target's valuation.

  • Technology and Biotechnology: In these sectors, contingent consideration often hinges on achieving specific milestones such as regulatory approvals (e.g., FDA approval for a new drug), patent grants, or reaching certain user adoption metrics.
  • Private Equity Exits: Private equity firms frequently utilize earn-out provisions when divesting portfolio companies. This allows them to maximize their return if the company continues to perform well post-acquisition, while also making the deal more palatable for buyers. Earn-out payments were included in deals totaling $26.86 billion globally between January 1 and June 19, 2023, with private equity exits accounting for over 22% of that total.3
  • Tax Planning: For sellers, the receipt of contingent payments can have significant tax implications. The Internal Revenue Service (IRS) provides guidance on reporting income from contingent payment sales, which are a type of installment sale where the total selling price cannot be determined by the end of the tax year of the sale.2

Limitations and Criticisms

While contingent consideration can be a valuable tool in M&A, it comes with several limitations and criticisms. One significant challenge lies in the complexity of its accounting and valuation. Determining the fair value of contingent consideration at the acquisition date, and subsequently remeasuring it, requires subjective judgments about future outcomes and probabilities. This can lead to variability and potential inconsistencies in reported financial results. Accounting bodies have also debated the appropriate measurement and recognition of changes in the fair value of contingent consideration, particularly concerning whether gains or losses should be recognized in profit or loss or other comprehensive income.1

Furthermore, contingent consideration arrangements can lead to post-acquisition disputes between the buyer and seller. Disagreements often arise over the calculation of the earn-out metrics, the buyer's operational control over the acquired business during the earn-out period (which can influence performance), or the seller's continued involvement. These complexities necessitate meticulously drafted legal agreements and often require robust due diligence to anticipate and mitigate potential conflicts.

Contingent Consideration vs. Earnout

The terms "contingent consideration" and "earnout" are often used interchangeably, and in many contexts, an earnout is indeed a form of contingent consideration. The primary distinction lies in their breadth:

  • Contingent Consideration is the broader accounting and financial term. It refers to any future payment or receipt whose value or occurrence depends on specified future events. This can include earn-outs, but also other arrangements like indemnification clauses or clawback provisions where payment might be returned to the acquirer. From an accounting perspective, contingent consideration is generally classified as a financial instrument, liability, or equity.
  • Earnout is a specific type of contingent consideration, almost exclusively used in mergers and acquisitions. It is a contractual provision where the seller receives additional payments in the future based on the acquired company meeting certain predetermined performance targets (e.g., revenue, EBITDA, or product milestones) over a specified period. The term "earnout" focuses on the "earning" of additional payments by the seller based on post-acquisition performance.

While all earnouts are contingent consideration, not all contingent consideration arrangements are earnouts. The confusion often arises because earnouts are the most common and well-known type of contingent consideration in M&A deals.

FAQs

What is the main purpose of contingent consideration in an acquisition?

The main purpose is to bridge the valuation gap between a buyer and a seller when there is uncertainty about the future performance or value of the acquired business. It allows the buyer to pay less upfront, and the seller to receive more if the business performs well.

How is contingent consideration recorded on financial statements?

Contingent consideration is initially recognized at its fair value on the acquisition date as part of the overall consideration transferred. It is typically recorded as a liability on the acquirer's balance sheet. Subsequent changes in its fair value, if classified as a financial liability, are recognized in the income statement as a gain or loss.

Can contingent consideration be an asset?

Yes, while typically a liability, contingent consideration can be an asset if the arrangement gives the acquirer the right to a return of previously transferred consideration should specified conditions not be met. This means the acquirer could receive a payment back from the seller.

What are common triggers for contingent consideration payments?

Common triggers include financial performance metrics such as achieving specific revenue, gross profit, or EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) targets. Non-financial milestones like securing regulatory approvals, successfully launching a new product, or reaching a certain customer base can also serve as triggers.

Does contingent consideration always lead to a payment?

No. Whether a payment is made depends on whether the predefined conditions or milestones are met. If the targets are not achieved, no additional payment may be required from the acquirer, or the acquirer may receive a return of consideration, depending on the terms of the agreement. This inherent uncertainty is why it's referred to as "contingent."