Contingent consideration and earnouts

In this lesson you will

Measure contingent consideration at acquisition-date fair value
Classify an earnout as a liability or equity using Topic 480 and Subtopic 815-40
Account for changes in fair value after the acquisition date
Separate contingent consideration from compensation for post-combination service

What it is

Contingent consideration is an obligation of the acquirer to transfer additional assets or equity to the former owners if specified future events occur or conditions are met. Earnouts tied to revenue or EBITDA are the most common. The Master Glossary also covers the reverse case: a right of the acquirer to the return of previously transferred consideration, such as a clawback.

Initial measurement

805-30-25-5 requires the acquirer to recognize the acquisition-date fair value of contingent consideration as part of the consideration transferred. Probability is a measurement input, not a recognition threshold. An earnout with a 10 percent chance of paying is still recognized, at a small fair value.

Fair value is usually measured with a scenario-based model or, for path-dependent or option-like payoffs, a Monte Carlo simulation. Key inputs are the forecast of the metric, its volatility, the probability of each scenario, and a discount rate that reflects the timing of payment and the acquirer's credit risk. The result is a Level 3 measurement under Topic 820.

Classification

805-30-25-6 classifies the obligation as a liability or as equity using Topic 480, Subtopic 815-40 and other applicable GAAP:

An earnout payable in cash, or in a variable number of shares worth a fixed amount, is a liability.
An earnout payable in a fixed number of the acquirer's shares, with no features that fail the indexation and equity classification tests in Subtopic 815-40, can be equity.

A right to the return of consideration is classified as an asset.

Subsequent accounting

805-30-35-1 splits changes after the acquisition date into two kinds:

Measurement-period adjustments. Changes that result from new information about facts and circumstances that existed at the acquisition date adjust the provisional amount and goodwill, as described in the measurement period lesson.
Post-acquisition events. Changes that result from meeting an earnings target, reaching a share price or hitting a milestone are not measurement-period adjustments.

For the second kind:

Equity-classified contingent consideration is not remeasured. The eventual settlement is accounted for within equity.
Liability-classified contingent consideration is remeasured to fair value at each reporting date until settled, with changes recognized in earnings, unless the arrangement is a hedging instrument for which Topic 815 requires the change in other comprehensive income.

Because the remeasurement goes through earnings, a strong post-acquisition year produces an expense. Analysts and lenders often ask about it, and the footnote should explain the driver.

Payments to selling owners who stay

A common trap is an earnout paid to founders who keep working for the business. 805-10-55-25 lists indicators for deciding whether the payment is consideration for the business or compensation for future service. The strongest is in 805-10-55-25(a): if the payment is automatically forfeited when employment ends, the arrangement is compensation for post-combination services, recognized as expense over the service period. Other indicators include the length of required employment, the level of pay compared with other key employees, whether selling owners who do not become employees receive less per share, and the formula used to compute the payment.

Disclosures

Subtopic 805-30 requires, for each business combination, the amount recognized at the acquisition date, a description of the arrangement and the basis for the payment, and an estimate of the range of outcomes (undiscounted) or a statement that a range cannot be estimated, with reasons. If the maximum is unlimited, that fact is disclosed. Level 3 rollforward disclosures under Topic 820 also apply to a remeasured liability. The Level 3 fair value rollforward calculator helps tie the opening balance, remeasurement and settlement.

Worked example

A cash earnout remeasured and settled

Ashford Medical acquires a clinic network on January 1. The purchase agreement pays the sellers, none of whom stay on as employees, an extra $2,000,000 in cash one year later if the clinics' EBITDA for the year reaches $5,000,000. Payment is in cash, so the earnout is a liability.

At closing, management's valuation puts the probability of reaching the target at 40 percent and uses a 10 percent discount rate. Fair value: 2,000,000 x 0.40 / 1.10 = $727,273. Ashford adds $727,273 to consideration transferred and records a liability of the same amount.

At June 30, the clinics are ahead of plan. The probability is now 70 percent and six months remain. Fair value: 2,000,000 x 0.70 / 1.10^0.5 = 1,400,000 / 1.04881 = $1,334,848. The increase of 1,334,848 - 727,273 = $607,575 results from performance after closing, so it is an expense in the income statement. Goodwill does not change.

At year end EBITDA is $5,300,000 and the target is met. Ashford pays $2,000,000. The final remeasurement adds 2,000,000 - 1,334,848 = $665,152 of expense.

Conclusion: total post-acquisition expense from the earnout is 607,575 + 665,152 = $1,272,727, which equals the $2,000,000 paid less the $727,273 included in the purchase price.

Self-check

Answer each question before you open the answer.

Is an earnout with only a 15 percent chance of paying recognized at the acquisition date?
Show answer
Yes. Contingent consideration is recognized at acquisition-date fair value under 805-30-25-5; probability affects the measurement, not whether it is recognized.
An equity-classified earnout payable in a fixed number of shares becomes more likely to pay. Is it remeasured?
Show answer
No. Equity-classified contingent consideration is not remeasured, and its settlement is accounted for within equity.
A founder receives an earnout only if still employed when it is paid. How is it accounted for?
Show answer
As compensation for post-combination services, not consideration for the business, because payments automatically forfeited on termination are compensation under 805-10-55-25(a).
Where does a change in the fair value of a liability-classified earnout go when the change results from post-closing results?
Show answer
To earnings, under 805-30-35-1, because the change is not a measurement-period adjustment.

Sources

FASB, Statement No. 141 (revised 2007), Business Combinations

Back to the syllabus

Standards are paraphrased from the primary sources listed above; read the source before relying on a requirement. This lesson is training material, not professional advice. Report an error