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I T I N G

The Valuation of Earn-outs and Acquired Contingencies Under SFAS 141(R)

By Marc Asbra and Karen Miles
t the end of 2007, the FASB released SFAS 141(R), Business Combinations, which governs the financial accounting for mergers and acquisitions (M&A) that have closed on or after the first annual reporting period beginning on or after December 15, 2008. While SFAS 141(R) includes several minor changes to current GAAP, the treatment of certain items under SFAS 141(R) will dramatically affect the initial and subsequent recording of a transaction in the acquirers financial statements, and may even influence the structuring of certain deals. There are three critical provisions in SFAS 141(R) to consider: All forms of purchase consideration (including acquirer stock) are measured as of the acquisition date, the date at which the acquirer obtains control of the target. Transaction costs and related expenses (including restructuring expenses) are excluded from purchase consideration; the items are expensed as incurred. Earn-outs, other forms of contingent consideration, and certain acquired contingencies (assets and liabilities) are recorded at fair value as of the acquisition date. While the first and second items deserve attention in their own right, determining the fair value of contingent elements in a transaction will present new challenges to financial statement preparers. Valuation approaches and other issues related to earnouts and acquired contingencies must be considered.

Earn-outs
An earn-out can be a valuable device in structuring an M&A transaction, particularly when the buyer and seller have divergent views about the potential future success of the target company. Sellers seek compensation for future market opportuni-

ties they believe their business can exploit. Conversely, buyers are willing to pay for sustainable earnings and current achievements, but temper their expectations of yet-to-be-exploited opportunities. If structured properly, an earn-out can place the total transaction proceeds at a place on the risk-return spectrum that effectively balances the requirements of the buyer and the seller. The future payments give the seller an opportunity to realize more equity upside from the sale of the business, while at the same time providing the buyer with downside protection through the sellers strong interest in the success of the postcombination company. Under current GAAP, earn-out payments are recorded in the acquirers financial statements only if and when they are earned. Under SFAS 141(R), however, earn-out payments will be recorded at fair

value as of the acquisition date. As with many aspects of M&A negotiations, the elements and structure of an earn-out are limited only by the ability of the buyer and seller to think creatively about the future. Earn-outs can incorporate general or specific objectives, include financial or nonfinancial targets, contain single or multiple elements, cover short or long periods, and involve cash or other forms of consideration. Whether simple or complex, the forward-looking characteristics of earn-outs typically mean that the optimal method for quantifying their fair value is the income approach. The income approach generally estimates value by discounting expected future cash flows to the present through a rate of return (i.e., discount rate) that accounts for both the time value of money and investment risk factors. The determinaMARCH 2009 / THE CPA JOURNAL

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tion of the fair value of an earn-out under this approach presents a number of challenges and prompts several questions: What is the likelihood that the earn-out will be achieved? What cash flows or other activities are directly associated with the earn-out? What is the level of risk in achieving the earn-out? What type of discount rate should be used in the analysis? How would that rate compare to the overall discount rate for other assets and liabilities being valued in the transaction? What adjustments are needed if the earn-outs are noncash? As one can imagine, the buyer and seller may have dramatically different opinions on these questions and the underlying issues. Similarly, divergent fair value conclusions can result from even small differences in the valuation assumptions used. Like all other fair value analyses done for acquisition accounting purposes, the valuation study for earn-outs must be thorough, supported by reasonable assumptions, and fully documented.

Example
The following discussion focuses on the valuation of a relatively common earn-out based on the target business achieving cer-

tain thresholds of earnings before interest, taxes, depreciation, and amortization (EBITDA). The target company achieved $5 million in EBITDA on $25 million in sales in the year immediately prior to the transaction and presented a business plan to the buyer that demonstrated substantial future growth in revenue and profit. The buyer successfully negotiated the purchase of the target company for an initial price of $23 million, plus a three-year earn-out. Exhibit 1 shows that the earn-out is based on the buyers projected EBITDA levels and could result in the payment of an additional $4.5 million of consideration. The fair value of the earn-out, however, is determined to be approximately $3.3 million, or more than 25% below the nominal amount. The lower fair value results from the application of a 15% discount rate to capture the inherent risk that the target company will not achieve the projected EBITDA targets. Because of the relatively simple structure in this example, Exhibit 1 uses a single, likely scenario in determining the fair value of the earn-out. For more complex structures, an alternative analysis would utilize various projected scenarios and employ a probability-weighting scheme to estimate fair value. This alternative would provide flexibility in modeling the various future

events and assessing the potential earnout payments. Particular care needs to be exercised in constructing the probability weighting scheme, however, as the selection of probability factors can significantly affect the ultimate fair value conclusion. Care must also be taken to ensure that the financial projections utilized to determine the fair value of the earn-out are consistent with those used to estimate the fair values of the acquired intangible assets, which are often developed from similar income-based approaches. Not only is the determination of the fair value of an earn-out critically important for allocating the purchase price at the time of the transaction, but it is also significant for the acquirers future goodwill impairment testing. Exhibit 2 presents the implications of SFAS 141(R) as it relates to goodwill impairment testing. If the target business successfully achieves the earnout payments, the final amount of goodwill will actually be lower under SFAS 141(R) than it would under prior GAAP. This lower amount is placed on the acquirers balance sheet immediately, however, which may expose the acquirer to a higher likelihood of potential goodwill impairment charges in the event the earn-out targets are not achieved and the business experiences other challenges. The higher

EXHIBIT 1 Fair Value of Earn-out

Projected Seller Projections and Earn-out Sales EBITDA Earn-out Target EBITDA Earn-out Payments Income Approach Earn-out Payments Discount Period Discount Rate Present Value of Cash Flow Fair Valu e ( R ounded) 15.0% Actual $25,000 5,000 Year 1 $32,500 7,500 $7,500 1,000 Year 1 $1,000 1.0 0.870 $870 $3,300 Year 2 $40,000 10,000 $10,000 1,500 Year 2 $1,500 2.0 0.756 $1,134 Year 3 $47,500 12,500 $12,500 2,000 Year 3 $2,000 3.0 0.658 $1,315 Year 4 $0 4.0 0.572 $0 Year 4 $55,000 15,000

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amount of goodwill finally recorded under prior GAAP, in contrast, is placed on the balance sheet only after the earn-out targets have been reached. The payment of the earn-outs could indicate that the postcombination business is enjoying some degree of success, which might lessen the potential likelihood for goodwill impairment charges, all else being equal. Moreover, the amount of goodwill initially recorded under current GAAP provides a cushion to the acquirer in the event profit expectations do not materialize. That is, the probability of having a goodwill impairment charge is lower under prior GAAP because the goodwill related to the earn-out elements has not yet been placed on the balance sheet. Including the fair value of an earnout in the purchase price also has implications beyond financial reporting. Because valuation multiples implied from earn-out transactions under SFAS 141(R) will necessarily be higher than those under current GAAP, comparisons to prior transaction multiples or industry rules of thumb will require a more complicated analysis. To the extent an

earn-out represents a significant component of the purchase price, investors and analysts may pressure acquirer management teams for comprehensive disclosures regarding the nature of the earnout and the assumptions used to determine its fair value.

Acquired Contingencies
M&A transactions often include acquired contingencies on both sides of the target companys balance sheet: assets and liabilities. One of the more notable examples on the left-hand side is an indemnification asset, whereby the seller contractually indemnifies the acquirer for the outcome of a contingency or uncertainty related to all or part of a specific asset or liability. One of the more notable examples on the right-hand side is pending or threatened litigation. These and other contingencies are generally governed by SFAS 5, Accounting for Contingencies, which defines a contingency as an existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss to an entity that will ultimately be resolved

when one or more future events occurs or fails to occur. While SFAS 5 technically deals with assets (gains) and liabilities (losses), contingencies that might result in gains usually are not reflected on the balance sheet, since to do so might be to recognize revenue prior to its realization. As such, in practical terms, SFAS 5 deals mainly with the world of contingent liabilities. A contingent liability under SFAS 5 must meet two criteria: 1) it is probable that a liability had been incurred (or an asset had been impaired) at the measurement date; and 2) the amount of loss can be reasonably estimated. Current GAAP permits deferred recognition of acquired (pre-acquisition) contingencies until these recognition criteria are met. SFAS 141(R), however, has less stringent criteria in recognizing acquired contingencies and further segments between contractual and noncontractual contingencies. Specifically, contingent liabilities related to contracts (referred to as contractual contingencies) are measured at fair value as of their acquisition date. For all other noncontractual contingencies, the acquirer must recognize

EXHIBIT 2 Recording of Goodwill

Current GAAP Initial Purchase Price Earn-outs Total Transaction Value Net Tangible and Intangible Assets Goodwill $23,000 0 23,000 9,000 $14,000 Interim $ 0 4,500 4,500 Final $23,000 4,500 27,500 9,000 $18,500 SFAS 141(R) $23,000 3,300 26,300 9,000 $17,300 Difference $ 0 (1,200) (1,200) 0 ($1,200)

Current GAAP Purchase Price Earn-outs Total Transaction Value Net Tangible and Intangible Assets G oodwi l l Initial $ 23,000 0 $ 23,000 9,000 1 4 ,0 0 0 Interim $ 0 4,500 4,500 Final $ 23,000 $ 4,500 27,500 9,000 $ 1 8 ,5 0 0 SFAS 141(R) $ 23,000 3,300 26,300 9,000 $ 1 7 ,3 0 0 Difference $ 0 (1,200) (1,200) 0 ( $ 1 ,2 0 0 )

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a liability only if it is more likely than not (i.e., greater than 50%) that a liability exists at the acquisition date. SFAS 141(R) eliminates the condition that the liability be reasonably estimable. If it is deemed more likely than not, the noncontractual liability is recorded at fair value as of the acquisition date, consistent with the treatment of contractual contingencies. While the ultimate reality might be different, the presumption of most readers of SFAS 141(R) is that noncontractual contingencies will be identified and valued more frequently than under prior GAAP. Consider pending litigation as an example. While more complex models certainly exist, lawsuits and other contingent claims are often valued utilizing a decision-tree analysis. As the name suggests, a decision tree generally incorporates various future outcomes along as many potential branches as the user deems appropriate. As the branches diverge over time, probability factors are assigned at each of the nodes

representing the likelihood of each potential path occurring. In the case of a lawsuit or other financial claim, payment amounts are also estimated for the various outcomes. As illustrated below, the sum of the probability-weighted payment amounts serves as an indication of the fair value of the claim underlying the lawsuit. While this simple framework is useful in demonstrating an effective quantification technique, the valuation of a pending claim in the real world is more complex and requires thoughtful consideration and an analysis of the facts and circumstances of both the parties and the case. Other factors also warrant consideration, including expected legal costs and the time value of money, as well as the impact from the general disruption to the business and the diversion of managements time and attention during the litigation. The complexities of such analyses often prompt companies to seek outside assistance from lawyers and valuation spe-

cialists when developing reasonable and supportable fair value estimates. Public companies have the added sensitivity of financial statement disclosures related to acquired contingencies, which can greatly influence a companys legal strategy. SFAS 141(R) states that, for liabilities arising from contingencies, management should disclose the following: The amounts recognized at the acquisition date, or an explanation of why no amount was recognized. The nature of recognized and unrecognized contingencies. An estimate of the range of outcomes (undiscounted) for contingencies (recognized and unrecognized); if a range cannot be estimated, that fact and the reason behind it should be disclosed. SFAS 141(R) allows an acquirer in a transaction involving multiple acquired contingencies to aggregate disclosures for liabilities (and assets) arising from similar contingencies. While the aggregation of

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information would limit the counterpartys ability to glean information about the lawsuit, the disclosure of any sensitive information is likely to be met with strong resistance by an acquirers management and legal counsel.

Increased Complexity
From a purely academic perspective, M&A transactions should be evaluated according to their underlying economics net present value, investment return, economic value added, or some other cash-flowbased financial metricand not judged by the financial statement impact caused by GAAP accounting requirements. M&A transactions are not completed in the classroom, however, and earnings-per-share figures are not ignored by investors. SFAS

141(R) will likely improve the consistency and transparency of financial reporting for M&A transactions, but it does so with the added cost of certain complexities, particularly as they relate to earn-outs and acquired contingencies. Management should be aware of the changes SFAS 141(R) represents, as it will be increasingly important to assess the initial and subsequent financial statement implications as early as possible when structuring an M&A transaction. The treatment of acquired contingent liabilities in SFAS 141(R) was the subject of significant debate leading up to its release. The FASB responded on December 15, 2008, with a proposed FASB Staff Position (FSP) that would amend SFAS 141(R) to require that contingent assets and liabilities be recognized

at fair value per SFAS 157, Fair Value Measurements, if the acquisition-date fair value can be reasonably determined. If the fair value cannot be reasonably determined, then the acquirer would follow the guidance set forth in SFAS 5. While the FSP had not been finalized at the time of this publication, if approved as currently drafted, the effect of the FSP would generally be a reversion back to current practice under SFAS 141 regarding acquired contingencies. Marc Asbra, CFA, is a a senior vice president in Houlihan Lokeys Los Angeles office. Karen Miles, CPA, heads Houlihan Lokeys financial opinions and advisory services business for Southern California.

EXHIBIT 3 Lawsuit Decision-Tree Analysis

Conditional Probabilities W i thdraw (1%)

Payment Nominal Probability Amount Weighted $0 $0

1%

L i ti gati on Claim

19%

Settl e

(19%)

$ 2 0 0 ,0 0 0

$ 3 8 ,0 0 0

80% Litigate

Win 40%

(80%) (40%)

$0

$0

25% 60% Lose 50%

High Damages

(80%) (60%) (25%)

$1,000,000

$120,000

Medium Damages 25%

(80%) (60%) (50%)

$500,000

$120,000

Low Damages

(80%) (60%) (25%) Total Expected Value

$250,000

$30,000 $308,000

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MARCH 2009 / THE CPA JOURNAL