Understanding & Valuing Contingent Consideration
30 December 2019
When negotiating the purchase price of a business, Contingent Consideration is often used to bridge the price gap between what the seller would like to receive and what the buyer would like to pay. More generally, a portion of the purchase consideration may be contingent on the outcome of future events. For example, additional consideration may be paid if the acquired business meets certain targets (such as future revenue, margin, or profit targets), passes regulatory reviews, has successful litigation outcomes, meets covenants, or completes product development.
The valuation of Contingent Consideration is inherently challenging due to dependence on the occurrence of future events and the often complex structure of the payoff functions. As part of the initial recognition and measurement requirements under Indian Accounting Standard (Ind AS) – Business Combinations (Ind AS 103), Provisions, Contingent Liabilities and Contingent Assets (Ind AS 37), Financial Instruments (Ind AS 109) and International Financial Reporting Standards (IFRS) Standard 3 Business Combinations (Revised) (IFRS 3R), Contingent Consideration included in a business combination must be measured at fair value as of the acquisition date.
Above mentioned Standards define Contingent Consideration as usually being an obligation of the acquirer to transfer additional assets or equity interests to the former owners of the acquiree as part of the exchange for control of the acquiree if specified future events occur or conditions are met (an “Earnout”). However, Contingent Consideration also may give the acquirer the right to claw back previously transferred consideration if specified conditions are met (a “Clawback”).
There are cases where the parties to a transaction will structure the Contingent Consideration so that the buyer may be entitled to a Clawback (or refund) of a portion of the initial purchase consideration from the seller. In these cases, the buyer has essentially taken out insurance that is payable by the seller if the acquired business underperforms or to mitigate specific risks. Clawbacks are therefore contingent assets to the buyer that reduce the fair value of the total purchase consideration.
In general, the valuation considerations for Clawbacks are the same as for Earnouts. The valuation specialist should consider the risk of and expectations for the underlying metric, the impact of the Clawback payoff structure on risk (especially if the structure is nonlinear), as well as any counterparty credit risk.
Valuation of Contingent Consideration
For valuing Contingent Consideration, the market approach is rarely used due to the lack of an active trading market that provides reliable indications of value. The cost approach is also typically not appropriate, since typically there is no obvious way to estimate a replacement cost and the cost approach does not consider future expectations.
We observed two methods for valuing Contingent Consideration commonly used by valuation specialists:
The Scenario-Based Method (SBM) is a method under which the valuation specialist identifies multiple outcomes, probability weights the Contingent Consideration payoff under each outcome, and discounts the result at an appropriate rate to arrive at the expected present value of the Contingent Consideration.
SBM is widely used for valuing Contingent Consideration when the risk of the underlying metric is diversifiable, e.g., for achievement of diversifiable nonfinancial milestones. SBM is used when the payoff structure is linear (e.g., a fixed percentage of revenues or EBITDA with no thresholds, caps, or path dependencies such as carry-forwards, roll-backs or cumulative targets). We do not recommend the use of SBM for nonlinear payoff structures involving a Contingent Consideration metric with non-diversifiable risk.
The Option Pricing Method (OPM) is used to value Contingent Consideration for which the payoff structure is nonlinear and involves a metric or event with non-diversifiable risk. The payoff functions for common Contingent Consideration arrangements that have a nonlinear structure are option-like (e.g., resemble calls, caps, collars, cash-or-nothing, asset-or-nothing, etc. options) in that payments are triggered if certain thresholds are met.
The essence of the OPM is to adjust the Contingent Consideration metric forecast for risk, or to create a “risk-neutral” metric forecast, by applying a risk-adjusting discount rate to the metric forecast and then to evaluate the Contingent Consideration payoff function using the risk-neutral framework. Once the metric forecast has been adjusted for risk, the expected Contingent Consideration payoff is calculated based on the riskneutral distribution (typically lognormal) of the metric, and discounted at the risk-free rate plus any adjustment for counterparty credit risk from the expected payment date(s) to the valuation date. When a payment in one period is dependent on the outcomes in other periods, one typically cannot model the payments independently. More complex techniques, the most common of which is a Monte Carlo simulation, are generally required.
Using a Binomial Lattice to Handle Buyer or Seller Choices
Earnouts may be structured with the ability of the buyer or seller to make decisions over the term of the Earnout that impact its payoff. In these cases, a binomial tree (or more generally a lattice or finite-difference technique) can be used to incorporate optimal decisions into the Earnout valuation.
A binomial tree, whose branches represent potential future metric paths, is constructed based on assumptions for future volatility in a risk-neutral framework. That is, the risk-neutral probability distribution of future metric outcomes is modeled at successive time steps. The optimal decision feature can then be incorporated by working backwards through the tree, from the end of the Earnout term to the valuation date, by minimizing (in the case of the buyer’s decision) or maximizing (in the case of the seller’s decision) the expected present value of the payoff.
Valuing Earnouts that have both path-dependent and optimal decision features generally requires the use of a Monte Carlo simulation in conjunction with an algorithm to address the buyer or seller decision for each iteration of the simulation.
The Risk Associated with the Contingent Consideration Payoff Structure
The payoff structure can affect the risk associated with an Earnout, if the risk of the Earnout metric is non-diversifiable.
For a metric with only diversifiable risk, the appropriate discount rate is the risk-free rate, plus any adjustment for counterparty credit risk, applied to the expected Earnout cash flow over the relevant time horizon. When there is no systematic risk associated with the metric, the payoff structure cannot affect the amount of systematic risk and therefore the payoff structure does not affect the magnitude of the required rate of return.
For a metric (such as a financial metric) with non-diversifiable risk, the relative risk of the Earnout as compared to the risk of the underlying financial metric will depend on the Earnout payoff structure.
Discount Rate and Market Risk Considerations
Contingent Consideration payoffs are exposed to various types of risks. When selecting the discounting for the Contingent Consideration valuation, the valuation specialist should consider:
- The time value of money – typically captured by the riskfree rate
- Counterparty credit risk, which represents the risk that the obligor will not be able to fulfill its obligation if and when a payment becomes due
- Required Metric Risk Premium – market participants require a premium in excess of the risk free rate that captures the metric’s exposure to systematic risk and the portion of any additional risk premiums (e.g., size premiums, country-risk premiums, and company-specific premiums) relevant to the Contingent Consideration metric
- The impact on risk of the payoff structure
According to studies in recent years, the percentage of deals for private company targets that include Contingent Consideration is in the range of 19% to 38%, but can reach as high as 75% in industries such as biotech and pharmaceuticals.
Source- Guidelines on Valuation suggested by The Appraisal Foundation