A contingent consideration agreement is a separate understanding between the entity’s acquiring party and the entity seller’s to pay an additional price based on the occurrence of a target performance based on well-defined event or events described and outlined in the acquisition agreement.
These payments are referred to as earn-outs, the objective being to facilitate a closer meeting of the minds between the buyer and seller valuations. Terms can range over single or multiple reporting periods and generally involve additional consideration based on achieving agreed upon metrics over those single or multiple reporting periods. Not all of the achievements are financial and can include non-financial objectives which facilitate value enhancement such as those related to R&D, new product development, customer retention, and employee turnover.
Valuation of a Contingent Consideration
The valuation of unpaid contingent consideration, based on cash payments, involves probability related risk and present value considerations. The contingent amounts are payable in the future if and when, as defined, the contingent metrics are met. Since the likelihood of a payout depends solely whether goals are achieved, it either happens or does not. There are several theories about valuation, some of which encompass option pricing models, but for small business entities fair value of the net assets determines the contingencies by affecting acquisition goodwill and correspondingly liabilities for the contingent amount (fair value balance sheet presentations). Another way to look at the value of the contingency is to determine how a financial institution would value the contingency if it were offered as collateral for a loan (fair market value presentations).
Dennis B . Kremer, CPA/ABV/CFF/CGMA, CVA, CFE