Could Contingent Consideration be Deemed Compensation in Business Transaction?
By Michael French, CPA, ABV, CFE, Managing Director
Often, in the acquisition of a business, the buyer and seller may enter into an arrangement where contingent payments are made to the seller.
Otherwise known as “earn-out” payments, contingent consideration can help buyers and sellers reach agreement about a company’s valuation. In its simplest form, contingent consideration is a payment (or series of payments) made to a seller once the company reaches certain post-transaction benchmarks. The benchmarks can be financial – for instance, the achievement of a certain percentage increase in revenues within an agreed-upon timeframe. Or they can be non-financial, such as meeting employee or customer retention targets or completing new product development.
Business Combination Accounting Treatment
In business combination accounting, the treatment of contingent consideration is a key element of a transaction, and several factors determine how it is accounted for.
In some cases, sellers remain with the company as key employees after a transaction. This can give rise to questions as to whether post-transaction payments should be accounted for as contingent consideration or compensation. In accordance with ASC 805-10-55-24 [Financial Accounting Standards Board, Business Combinations (Topic 805), Clarifying the Definition of a Business], the determination of whether payments are contingent consideration or compensation requires an understanding of why the payments are included in the arrangement, whether the buyer or seller initiated the arrangement, and when the parties entered into the arrangement.
The determination of whether payments are contingent consideration or compensation carries ramifications for both the buyer and seller. If it is contingent consideration, a determination must be made as to whether the triggering factors will be met. If there is a high probability, there will be impacts on asset and liability valuations. For the seller, the additional payment will constitute consideration on the sale of the business.
Eight Key Factors
If it’s unclear whether an arrangement is part of the exchange or a separate transaction, ASC 805-10-55-25 provides eight indicators that should be considered:
- Continuing employment by the sellers who become key employees. A contingent consideration arrangement in which payments are automatically forfeited if employment terminates is considered compensation for post-combination services.
- Duration of continuing employment. If the period of employment is the same as, or longer than, the contingent payment period, the contingent payments could be considered compensation.
- Level of compensation. If the employee compensation (other than the contingent payments) is reasonable in comparison to that of other key employees, the contingent payments may be considered additional consideration rather than compensation.
- Incremental payments to employees. If selling shareholders who do not become employees receive lower contingent payments on a per-share basis than the selling shareholders who become employees of the combined entity, the incremental amount of contingent payments to the selling shareholders who become employees may be considered compensation.
- Number of shares owned. The relative number of shares owned by the sellers who remain as key employees may indicate the substance of the contingent consideration arrangement. If the sellers who owned substantially all the shares in the company continue as key employees, the arrangement may be determined to be a profit-sharing arrangement intended to provide compensation for post-transaction services. Alternatively, if sellers who continue as key employees owned only a small number of shares and all sellers receive the same amount of contingent consideration on a per-share basis, the contingent payments may be deemed additional consideration.
- Linkage to valuation. If the initial consideration transferred at the acquisition date is based on the low end of a range established in the valuation of the acquired entity, and the contingent formula relates to that valuation approach, the contingent payments are deemed additional consideration.
- Formula for determining consideration. If a contingent payment is determined on the basis of a multiple of earnings, that indicates the obligation is contingent consideration and the formula is intended to establish or verify the fair value of the acquiree. But a contingent payment that is a specified percentage of earnings suggests the obligation to employees is a profit-sharing arrangement to compensate for services rendered.
- Other agreements and issues. The terms of other arrangements (such as noncompete agreements, executory contracts, consulting contracts, and property lease agreements) and the income tax treatment of contingent payments may indicate that contingent payments are attributable to something other than consideration for the acquiree.
For more information about the business combination accounting treatment of contingent consideration in your business transaction, contact your PKF Advisory team member or:
Michael French, CPA, ABV, CFE