By Michael French, CPA, ABV, CFE, Managing Director

In mergers and acquisitions (M&A), contingent consideration is a mechanism used to bridge valuation gaps between buyers and sellers. It involves additional payments made by the buyer to the seller based on the future performance of the acquired business. This approach aligns the interests of both parties and mitigates risks associated with uncertain future outcomes. This article explores the intricacies of contingent consideration, its types, accounting and tax implications and its role in M&A transactions.

What is Contingent Consideration?

Contingent consideration is governed by Accounting Standards Codification (ASC) 805 Business Combinations, which defines it as an obligation by the buyer to transfer additional assets or equity interests to the seller if certain future events occur or conditions are met. Contingent consideration may also give the buyer the right to claw back any previous consideration under certain circumstances.

Key Elements

Key elements of contingent consideration may include the percentage of contingent consideration relative to the size of the purchase. A higher percentage may benefit the buyer by protecting against overpaying, while a lower percentage may benefit the seller, who no longer controls the company. Accounting implications and valuations may also influence the negotiation around the size of the contingent consideration.

Payoff structure can be instrumental in ensuring that the contingent consideration achieves its objectives. Additionally, the performance timeframe and the form of settlement (cash, stock or a combination) are further key elements of contingent consideration.

Types of Contingent Consideration

Contingent consideration can take various forms, including earn-outs, milestone and performance-based payments.

1. Earn-outs: Earn-outs are the most common form of contingent consideration. They involve payments based on the acquired business's future financial performance, such as revenue or EBITDA targets.
2. Milestone payments: These are payments triggered by achieving specific non-financial milestones, such as regulatory approvals or product development stages.
3. Performance-based payments: These payments are tied to achieving specific operational or strategic goals, such as market share targets or customer acquisition numbers.

Accounting for Contingent Consideration

The accounting treatment of contingent consideration depends on whether it is classified as equity or a liability. This classification significantly impacts the financial statements of the acquiring company.

1. Liability classification: If the contingent consideration is classified as a liability, it is remeasured at fair value at each reporting period, with changes recorded through income until the contingency is resolved. This can introduce volatility in the acquirer's financial statements.
2. Equity classification: If classified as equity, the contingent consideration is not remeasured after the initial recognition. This provides more stability in financial reporting but may not reflect the true economic value of the contingent payments.

Tax Implications

The tax treatment of contingent consideration can be complex and varies depending on the jurisdiction and specific terms of the transaction.

1. Open transaction approach: Under this approach, the seller may defer recognizing gain on the transaction until the contingency is resolved. This approach can provide tax deferral benefits but requires careful planning and documentation.
2. Closed transaction approach: Here, the seller recognizes the entire gain at the time of the transaction, even if some payments are contingent. This approach simplifies tax reporting but may result in higher immediate tax liabilities.
3. Installment sales: This method allows the seller to recognize gain as payments are received, spreading the tax liability over multiple periods. This can be beneficial for cash flow management but requires compliance with specific tax rules.

Valuation Challenges

Valuing contingent consideration involves significant judgment and estimation. The key challenges include estimating future performance, discount rates and probability assessments.

Accurately predicting the future performance of the acquired business is inherently uncertain. Buyers and sellers must agree on realistic performance targets and valuation methods.

The choice of discount rate can significantly affect the present value of contingent payments. Higher discount rates reduce the present value, while lower rates increase it.

Assessing the likelihood of achieving performance targets is crucial. This involves analyzing historical performance, market conditions and other relevant factors.

Legal Considerations

The legal framework for contingent consideration must be carefully drafted to avoid disputes and ensure enforceability. Key considerations include clear definitions, dispute resolution mechanisms and regulatory compliance.

The terms and conditions of contingent payments must be clearly defined, including performance metrics, measurement periods and payment schedules.

Including mechanisms for resolving disputes, such as arbitration or mediation, can help manage conflicts that may arise during the contingency period.

Ensuring compliance with relevant laws and regulations, such as securities laws and tax codes, is essential to avoid legal complications.

Strategic Implications

Contingent consideration can have significant strategic implications for both buyers and sellers.

By tying payments to future performance, contingent consideration aligns the interests of buyers and sellers, encouraging collaboration and shared goals.

For buyers, contingent consideration mitigates the risk of overpaying for an underperforming asset. For sellers, it provides an opportunity to realize additional value if the business performs well.

Additionally, contingent consideration can serve as an incentive for the management team of the acquired business to achieve performance targets, driving growth and value creation.

Summary

Contingent consideration is valuable in M&A transactions, offering flexibility and risk-sharing benefits. However, it also introduces accounting, tax, valuation and legal complexity. Both buyers and sellers must carefully consider these factors to structure effective and mutually beneficial contingent consideration arrangements. By doing so, they can enhance the success of their M&A transactions and achieve their strategic objectives.

For more information or a discussion about the role that contingent consideration may play in your M&A transaction, contact your PKF Advisory team member or:

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Michael French, CPA, ABV, CFE
Managing Director

Tel: 949.860.9891
Email: mfrench@pkfadvisory.com