Contingent consideration for closing deals through earn-out structures

Author:  Amish S Mehta, Partner, Transactions & Corporate Finance, EY India has authored this article.

Contingent consideration is a mechanism wherein a portion of the purchase consideration is payable in the future upon the achievement of pre-determined performance targets, milestones, or other contingent events. Such arrangements are used in acquisitions and fund raises primarily to bridge valuation gaps between the buyer and the seller. 

From a commercial perspective, contingent consideration enables buyers to mitigate the risk of upfront overpayment while allowing sellers to participate in future upside performance. As a result, it is becoming an increasingly common feature of transactions, especially in high-growth companies or start-ups.

The increasing prevalence of contingent consideration in transactions is driven by high fluctuations in valuation multiples due to uncertainty regarding future operating performance. Earn-out structures enable parties to mitigate this uncertainty by deferring a portion of the consideration and tying it to the achievement of predefined financial or operational targets, thereby aligning the interests of buyers and sellers.

Accounting standards for financial reporting covering business combinations prescribe that contingent consideration should be measured at fair value on the acquisition date and further trued up on each subsequent reporting date.

Typically, the payout of contingent consideration is based on the following metrics:

• Revenue targets
• EBITDA or profitability targets
• R&D achievements
• Regulatory approvals
• Product commercialization milestones

Financial metrics (revenue and EBITDA) are the most widely adopted performance measures, as their measurement is highly objective and directly aligned with value accretion. 

Key valuation methodologies

The Appraisal Foundation's guidance on the valuation of contingent consideration identifies the following approaches: 

• Scenario-based method (SBM)
• Option pricing method (OPM)

The selection of an appropriate valuation methodology depends primarily upon the nature of the underlying metrics and the payoff structure of the contingent consideration. The diagram below represents a snapshot of the process: 

For the selection of the valuation methodology, the first step would be to identify the type of underlying metric upon which the payoff is dependent.

If the underlying metric is a financial metric, the second step is to understand and categorize the structure of the payoff as either linear or non-linear.

Scenario-based method (SBM)

Scenario-based method requires an estimation of possible future outcomes for the underlying metrics and the payoff associated with each outcome. The contingent payment corresponding to each outcome is estimated along with its probability, followed by probability-weighted computation to arrive at the expected payout. The expected payout is then discounted to present value using an appropriate discount rate.

This methodology is generally appropriate when:

• Outcomes can be clearly identified
• The payoff structure is relatively simple or linear
• Risks are diversifiable
• Milestones relate to specific binary outcomes such as regulatory approvals or R&D

Key valuation considerations include:

• Time value of money
• Counterparty credit risk
• Probability assessment
• Risk-adjusted discount rate 

Option pricing method (OPM)

The option pricing method treats contingent consideration as a financial option because payments are triggered only when specified thresholds are achieved. This method is relied upon when the underlying metric is a financial metric with non-diversifiable risk and the payoff structure is non-linear. OPM circumvents the difficulties associated with estimating a discount rate for accounting the risk specific to the underlying metric and payoff structure. Alternatively, it relies on a risk-neutral framework.

The method is particularly used for:

• Non-linear payout structures
• Multiple threshold arrangements
• Cap-and-floor mechanisms
• Interdependent performance metrics
• Path dependent structures

Common techniques include Black-Scholes Merton, Binomial or Monte Carlo simulation models.

OPM is commonly used when contingent payments depend upon future EBITDA, revenue, enterprise value, or share value exceeding predefined thresholds.