The landscape of mergers and acquisitions is evolving, and acquisitions are happening at a record pace given the current state of the economy. Whether you are a business owner looking to sell your company, an attorney looking to structure a transaction, or a potential buyer looking to acquire another company, there is an excellent chance that contingent consideration will play a part in your transaction.

Contingent consideration is a complex topic that is becoming a more common practice in transactions today, and an understanding of the specific instrument is a must for all parties involved. Look to engage a valuation professional to help with this complex component of your transaction.

What is Contingent Consideration?

Contingent consideration is a tool being used more commonly in transactions that requires sellers to “prove their worth” by tying a portion of the purchase price post-close to certain metrics or hurdles. An example of this type of hurdle could be as follows: the sellers will receive an additional $x million of consideration (purchase price) if the Company’s revenue exceeds budgeted amounts in the year following the closing of the transaction.

A Company’s value, or purchase price, tends to be the most debated component of a transaction. A large discrepancy in value between a buyer and seller can often kill a deal. Contingent consideration allows for the respective parties to “meet in the middle” when it comes to differing opinions on the purchase price for the Company. Contingent consideration can come in the form of earnouts, one-time payments, multi-year payments, and stock vesting, among others.

The different forms of contingent consideration are generally earned based on the achievement of certain metrics: 1) financial performance hurdles (i.e. exceeding profitability metrics or selling a certain number of products), and 2) non-financial performance hurdles (i.e. taking a product to market or retaining a key employee post-close). Contingent consideration is a powerful tool to consider for both the buyer and the seller.

What are the Benefits of Contingent Consideration?

Historically, sellers have viewed any transaction other than an all-cash upfront transaction as a “bad deal.” However, contingent consideration can provide significant benefits to both buyers and sellers if structured properly. Contingent consideration arrangements protect the buyer if the Company doesn’t perform as expected post-close (paying too much).

Contingent consideration arrangements also give sellers additional consideration when the Company performs to its expectations and allows sellers to participate in additional upside if performance exceeds expectations. Contingent consideration can provide a structure that gives management additional incentive to stay invested in the Company’s operations after the closing of the transaction, which leads to easier integration and smoother transition. Contingent consideration arrangements have upside for both parties when structured properly.

Valuation Considerations

Many buyers and sellers view the face value of the contingent consideration payment as the fair value of the instrument. However, that thinking is flawed. Contingent consideration is often valued using option pricing models, Monte Carlo simulations, and other complex financial modeling tools. The risk and probabilities that the specific metrics will be achieved are considered in these valuation tools, and as a result, the value is almost always less than the face value of the contingent consideration payment.  Buyers and sellers need to understand the value of contingent consideration, not only for purposes of negotiating the transaction, but for financial statement reporting and tax reporting as well.

All parties involved in a transaction (buyers, sellers, and attorneys) should gain a good understanding of the contingent consideration component of the deal.

Summary

Contingent consideration is becoming a lot more popular in transactions. There are many forms of contingent consideration components that can benefit the buyer and seller in a transaction when structured properly. Given the popularity and complexity of contingent consideration, buyers and sellers need to understand the value of the instruments being used. LBMC’s Valuation and Litigation Support Services team specializes in the valuation and reporting of these complex instruments. To learn more about how LBMC can help with this complex component of your transaction, contact us today.

Jordan Enix is a Senior Manager in LBMC’s Valuation & Litigation Support Services division. He can be reached at jenix@lbmc.com.