Earnout aggravation

The US Financial Accounting Standards Board’s FAS141R came into effect this year, bringing with it a new accounting regime for “earnouts”.

Earnouts are a method of bridging a pricing gap between a buyer and a seller. In the current environment, this is a particularly relevant tool: most sellers would prefer to think the last year’s performance is not indicative of the true value of their company, while most buyers believe current valuations are exactly what they seem to be.

One way for buyers and sellers to meet in the middle is by agreeing to an earnout payment. The buyer will agree to pay a certain amount at closing, followed by a supplemental payment at a later point if certain performance targets are met.

Historically, these earnouts were put on the books at the time of payment. Now, under FAS141R, the buyer has to record the fair value of the earnout at the time of closing. This requires that the buyer go through the complicated exercise of determining the probability that the earnout will have to be paid.
 
For example, explains Dennis White of law firm McDermott Will & Emery, if a buyer has agreed to pay an earnout of $1 million if the seller grows revenues by a certain amount within the next year, and the buyer believes that, according to its growth projections for the company, there is a 50 percent chance that the earnout will have to be paid, the earnout is worth $500,000 at the time of closing.
 
“The rationale is that it affords a more accurate picture of the real economic impact of doing these transactions and provides greater transparency,” White says. “But there are others who believe that it really brings into play a highly complicated, confusing process. But it is what it is, and at this point I don’t think there’s been any discussion of rolling back those rules, I think they’re here to stay at least for now.”

The equation becomes more complex with the structure of the earnout. Suppose the buyer agrees to pay $1 million if the seller’s revenues grow by 20 percent in one year, and $500,000 if the seller’s revenues grow by 10 percent in one year. The buyer believes there is a 20 percent chance it will have to pay $1 million, a 20 percent chance it will have to pay $500,000, and a 60 percent chance it will pay nothing. The value of the earnout is then $300,000 at closing. 

Determining the fair value of a company is tough enough on its own; figuring out the probabilities of the company meeting various performance targets is surely a burden no CFO is eager to take on. And it’s not a one-time exercise, White says: the buyer has to remeasure the fair value of the earnout for each reporting period until the earnout is paid (or not paid). If the probability of payment goes up in the next quarter, such that the fair value of the earnout rises to $800,000, the buyer has to reflect a charge of $300,000. Similarly if the fair value of the earnout declines to $200,000, the buyer has to reflect a gain of $300,000.

Furthermore, White says, if a private equity firm buys a company that has itself agreed to pay an earnout, the new private equity owner will have to assess the fair value of that earnout at closing and on an ongoing basis – even if the seller agreed to the earnout before the new rules came into effect, and is not performing any valuations of its own on the earnout.

“Earnouts are difficult to do to begin with,” White says. “Even before these accounting rule changes, they required a high level of negotiation, and there are a multitude of complications and opportunities for disputes. And now piled on top of that are these accounting complexities. Many buyers are saying even though an earnout might be a means of closing the valuation gap between a buyer and a seller, it’s more trouble than it’s worth.”