General Publications July 8, 2014

“How to Account for Earnouts in Financing Agreements,” Law360, July 8, 2014.

Extracted from Law360

An earnout, also known as “contingent consideration”[1] in accounting parlance, is a contractual provision in an acquisition agreement that adds a variable component to the purchase price for an acquisition. Earnouts allow a purchaser to pay a portion of the purchase price to a seller on a contingent basis if and to the extent the target business reaches certain milestones after the closing. Often these milestones are financial in nature (achieving, for example, revenue, net income or EBITDA benchmarks or reaching a stock price target), but they can also be non-financial in nature (such as obtaining regulatory approval for a proposed line of business).

Why use an earnout? Buyers and sellers often have differing views on the value or future prospects of the target business. An earnout can facilitate bringing together buyers and sellers in transactions where uncertainties exist by mitigating some of the risk of over-payment or under-payment. In other words, an earnout can serve as an effective risk-sharing tool to bridge the gap on purchase price expectation. Indeed, an earnout may make the difference between signing a deal and not reaching an agreement.

The presence of earnout provisions in the current acquisition environment is noteworthy. According to the M&A Market Trends Subcommittee of the Mergers & Acquisitions Committee of the American Bar Association, earnout provisions were included, on average, in 31.5% of the acquisition agreements analyzed in 2010 and 2012.[2] Despite their relative prevalence in acquisition transactions, incorporation of earnout-related provisions in financing agreements[3] has been haphazard.

Relatively recent changes in the accounting treatment for earnouts should serve as a catalyst for parties to revisit their application in financing agreements. These accounting changes, as described below, have had a meaningful impact on both the balance sheet and the income statement of the purchaser. Whether you are a purchaser, borrower, lender or other creditor, a basic understanding of how earnouts are treated from an accounting perspective will aid in the analysis of how they might operate within a financing agreement.

In 2007, Statement of Financial Accounting Standards 141(R) (which is codified as FASB ASC Topic 805, Business Combinations) made relatively dramatic changes in how acquiring companies are required to account for earnouts. Under FASB ASC 805-30-25, the fair value[4] of an earnout is required to be recorded as a liability on the balance sheet of the purchaser on the date of the acquisition if additional assets (such as cash) will be transferred to the seller (or within the equity section of the balance sheet when additional equity interests will be transferred to the seller).

This is in sharp contrast to prior accounting rules, under which any post-closing earnout obligations were accounted for at the time the contingency was resolved (e.g., at the time the future event occurred or conditions were met and the payment became certain). Furthermore, FASB ASC 805-30-35 provides that earnouts recognized as a liability must be re-measured to fair value at each reporting period until the contingency is resolved. To the extent there is a change in fair value, the change must be recognized in the income statement (as a gain or a loss in earnings). Contingent consideration recorded in equity is not required to be re-measured.

If the initial measurement of fair value of a given earnout is lower (or higher) than the payment that is to be made, the results can be unusual. For example, if the fair value measurement is less than the payment to be made, a loss will be recorded in earnings. The anomaly is that the purchaser is recording a loss while the acquired business is presumably performing better than the parties expected. Conversely, if the fair value measurement is higher than the payment, a gain is recorded. Again, it is counterintuitive that the purchaser records a gain even though the acquired business does not perform to expectation.

With a basic explanation of the current accounting treatment, we turn to the application of earnout obligations in the context of a financing agreement. For an acquisitive company in particular (or lenders to an acquisitive company), it is important to analyze how earnout obligations flow through the borrower’s financing agreement. Curiously, many financing agreements are silent when it comes to addressing earnout obligations.[5] Silence will likely be more detrimental to an acquisitive company subject to the restrictions and limitations imposed by a customary financing agreement.

A central question in analyzing the financing agreement is whether the parties elect to include or exclude earnout obligations from the definition of “indebtedness” or “debt” under the financing agreement (referred to hereinafter as “Debt”). If included in Debt, the earnout obligation could increase the borrower’s leverage and consequently will affect financial covenant compliance, pricing (if leverage based), and the ability to consummate certain transactions, including the incurrence of additional debt, acquisitions, investments and restricted payments to the extent they are governed by or restricted based on leverage.

As discussed above, GAAP provides that earnout obligations requiring future cash payments to a seller be accounted for as a liability on a borrower’s balance sheet. If a financing agreement has a GAAP-based definition of Debt, i.e., it provides that Debt includes “all obligations that would be required to be reflected as a liability on the balance sheet in accordance with GAAP,” then an earnout obligation would necessarily be included in any determination of Debt.

More often, financing agreements define Debt more narrowly using a specific litany of obligations that constitute Debt. In some agreements, this litany directly addresses earnout obligations by expressly including or excluding them from Debt. In those cases where the financing agreement is silent, an earnout obligation will more likely be included in Debt, since the most common definitions of Debt include “obligations . . . for the deferred purchase price of property or services.”

There are a fair number of recent financing agreements that purport to exclude from Debt “any earnout obligations until such obligation becomes a liability on the balance sheet of such Person in accordance with GAAP”. This suggests a complete misunderstanding of the current accounting rules. Such a provision would comport with the pre-2007 accounting treatment of earnouts (where the earnout obligation was not accounted for until the contingency was resolved), but appears tautological under the current accounting rules. Under FASB ASC 805-30-25, the earnout would be, in accordance with GAAP, required to be recorded as liability on the date of the acquisition.

Borrowers and lenders may have legitimate reasons to include or exclude earnout obligations from Debt. Borrowers claim that the contingent nature of these obligations should not result in a full “hit” from a leverage perspective. Lenders respond that other contingent liabilities are often included in Debt, such as letter of credit obligations and guarantees of funded debt. Moreover, lenders may argue that there are striking similarities between an earnout and a seller note with offset rights, and seller notes are invariably included in Debt.

Regardless of one’s belief as to whether earnouts should be included as Debt, it is important for both borrowers and lenders to consider how earnout obligations might affect their financing agreements. The parties will want to consider, among other things:

  • if pricing for a credit facility is leveraged-based, whether earnout obligations should be included as Debt for this purpose;
  • whether and the extent to which the financial covenants should take into account the borrower’s existing earnout obligations and its intended use of earnouts on a going forward basis;
  • if earnouts are treated as Debt, whether there should be a specific basket or carve-out in the negative covenant restricting Debt to allow earnout obligations either generally or subject to limitations described below (otherwise the borrower will need to use other debt baskets, if available, or be precluded from using earnouts);
  • whether the borrower should notify its lenders of “material” earnout obligations that are incurred, including the principal terms thereof;
  • whether earnout obligations should be subordinated, unsecured and/or otherwise subject to leverage-based covenant tests in order to be incurred;
  • if earnouts are treated as Debt, the impact such treatment will have on financial covenant levels that are set to regulate the borrower’s ability to incur incremental debt, to pay dividend or make other restricted payments or to effect certain investments; and
  • limitations running through the financing agreement restricting payment of earnouts generally, including whether lenders should have conditionality/covenant compliance tests in order for (i) borrowers to exercise buyout options related to earnouts or (ii) sellers to accelerate their earnout obligations.

In addition to the changes related to the balance sheet resulting from recording an earnout as a liability as of the acquisition date, the new accounting rules for earnouts can also distort or skew a purchaser’s EBITDA. Recall that the liability booked for an earnout is required to be re-measured at certain periods which may necessitate recording a gain or loss in a purchaser’s earnings. See FASB ASC 805-30-35. Also recall that these gains or losses can create anomalous results.

If the acquisition in question is performing worse than the parties expected, the purchaser may be required to book a gain, thereby increasing the company’s EBITDA. Some financing agreements exclude these types of gains or losses by a catch-all exclusion of all non-cash gains or losses. However, where there is no such exclusion for non-cash items, it is entirely appropriate to exclude any non-cash gains or losses associated with the fair value re-measurement rules under FASB ASC 805-30-35.

Earnouts can be beneficial to both borrowers and lenders. They provide a tool that can mitigate the risk for both borrowers and lenders of over-paying for acquired assets. Earnouts no doubt have debt-like characteristics and lenders will seek to monitor and regulate the leverage and liquidity of their borrowers. An understanding of the accounting treatment and interrelated relationship of earnouts with the financing agreements of the purchaser should foster the use of this beneficial acquisition tool.

[1] “Contingent consideration” is defined as an obligation of the acquirer to transfer additional assets or equity interests to the former owners of a target as part of the exchange for control of a target if specified future events occur or conditions are met; see Topic 805-30-20 of the Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification (“ASC”).

[2] ABA, 2011 and 2013 Private Target Mergers & Acquisitions Deal Points Study. These two studies analyzed a combined sampling of more than 200 publicly available acquisition agreements for transactions completed in 2010 and 2012, respectively, that involved private target companies. The 2011 study of transactions completed in 2010 cited use of earnouts in 38% of the acquisition agreements reviewed. The 2013 study of transactions completed in 2012 cited use of earnouts in 25% of the acquisition agreements reviewed.

[3] For purposes of this article, the term “financing agreement” is intended to have broad scope and includes credit agreements, loan agreements, indentures, note purchase agreements and other similar financing agreements.

[4] Valuation of contingent consideration can be quite complex. Methodologies for determining the fair value of an earnout is beyond the scope of this article.

[5] In connection with this article, the author reviewed a random sampling of 116 publicly filed credit agreements that closed during the first half of 2012. Of the credit agreements reviewed, 80 credit agreements (nearly 70% of the sample reviewed) contained no references to earnout obligations. Conversely, nearly 30% of the credit agreements in the sample contained some reference to earnout obligations.

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