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In the world of mergers and acquisitions, earnouts (also formally known as a contingent consideration) can be a useful tool to help bridge the valuation gap between a buyer and seller in the negotiation phase of a transaction. With the ongoing COVID-19 pandemic and economic uncertainty that remains in our current market, many M&A advisors are turning to earnouts to help close a deal.
Although they can help salvage a transaction, accounting for earnouts can raise some frustration for both the buyer and seller if not clearly defined in the purchase agreement.
In an earnout, a buyer will make an initial purchase payment for a target business with potential additional payments made over time based on the achievement of specific performance metrics, as outlined in the purchase agreement. These performance metrics may include operational and/or financial metrics and are most commonly based on revenues or profits.
For sellers, revenue-based metrics are preferred due to their straightforwardness, while buyers lean toward profit-based metrics, such as earnings before interest, taxes, depreciation and amortization (EBITDA), to protect themselves from possibly overpaying, especially when there is uncertainty related to revenue performance. Regardless of the financial metrics being used, there are several accounting factors to consider as they could have a significant impact on both parties as the earnout takes place.
For example, the seller will have to recognize they no longer have financial or operational control of the business, so if a buyer changes how the company expenses are handled or makes a significant purchase while the earnout is taking place, it could directly impact the company’s profitability. This a common scenario, which is why the purchase agreement and earnout should clearly define how accounting matters will be handled.
There are several accounting factors to consider, including:
How the treatment is classified is key, as generally accepted accounting principles (GAAP) require a liability for the earnout to be recorded on the balance sheet. Under GAAP, compensation is recognized as an expense and is therefore recorded in equity, while an additional purchase is recognized at fair value in the income statement and must be adjusted appropriately based on the type of business.
While earnouts can help buyers and sellers come to a mutual agreement in a transaction, they can be a complex process. Whether you’re a buyer or seller, having the right team is key to your transaction and overall accounting liability. To obtain assistance with navigating your earnout, contact us today.
This publication is distributed for informational purposes only, with the understanding that Doeren Mayhew is not rendering legal, accounting, or other professional opinions on specific facts for matters, and, accordingly, assumes no liability whatsoever in connection with its use. Should the reader have any questions regarding any of the news articles, it is recommended that a Doeren Mayhew representative be contacted.
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