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Daniel Kahn

Valuing Contingent Considerations

Three primary sources of risk that should be considered in estimating the discount rate to be used to value an earn-out.

May 23, 2011
by Daniel Kahn

Companies entering into transactions often specify that a certain portion of the consideration to be paid will be contingent on the realization of certain favorable outcomes. Examples of common contingent consideration or earn-out structures are a fixed payment upon achievement of certain earnings thresholds or technical milestones, such as successful completion of a development project or receipt of regulatory approval for a new drug. Similarly, earn-outs may entail a payment equal to a percentage of earnings above a threshold rather than a fixed payment.
Earn-outs often entail multiple contingencies over multiple time periods.

Companies rely on contingent consideration as a means to resolve disagreement regarding the value of the enterprise by postponing payment of a portion of the consideration until some of the uncertainty regarding the future performance of the target is resolved. Earn-outs may also be used as a means to retain key personnel and in some cases, as a means of seller financing.
Earn-outs are used by companies across a broad range of industries and deal sizes.

Under certain circumstances and in accordance with the Financial Accounting Standards Board (FASB) Accounting Standards Codification Topic 805, “Business Combinations”, companies are required to estimate the fair value of an earn-out as of the transaction date and as of subsequent measurement dates. The valuation of contingent consideration poses a number of complexities including the estimation of the earn-out’s expected cash-flows and of the appropriate discount rate to present value those expected cash-flows.

Earn-out structures often incorporate nonlinearities in the payoff function. These nonlinearities arise from contractual terms that typically specify that no payment will be made if a contingency is not met and a positive payment will be made if it is. Since the payoff function is not linear, it is not appropriate to consider only the earn-out associated with the expected underlying outcome (i.e. the mean of the distribution of possible outcomes). Instead, the payment associated with each point on the distribution of possible outcomes must be considered in order to estimate the expected earn-out.

Given an estimate of the expected earn-out, one must then estimate its present value. Probability weighting cash-flows and discounting those probability weighted cash-flows are two distinct steps in any valuation. Just as the weighted average cost of capital (WACC) is an appropriate risk-adjusted discount rate used to present value expected cash-flows in the valuation of a business enterprise, so an appropriately chosen risk-adjusted discount rate should be used to present value to the expected earn-out.

There are three primary sources of risk that should be considered in estimating the discount rate to be used to value an earn-out. They are:

  1. Risk associated with the underlying outcome. The first source of risk is the risk inherent in the underlying outcome and is generally represented as the required rate of return on the capital necessary to produce the outcome. In many earn-outs, the underlying outcome is subject to a firm wide level of risk and so the deal IRR provides an appropriate measure of the required rate of return on the debt and equity capital needed to generate the outcome.
  2. Risk associated with the functional form of the earn-out. The second source of risk is the risk inherent in the shape of the payout function. When the payout function is nonlinear, the risk of the earn-out may be greater or lesser than the risk of the underlying outcome.
  3. Credit risk associated with the payment of the earn-out. The third source of risk is the credit risk associated with the payment of the earn-out and should reflect the fact that the earn-out generally does not represent a direct claim on the cash-flows associated with the underlying outcome, but rather a subordinated, unsecured claim on the acquirer. As such, the credit risk of the acquirer, taking into consideration the position of the claim in the acquirer’s capital structure and the expected timing of the payout, should form the basis for estimating this component of the discount rate.

Risk of Earn-outs and Its Functional Form

The following examples illustrate the relationship between the risk of the earn-out and its functional form as well as the interaction with the probabilities of achieving the earn-out contingencies.

Consider an earn-out in which the target receives $1 million if earnings are greater than $10 million and zero dollars otherwise. If the probability of achieving the earnings threshold of $10 million is 100 percent then the appropriate discount rate would be the acquirer’s cost of debt that reflects time value and the acquirer’s credit risk. If the probability is lower than 100 percent, then the payoff is riskier and a discount rate higher than the cost of debt would be appropriate.

Alternatively, consider a different functional form in which the target receives 10 percent of earnings if earnings are greater than $10 million and zero dollars otherwise. If the probability of achieving the earnings threshold of $10 million is 100 percent, then the appropriate discount rate would be the deal IRR (receiving 10% of the earnings entails the same risk as the earnings themselves) plus the acquirer’s credit spread. If the probability is lower than 100 percent, then the payoff is riskier and a discount rate is higher than the deal internal rate of return (IRR) plus credit spread would be appropriate.

The time remaining to the resolution of the earn-out is also a factor in assessing the riskiness of the earn-out cash-flows. If a high degree of uncertainty regarding achieving the contingency is still present when there is little time remaining, the cash-flows would be considered to be riskier than if there were the same degree of uncertainty but a longer remaining time period.

The greatest challenge in estimating the discount rate is quantifying the adjustment to the IRR to reflect the risk associated with the functional form of the earn-out. Option pricing theory provides a useful framework for quantifying these adjustments. An earn-out based on a fixed payment is similar to a binary option. An earn-out based on a variable payment that is proportionate to earnings is similar to a call option. Most earn-out structures can be engineered as a combination of call and binary options. For example, an earn-out based on a fixed percentage of incremental earnings above a threshold that is capped at a fixed-dollar amount for earnings above a second threshold can be expressed as a long position in a call option with a strike at the first earnings threshold and a short position in a call option with a strike at the second earnings threshold.

We know that a call option on an underlying outcome is always at least as risky as the underlying outcome and that a binary option may be more or less risky than the underlying depending on the probability of achieving the threshold (i.e. the strike price). Option-pricing theory addresses the difficulty of quantifying the increment or decrement to the IRR by employing a risk-neutral framework. Option-pricing methods therefore provide a useful basis for estimating the value of an earn-out.
 
Adapting option-pricing methods to value earn-outs does, however, pose some additional challenges. When valuing an option on equity, the current stock price is an appropriate starting point as the stock price represents the present value of expected future cash-flows and is therefore a forward looking measure. Current earnings, however, may or may not be an accurate representation of expected future earnings. Therefore, when valuing an earn-out, consideration should be given to management’s expectations regarding the expected distribution of future earnings in the specification of the option-pricing model.

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Daniel Kahn, PhD, is principal in Ernst & Young’s Transaction Advisory Services Practice where he is the national leader of the Complex Securities Valuation Practice. He will be speaking at the AIPCA Fair Value Measurement and Reporting Conference, June 6 and 7 in Las Vegas, NV.