Contingent consideration and non-cash consideration are increasingly popular mechanisms both for closing deals, bridging a gap in price expectations, and addressing potential risks in post-deal performance.
Contingent consideration can take many different forms:
- An earn-out is the most common form where a portion of the purchase price is conditional on future events, usually the financial performance of the business.
- Retention or holdback can be described as a portion of the purchase price that is not paid at the completion date to protect the buyer against potential post-deal liabilities. These may be held in an escrow account and can arise to cover:
- Potential normalised working capital adjustments; or
- Outstanding litigation; or
- Pension deficits; or
- Warranty and indemnity claims
For the purchaser, contingent consideration must be measured at fair value to determine the acquired goodwill. The valuation of earn-outs presents the following challenges:
- The inherent difficulty to project the timing and occurrence of future events
- The difficulty of determining the outcome of future events
- The selection or estimation of performance target achievement probabilities
- The selection of an appropriate discount rate
An earn-out is deferred consideration dependent upon the future performance of the business being acquired. The principal purpose is to bridge the price expectation gap between the buyer who will pay a price on past profits and the seller who expects a price based on the future potential of the business.
The difficulty for earn-outs is balancing the needs of a vendor to run the business and the purchaser to control it. The vendor needs to retain control, the purchaser needs to be involved in shareholder issues – new investments.
Features of earn-outs:
- Often based on EBITDA or pre-tax profits
- Can often be based on averages of profits for two or more periods
- Often paid between 2 and 4 years
- Targets are often set in proportional bands, rather than a cliff edge and increase in value as profit or EBITDA grows to incentivise all parties, for example, EBITDA >£a multiplied by x, EBITDA >£b multiplied by y
| Buyer | Seller | Seller | ||
| Advantages | Disadvantages | Advantages | Disadvantages | |
| Lower initial consideration;
A pool to offset warranty & indemnity claims; Motivated seller with continued commitment; The maximum cost is known (if capped); Secures non-competition |
Harder to integrate;
Difficult to motivate past management; Cash generated is often insufficient to meet earn-out consideration; Need to ensure funding availability at the end of the period; Seller may insist on reverse due diligence to provide comfort on the ability of the acquirer to pay the earn-out |
Higher overall price;
Employees can benefit; Retain ‘directorship’ (but needs protection in the employment contract) |
Risk of not receiving the full price;
Profit or calculation disputes, or working capital issues; Not a full clean exit; The tax treatment of the earn-out requires careful consideration; Payment is dependent on the financial strength of the acquirer |
|
Practical considerations:
- Accounting policies to be adopted and used to calculate the earn-out
- Impact of the acquisition on business performance
- Who can hire and fire staff
Contingent consideration or non-cash consideration is also a mechanism for using the vendor as a source of acquisition finance.
The most common other forms of non-cash consideration are:
- Ordinary shares
- Unsecured loan notes
- Ordinary shares in the original target company, acquirer company, or an intermediate company
Determining the value of a share exchange is particularly intricate where both the buyer and vendor are private companies. As a result, it becomes a relative valuation exercise between the buyer and the vendor.
Additional valuation considerations arise when a share exchange between companies represents controlling and/or minority interests. In the absence of a shareholder agreement that specifies shareholder rights, a minority position may be worth less than its pro-rata portion of the private company value.
The target’s assets can also be utilised to provide funding
- Property sale and leaseback deals; or
- Invoice discounting and stock financing of working capital; or
- Simply the disposal of surplus assets including subsidiaries
If you would like to learn more about how member firms of Pandea Global M&A can support your business, or if you are an advisory practice interested in joining the network, please contact Callum and Connor.
Callum Sellar
E: [email protected]
Connor Monaghan
E: [email protected]