An acquirer may enter into an arrangement to make contingent payments to the selling shareholders of the acquiree. These arrangements need to be analyzed to determine if they should be included in the consideration transferred for the acquiree (i.e., contingent consideration), accounted for as a separate transaction apart from the business combination (generally compensation cost), or a combination of both. In accordance with ASC 805-10-55-24
, this assessment requires obtaining an understanding of why the contingent payments are included in the arrangement, which party (the acquiree or the acquirer) initiated the arrangement, and when the parties entered into the arrangement.
If it is not clear whether an arrangement is part of the exchange for the acquiree or is a separate transaction, ASC 805-10-55-25
provides eight indicators that should be considered. While these criteria specifically apply to arrangements for contingent payments, they are also useful in considering other arrangements for payments to employees or selling shareholders, such as when certain selling shareholders (who are also employees) receive a higher price per share than other selling shareholders. Additionally, arrangements between the selling shareholders and the acquiree’s employees should be evaluated to determine whether such arrangements were entered into for the benefit of the acquirer and thus represent compensation (e.g., stay bonuses paid by the selling shareholders out of their proceeds).
Excerpts from ASC 805-10-55-25
a. Continuing employment. The terms of continuing employment by the selling shareholders who become key employees may be an indicator of the substance of a contingent consideration arrangement. The relevant terms of continuing employment may be included in an employment agreement, acquisition agreement, or some other document. A contingent consideration arrangement in which the payments are automatically forfeited if employment terminates is compensation for postcombination services. Arrangements in which the contingent payments are not affected by employment termination may indicate that the contingent payments are additional consideration rather than compensation.
b. Duration of continuing employment. If the period of required employment coincides with or is longer than the contingent payment period, that fact may indicate that the contingent payments are, in substance, compensation.
c. Level of compensation. Situations in which employee compensation other than the contingent payments is at a reasonable level in comparison to that of other key employees in the combined entity may indicate that the contingent payments are additional consideration rather than compensation.
d. Incremental payments to employees. If selling shareholders who do not become employees receive lower contingent payments on a per-share basis than the selling shareholders who become employees of the combined entity, that fact may indicate that the incremental amount of contingent payments to the selling shareholders who become employees is compensation.
e. Number of shares owned. The relative number of shares owned by the selling shareholders who remain as key employees may be an indicator of the substance of the contingent consideration arrangement. For example, if the selling shareholders who owned substantially all of the shares in the acquiree continue as key employees, that fact may indicate that the arrangement is, in substance, a profit-sharing arrangement intended to provide compensation for postcombination services. Alternatively, if selling shareholders who continue as key employees owned only a small number of shares of the acquiree and all selling shareholders receive the same amount of contingent consideration on a per-share basis, that fact may indicate that the contingent payments are additional consideration. The preacquisition ownership interests held by parties related to selling shareholders who continue as key employees, such as family members, also should be considered.
f. Linkage to the valuation. If the initial consideration transferred at the acquisition date is based on the low end of a range established in the valuation of the acquiree and the contingent formula relates to that valuation approach, that fact may suggest that the contingent payments are additional consideration. Alternatively, if the contingent payment formula is consistent with prior profit-sharing arrangements, that fact may suggest that the substance of the arrangement is to provide compensation.
g. Formula for determining consideration. The formula used to determine the contingent payment may be helpful in assessing the substance of the arrangement. For example, if a contingent payment is determined on the basis of a multiple of earnings, that might suggest that the obligation is contingent consideration in the business combination and that the formula is intended to establish or verify the fair value of the acquiree. In contrast, a contingent payment that is a specified percentage of earnings might suggest that the obligation to employees is a profit-sharing arrangement to compensate employees for services rendered.
h. Other agreements and issues. The terms of other arrangements with selling shareholders (such as noncompete agreements, executory contracts, consulting contracts, and property lease agreements) and the income tax treatment of contingent payments may indicate that contingent payments are attributable to something other than consideration for the acquiree. For example, in connection with the acquisition, the acquirer might enter into a property lease arrangement with a significant selling shareholder. If the lease payments specified in the lease contract are significantly below market, some or all of the contingent payments to the lessor (the selling shareholder) required by a separate arrangement for contingent payments might be, in substance, payments for the use of the leased property that the acquirer should recognize separately in its postcombination financial statements. In contrast, if the lease contract specifies lease payments that are consistent with market terms for the leased property, the arrangement for contingent payments to the selling shareholder may be contingent consideration in the business combination.
All of the indicators should be considered when analyzing whether the contingent consideration is for postcombination services. However, ASC 805-10-55-25
(a) requires the consideration to be accounted for as postcombination compensation cost if the consideration is automatically forfeited upon termination of employment. Additionally, even if the consideration to be transferred is not required to be forfeited upon termination of employment, we believe that the acquirer should evaluate whether the arrangement contains an in-substance service period, which may indicate that the substance of the arrangement is compensatory. The determination of whether an arrangement contains an in-substance service condition is a matter of judgment based on relevant facts and circumstances. The following factors, which are consistent with the analysis described in ASC 718-20-55-87
through ASC 718-20-55-92
, may be considered as part of this determination:
- The acquiree’s business is in an industry in which retention of employees is important to preserving the value of its operations.
- The recipient(s) of the contingent payments are critical to the future success of the acquiree’s business, which may be due to the size and the nature of the acquiree, the expertise these recipients possess, or the relationships these recipients have with customers of the acquiree.
- The value of the contingent payment that may be received by the selling shareholder(s) is significant in relation to the upfront payment received from the acquirer.
- While the contingent payment is not contingent on future service to the acquirer, the contingent payment will be transferred over a period that aligns with employment agreement(s) entered into by the selling shareholder(s) with the acquirer.
- The selling shareholder(s) have also entered into noncompete agreements which align with the employment agreement(s) entered into by the selling shareholder(s) with the acquirer.
All surrounding circumstances and contracts should be considered in assessing the substance of contingent payment arrangements. There may be situations when there are employment requirements in order to be eligible to receive a contingent payment included in a separate agreement, which the acquirer may not even be a party to. For example, assume an acquiree is structured as a holding company, owned by a group of key employee shareholders, that owns a 100% interest in an operating company. The holding company agrees to sell the operating company to an acquirer in exchange for cash and contingent consideration payable in the future. The selling shareholders will remain employed after the acquisition. Both the initial payment and the contingent consideration is payable to the holding company, which in turn would distribute the proceeds to the employee shareholders. The contingent payments are tied to the acquiree achieving certain revenue and earnings targets, and are not dependent upon the continued employment of any individual. However, the holding company and the employee selling shareholders enter into a separate arrangement that requires the employee shareholders to forfeit their ownership in the holding company if they terminate employment with the acquirer. Because the forfeiture of shares in the holding company results in their inability to share in the contingent payment that will be made to the holding company if the targets are achieved, the employee selling shareholders’ ability to receive contingent payments is substantively dependent upon their continued employment with the acquirer. Therefore, the contingent consideration should be accounted for as postcombination compensation cost.
Example BCG 3-2 and Example BCG 3-3 provide examples of contingent consideration arrangements that are forfeited upon the termination of employment. Example BCG 3-4 provides an example of incremental payments to an employee.
EXAMPLE BCG 3-2
Contingent consideration arrangement - sole shareholder
Company A (the acquiree) is owned by a sole shareholder, Shareholder X, who is also the chief executive officer (CEO) of Company A. Company A is acquired by Company B (the acquirer). Shareholder X will, per the terms of the purchase agreement, receive additional consideration for the acquisition based upon specific earnings before interest, taxes, depreciation, and amortization (EBITDA) levels of Company A over the two-year period following the acquisition. Company B believes that retaining the services of Shareholder X for at least two years is critical to transitioning Company A’s ongoing business. The arrangement also stipulates that Shareholder X will forfeit any rights to the additional consideration if Shareholder X is not an employee of Company B at the end of the two-year period.
How should Company B account for the contingent consideration arrangement?
Under ASC 805-10-55-25
a contingent consideration arrangement in which the payments are automatically forfeited if employment terminates is considered compensation for the postcombination services. Accordingly, any payments made to Shareholder X for achievement of the specific EBITDA levels would be accounted for as compensation cost in Company B’s postcombination financial statements.
EXAMPLE BCG 3-3
Contingent consideration arrangement – payment contingent on continued employment of a specific employee
Company A (the acquiree) is owned by three shareholders, including Shareholder A, who is also the chief executive officer (CEO) of Company A. Company A is acquired by Company B (the acquirer). Company B believes that retaining the services of Shareholder A for at least two years is critical to transitioning Company A’s ongoing business. Accordingly, per the terms of the purchase agreement, the three selling shareholders will receive additional consideration for the acquisition based on Company A achieving specific EBITDA levels over the two-year period following the acquisition only if Shareholder A remains employed by Company B during the two years. The payment, if due, would be divided among the three shareholders on the basis of their relative ownership percentages. Even if the EBITDA targets are met, no contingent payment will be made to any of the three selling shareholders if Shareholder A is not employed by Company B at the end of the two years following the acquisition.
How should Company B account for the contingent consideration arrangement?
Under ASC 805-10-55-25
, a contingent consideration arrangement in which the payments are automatically forfeited if employment terminates is considered compensation for postcombination services. Accordingly, we generally believe that Company B should account for any payments made to the three shareholders for the achievement of the specific EBITDA levels as compensation cost in Company B’s postcombination financial statements. This is because these payments are contingent on continued employment (even though it is only the continued employment of Shareholder A).
An alternative view is that only the payment to Shareholder A should be compensation cost in Company B’s postcombination financial statements. In considering this view, all facts and circumstances should be considered (e.g., the relationship of the employees to each other, the reason for the agreement, etc.). Under this view, the payments to the other selling shareholders should be further evaluated in accordance with the other factors in ASC 805-10-55-25
to determine whether the payments represent compensation cost or consideration transferred in the business combination.
EXAMPLE BCG 3-4
Contingent payment – incremental payment to an employee
Company B acquires Company A in a transaction accounted for as a business combination. The CEO of Company A, who is also a shareholder, will be employed by Company B after the acquisition. None of the other shareholders are employees. As part of the acquisition agreement, Company B will pay Company A’s shareholders $10/share of stock at the acquisition date. Additionally, Company B will pay the shareholders of Company A a further $1/share of stock if Company A’s net income exceeds $1 million during the one-year period following the acquisition, except that the CEO of Company A will be entitled to an additional $2/share of stock (i.e., $3/share in total) in such case. The CEO’s payments are not automatically forfeited if she is no longer employed by Company B.
How should Company B account for this arrangement?
As Company B acquired Company A in a business combination accounted for under ASC 805
, the $10/share paid at closing is treated as consideration transferred. Company B would evaluate the factors in ASC 805-10-55-25
to determine whether the contingent payment arrangements should be accounted for as additional consideration transferred for Company A or as compensation. The $1/share of stock that all selling shareholders of Company A are entitled to receive would likely be accounted for as contingent consideration. As the CEO’s additional $2/share of stock is not automatically forfeited if she is no longer employed, the requirement in ASC 805-10-55-25
(a) to account for such arrangements as postcombination compensation cost is not met. However, as the CEO of Company A will receive a higher per-share payment as compared to the other shareholders of Company A and will be employed by Company B after the business combination, the incremental value paid to the CEO of Company A (i.e., the additional $2/share) should be treated as compensation cost in Company B’s postcombination financial statements.
See Question BCG 3-7 for a discussion of the accounting for a subsequent modification to an arrangement with contingent payments in a business combination.