With limited exceptions, the business combinations standards require the measurement of liabilities assumed to be at their acquisition-date fair values. ASC 805 and IFRS 3 incorporate the definition of fair value in the fair value standards; therefore, fair value must be measured based on the price that would be paid to transfer a liability.
Refer to FV 6 for further details on the fair value measurement of financial liabilities.
Contingent assets and liabilities
The valuation of contingent assets and liabilities is an area for which there is limited practical experience and guidance. ASC 805-20-25-19 through ASC 805-20-25-20B clarifies the initial recognition, subsequent measurement, and related disclosures arising from contingencies in a business combination. Under ASC 805, assets acquired and liabilities assumed in a business combination that arise from contingencies are required to be recognized at fair value at the acquisition date if fair value can be determined during the measurement period. If the acquisition date fair value of such assets acquired or liabilities assumed cannot be determined during the measurement period, the asset or liability should generally be recognized in accordance with ASC 450, Contingencies. See BCG 2 for more information.
IFRS 3.23 requires that an acquirer recognize, at fair value on the acquisition date, all contingent liabilities assumed that are reliably measurable present obligations. IAS 37.10 defines contingent liabilities as either present or possible obligations. Present obligations are legal or constructive obligations that result from a past event. Possible obligations are obligations that arise from past events whose existence will be confirmed only by the occurrence or nonoccurrence of one or more uncertain future events not wholly within the control of an entity. Contingent assets and possible obligations assumed are not recognized by the acquirer on the acquisition date.
A technique consistent with the income approach will most likely be used to estimate the fair value if fair value is determinable. A straightforward discounted cash flow technique may be sufficient in some circumstances, while in other circumstances more sophisticated valuation techniques and models such as real options, option pricing, Probability Weighted Expected Return Method sometimes called PWERM, or Monte Carlo simulation may be warranted.
Contingent consideration is generally classified either as a liability or as equity at the time of the acquisition. For details on the determination of the classification of contingent consideration, refer to BCG 2. Measuring the fair value of contingent consideration presents a number of valuation challenges. Generally, there are two methodologies used in practice to value contingent consideration. The first is a scenario-based technique and the second is an option pricing technique. The scenario-based technique involves developing discrete scenario-specific cash flow estimates or potential outcomes in circumstances when the trigger for payment is event driven. These amounts are then probability weighted and discounted using an appropriate discount rate. For example, a contingent payment that is triggered by a drug achieving an R&D milestone is often valued using a scenario-based method. The option pricing technique, which is more fully described in the Appraisal Foundation paper Valuation Advisory #4: Valuation of Contingent Consideration, is similar in concept, but uses an option-pricing framework for valuing contingent consideration. This eliminates the need to determine the appropriate discount rate and replaces scenarios with a volatility assumption. Option pricing techniques rely on estimates of volatility and a milestone-specific risk, referred to as Market Price of Risk. The option pricing technique is most appropriate in situations when the payment trigger is in some way correlated to the market (for example, if payment is a function of exceeding an EBITDA target for a consumer products company). The scenario method applies in situation when the trigger is not correlated (for example, if payment is tied to a decision by a court).
As is the case for all models, entities will need to consider the key inputs of the arrangement and market participant assumptions when developing the fair value of the arrangement. This will include the need to estimate the likelihood and timing of achieving the relevant milestones of the arrangement. Entities will also need to exercise judgment when applying a probability assessment for each of the potential outcomes. In the case of the option pricing method, the volatility assumption is key. In some cases, the volatility will not be objectively determinable (e.g., a revenue-based trigger for a company that has few or no reasonable comparative companies). In such cases, market participants may consider various techniques to estimate fair value based on the best available information.
The fair value of liability-classified contingent consideration will need to be updated each reporting period after the acquisition date. Changes in fair value measurements should consider the most current estimates and assumptions, including changes due to the time value of money.
Example FV 7-9 provides an overview of the application of a basic technique to measure contingent consideration.
EXAMPLE FV 7-9 Measuring the fair value of cash settled contingent consideration — liability classified
Company A purchases Company B for CU400. Company A and Company B agree that if revenues of Company B exceed CU2500 in the year following the acquisition date, Company A will pay CU50 to the former shareholders of Company B. Company B is a biotech with one unique oncology product. Company A should classify the arrangement as a liability because it requires Company A to pay cash.
How could the fair value of the liability be calculated based on the arrangement between Company A and Company B?
Company A would most likely consider a scenario-based discounted cash flow methodology to measure the fair value of the arrangement. A key determination for this approach is selecting a discount rate that best represents the risks inherent in the arrangement. In reality, there is more than one source of risk involved. For example, both projection risk (the risk of achieving the projected revenue level) and credit risk (the risk that the entity may not have the financial ability to make the arrangement payment) need to be considered.
Each of these risks may be quantifiable in isolation. When the two risks exist in tandem, consideration should be given to factors such as the potential correlation between the two risks and the relative impact of each risk upon the realization of the arrangement.
One alternative approach to determine the fair value of the cash settled contingent consideration would be to develop a set of discrete potential outcomes for future revenues. Some outcomes would show revenue levels above the CU2500 performance target and some would be below. Outcomes showing revenues above the CU2500 threshold would result in a payout. For those below the threshold, there would be no payout.
Each discrete payout outcome would then be assigned a probability and the probability-weighted average payout discounted based on market participant assumptions. For example, using the following assumed alternative outcomes and related probability, the fair value of the arrangement would be calculated as follows.
Example FV 7-10 provides an overview of the measurement of liability-classified share-settled contingent consideration.
EXAMPLE FV 7-10 Measuring the fair value of share settled contingent consideration — liability classified
Company A purchases Company B by issuing 1 million common shares of Company A stock to Company B’s shareholders. At the acquisition date, Company A’s share price is CU40 per share. Company A and Company B agree that if the common shares of Company A are trading below CU40 per share one year after the acquisition date, Company A will issue additional common shares to Company B’s former shareholders sufficient to mitigate price declines below CU40 million (i.e., the acquisition date fair value of the 1 million common shares issued).
The guarantee arrangement creates an obligation that Company A would be required to settle with a variable number of Company A’s equity shares, the amount of which varies inversely to changes in the fair value of Company A’s equity shares. For example, if Company A’s share price decreases from CU40 per share to CU35 per share one year after the acquisition date, the amount of the obligation would be CU5 million. Therefore, the guarantee arrangement would require liability classification on the acquisition date. Further, changes in the liability will be recognized in Company A’s earnings until the arrangement is settled.
How could the fair value of the contingent consideration arrangement be calculated based on the arrangement between Company A and Company B?
The contingent consideration arrangements would likely be valued using an option pricing technique that estimates the value of a put option. In this example, Company A is guaranteeing its share price, effectively giving a put option on the transferred shares. Assuming a 2% risk-free rate, no dividends, 55% volatility, a one year put option with a stock price of CU40 million, a strike price of CU40 million, and time to expiration of one year, the put value is CU8.2 million.
The best estimate or the probability-weighted approach will likely not be sufficient to value the share settled arrangement. In addition to the quantification of projection and credit risks, the modeling of Company A’s share price is required. The following factors, which are relevant in performing a valuation for such arrangements, are what make it unlikely that the probability-weighted approach would be appropriate:
Potential outcomes for Company A’s financial results next year
Potential outcomes for Company A’s share price over the coming year
Correlation of the potential financial results with share prices
Potential outcomes for other market events that could impact the overall stock market
Selection of an appropriate discount rate that adequately reflects all of the risks not reflected in other assumptions (e.g., projection risk, share price return estimation risk, Company A’s credit risk)
Example FV 7-11 provides an overview of the measurement of equity-classified share-settled contingent consideration.
EXAMPLE FV 7-11 Measuring the fair value of share settled contingent consideration — equity classified
Company A acquires Company B in a business combination. The consideration includes 10 million Company A shares transferred at the acquisition date and 2 million shares to be issued 2 years after the acquisition date, if a performance target is met. The performance target is met if Company B’s revenues (as a wholly owned subsidiary of Company A) exceed CU500 million in the second year after the acquisition. The market price of Company A’s stock is CU15/share at the acquisition date. Company A management assesses a 25% probability that the performance target will be met. A dividend of CU0.25 per share is expected at the end of years 1 and 2. The seller will not be entitled to receive a dividend on the contingent shares.
Because Company A has already received Company B’s business upon transfer of the 10 million Company A shares, the agreement for Company A to contingently deliver another 2 million shares to the former owners of Company B is a prepaid contingent forward contract.
How could the fair value of the equity classified prepaid contingent forward contract be valued based on the arrangement between Company A and Company B?
There may be several acceptable methods for determining the fair value of the forward contract. One that is commonly used is a model based on discounted expected payment. In this case, the fair value of the contingent consideration at the acquisition date would be based on the acquisition-date fair value of the shares and incorporate the probability of Company B achieving the targeted revenues. The fair value would exclude the dividend cash flows in years 1 and 2, as the market price is inclusive of the right to receive dividends to which the seller is not entitled and would incorporate the time value of money.
The discount rate for the present value of dividends should be the acquirer’s cost of equity
because returns are available to equity holders from capital appreciation and dividends paid. Those earnings are all sourced from net income of the acquirer.
Based on the facts above and an assumed 15% cost of equity, the fair value would be calculated as follows.
Revenue forecast (CU millions)
Payment in shares
Probability weighted number of shares
Probability weighted value
Dividend year 1 (500,000 shares x CU0.25/share)
Dividend year 2 (500,000 shares x CU0.25/share)
Present value of dividend cash flow (assuming 15% discount rate)
Present value of contingent consideration (7,500,000 – 203,214)
Each arrangement should be evaluated based on its own specific features, which may require different modeling techniques and assumptions. Additionally, the valuation model used for liability-classified contingent consideration would need to be flexible enough to accommodate inputs and assumptions that need to be updated each reporting period. The PFI used in valuing contingent consideration should be consistent with the PFI used in other aspects of an acquisition, such as valuing intangible assets. The valuation model used to value the contingent consideration needs to capture the optionality in a contingent consideration arrangement and may therefore be complex.
When an entity with listed debt is acquired, market evidence shows that the listed price of the debt changes to reflect the credit enhancement to be provided by the acquirer (i.e., it reflects the market’s perception of the value of the liability if it is expected to become a liability of the new group). If the acquirer does not legally add any credit enhancement to the debt or in some other way guarantee the debt, the fair value of the debt may not change.
The standards require the fair value of debt to be determined as of the acquisition date. If the acquiree has public debt, the quoted price should be used. If the acquiree has both public and nonpublic debt, the price of the public debt should be considered as one of the inputs in valuing the nonpublic debt.
Question FV 7-2 illustrates how a company should measure the fair value of debt assumed in a business combination.
Question FV 7-2 How should a company measure the fair value of debt assumed in a business combination?
The credit standing of the combined entity in a business combination will often be used when determining the fair value of the acquired debt. For example, if acquired debt is credit-enhanced because the debt holders become general creditors of the combined entity, the value of the acquired debt should follow the characteristics of the acquirer’s post combination credit rating. However, if the credit characteristics of the debt acquired remain unchanged after the acquisition because, for example, the debt remains secured by only the net assets of the acquired entity, the value of the acquired debt should reflect the characteristics of the acquiree’s pre-combination credit rating.
1A discount rate of 20% is used for illustrative purposes.
2 In most cases, there will be a correlation between the revenues of Company B and the share price of Company A. This requires a more complex analysis in which the movement of Company A’s share price fluctuates with Company B’s revenues.A simplifying assumption has been made in this example that Company B’s revenues and Company A’s share price are not correlated.
3The required rate of return on dividends would likely be less than the cost of equity in many cases. For simplicity, the example used the same discount rate.
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