In certain circumstances, contingent consideration in a business combination (e.g., an earn out) can be considered compensation expense in the post combination period. PwC’s Meg Rohas explains the basic concepts around contingent payments, the criteria to consider when things aren’t clear cut, and one area that can catch people off guard.
Hi, I’m Meg Rohas.
Business combinations often include payments that are contingent upon future results. When there is a contingent consideration arrangement in a deal, there are circumstances when those payments represent compensation expense in the post-combination period rather than purchase price.
In this video, I’ll share some basic concepts around contingent payments, the criteria to consider when things aren’t clear cut, and one area I see catching people off guard.
Contingent consideration arrangements bridge the gap between buyer and seller when there is a difference in price during negotiations. For example, if a buyer thinks the business is worth 10 million dollars, but the seller says it’s worth 15, the deal could fall apart. This is when contingent consideration may come into play. The buyer may say, I’ll pay you 10 million dollars now, and if the business performs like you say it will, I’ll pay you the extra 5 million dollars later. At first glance, it seems like this 5 million dollar payment would be additional purchase price. But if there happens to be an element of continuing employment, some - or all - of that 5 million dollars may actually be compensation expense.
What if I told you that the founding shareholder of that target business was also the CEO and signed an agreement to work for at least two years after the deal closes? These additional facts make it more difficult to determine if that contingent payment is additional purchase price, or if it’s actually a bonus payment to the CEO.
Most transactions are complicated, and the answers aren’t easy. When this happens, the guidance gives us eight indicators to consider. These should be considered for contingent payments of both cash and stock, to employees or selling shareholders.
The eight indicators include:
- The terms of continuing employment. If any of the selling shareholders become key employees, then it’s important to understand what happens to the contingent payment if the employee quits or is terminated. It’s important to note that if the contingent payments are automatically forfeited if employment terminates, then that contingent payment always represents compensation in the post-combination period. The rest of the indicators don’t matter.
- Duration of continuing employment. If the required period of employment is the same or longer than the contingent payment period, that may indicate the payment is for compensation.
- Level of compensation. If, excluding the amount of the contingent payment, the selling shareholder who becomes a key employee is generally making the same as other key employees, then that may indicate the contingent payment does not represent compensation.
- Incremental payments to employees. If selling shareholders who become employees earn a higher contingent payment on a per-share basis than non-employee selling shareholders, then the incremental amount may represent compensation.
- Relative number of shares owned by key employees. If the selling shareholders who become key employees owned substantially all of the target business, then that may indicate the contingent payments are similar to a profit sharing arrangement and would represent compensation.
- Linkage to valuation. If the initial consideration transferred - excluding the contingent payment - is less than the fair valuation of the business, this may indicate the contingent payment is additional consideration
- Formula used to determine the contingent payment. For example, if the contingent payment is calculated as 5% of future earnings, this may indicate the arrangement is more of a profit-sharing compensation arrangement. If the payment is calculated based on a multiple of earnings, then the formula may be intended to verify the fair value of the target business.
- Other agreements. You should consider the terms of other agreements like non-compete agreements, consulting contracts, and lease agreements that are executed at the same time as the transaction as they could have an impact on the analysis. Another good thing to consider is what the income tax treatment of the payments will be. Pay attention to those payments that the buyer will pay to an employee and report on their W-2.
These eight indicators function as data points to help you assess all of the facts to make your conclusion. If a majority of the indicators point to purchase price, you may still get to a compensation expense conclusion.
One of the most common mistakes I see in this area is when the selling shareholders have made a side agreement with key employees. For example, let’s assume we have a buyer who has agreed to pay the selling shareholders a contingent cash payment in 2 years if the business makes an EBITDA target. The CEO and CFO of the target business - who are not selling shareholders - have agreed to continue their jobs for market-rate salaries from the buyer. At the same time, the selling shareholders execute individual agreements with both the CEO and CFO, agreeing to pay them a cash bonus if they stay employed through the contingency period and the business hits the earnings target. Even though the buyer had no involvement in the side agreements, the bonuses that the CEO and CFO could receive from the seller would represent compensation expense of the buyer because the buyer is benefitting from the services provided. Therefore, the buyer has to separate the contingent payment into two components - a contingent consideration liability booked at fair value on the acquisition date, and compensation expense, which should be booked as the services are rendered by the CEO and CFO, beginning once the achievement of the EBITDA target became probable.
As you can see, the right answer is not always the obvious or most popular choice. Even when a buyer purposefully structures a contingent payment as part of the total price paid to the seller, the accounting answer may not always agree. Therefore, when accounting for contingent consideration arrangements, it is important to consider all of the facts - especially when employees share in the payout.