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PLUS Madoff Victims’ Tax Questions for 2008 Returns Accounting Across Borders Accounting Across Borders • N.Y. Legislation Delivers Reform, Mobility • IFRS on the Horizon N.Y. Legislation Delivers Reform, Mobility IFRS on the Horizon Madoff Victims’ Tax Questions for 2008 Returns

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Page 1: Earn Out Valuation

PLUSMadoff Victims’ Tax Questions for 2008 Returns

Accounting Across BordersAccounting Across Borders• N.Y. Legislation Delivers Reform, Mobility

• IFRS on the Horizon• N.Y. Legislation Delivers Reform, Mobility

• IFRS on the Horizon

Madoff Victims’ Tax Questions for 2008 Returns

Page 2: Earn Out Valuation

MARCH 2009 / THE CPA JOURNAL38

By Marc Asbra and Karen Miles

At the end of 2007, the FASBreleased SFAS 141(R), BusinessCombinations, which governs

the financial accounting for mergers andacquisitions (M&A) that have closed on orafter the first annual reporting period begin-ning on or after December 15, 2008. WhileSFAS 141(R) includes several minorchanges to current GAAP, the treatment ofcertain items under SFAS 141(R) will dra-matically affect the initial and subsequentrecording of a transaction in the acquir-er’s financial statements, and may eveninfluence the structuring of certain deals.

There are three critical provisions inSFAS 141(R) to consider:■ All forms of purchase consideration(including acquirer stock) are measuredas of the acquisition date, the date at whichthe acquirer obtains control of the target.■ Transaction costs and related expens-es (including restructuring expenses) areexcluded from purchase consideration;the items are expensed as incurred.■ Earn-outs, other forms of contingentconsideration, and certain acquired con-tingencies (assets and liabilities) are record-ed at fair value as of the acquisition date.

While the first and second items deserveattention in their own right, determiningthe fair value of contingent elements in atransaction will present new challenges tofinancial statement preparers. Valuationapproaches and other issues related to earn-outs and acquired contingencies must beconsidered.

Earn-outsAn earn-out can be a valuable device in

structuring an M&A transaction, particu-larly when the buyer and seller have diver-gent views about the potential future suc-cess of the target company. Sellers seekcompensation for future market opportuni-

ties they believe their business can exploit.Conversely, buyers are willing to pay forsustainable earnings and current achieve-ments, but temper their expectations ofyet-to-be-exploited opportunities. If struc-tured properly, an earn-out can place thetotal transaction proceeds at a place on therisk-return spectrum that effectively balancesthe requirements of the buyer and the sell-er. The future payments give the seller anopportunity to realize more “equityupside” from the sale of the business,while at the same time providing the buyerwith “downside protection” through the sell-er’s strong interest in the success of the post-combination company.

Under current GAAP, earn-out paymentsare recorded in the acquirer’s financialstatements only if and when they areearned. Under SFAS 141(R), however,earn-out payments will be recorded at fair

value as of the acquisition date. As withmany aspects of M&A negotiations, theelements and structure of an earn-out arelimited only by the ability of the buyer andseller to think creatively about the future.Earn-outs can incorporate general or spe-cific objectives, include financial or non-financial targets, contain single or multipleelements, cover short or long periods, andinvolve cash or other forms of considera-tion. Whether simple or complex, the for-ward-looking characteristics of earn-outstypically mean that the optimal method forquantifying their fair value is the incomeapproach.

The income approach generally esti-mates value by discounting expected futurecash flows to the present through a rate ofreturn (i.e., discount rate) that accountsfor both the time value of money andinvestment risk factors. The determina-

The Valuation of Earn-outs and AcquiredContingencies Under SFAS 141(R)

A C C O U N T I N G & A U D I T I N G

b u s i n e s s v a l u a t i o n

Page 3: Earn Out Valuation

tion of the fair value of an earn-out underthis approach presents a number of chal-lenges and prompts several questions:■ What is the likelihood that the earn-outwill be achieved?■ What cash flows or other activitiesare directly associated with the earn-out? ■ What is the level of risk in achievingthe earn-out? ■ What type of discount rate should beused in the analysis? ■ How would that rate compare to theoverall discount rate for other assets andliabilities being valued in the transaction? ■ What adjustments are needed if theearn-outs are noncash?

As one can imagine, the buyer andseller may have dramatically different opin-ions on these questions and the underly-ing issues. Similarly, divergent fair valueconclusions can result from even small dif-ferences in the valuation assumptions used.Like all other fair value analyses done foracquisition accounting purposes, the valu-ation study for earn-outs must be thorough,supported by reasonable assumptions, andfully documented.

ExampleThe following discussion focuses on the

valuation of a relatively common earn-outbased on the target business achieving cer-

tain thresholds of earnings before interest,taxes, depreciation, and amortization(EBITDA). The target company achieved$5 million in EBITDA on $25 million insales in the year immediately prior to thetransaction and presented a business planto the buyer that demonstrated substantialfuture growth in revenue and profit. Thebuyer successfully negotiated the purchaseof the target company for an initial priceof $23 million, plus a three-year earn-out.

Exhibit 1 shows that the earn-out isbased on the buyer’s projected EBITDAlevels and could result in the payment ofan additional $4.5 million of consideration.The fair value of the earn-out, however,is determined to be approximately $3.3 mil-lion, or more than 25% below the nomi-nal amount. The lower fair value resultsfrom the application of a 15% discount rateto capture the inherent risk that the targetcompany will not achieve the projectedEBITDA targets.

Because of the relatively simple struc-ture in this example, Exhibit 1 uses a sin-gle, likely scenario in determining the fairvalue of the earn-out. For more complexstructures, an alternative analysis would uti-lize various projected scenarios and employa probability-weighting scheme to estimatefair value. This alternative would provideflexibility in modeling the various future

events and assessing the potential earn-out payments. Particular care needs to beexercised in constructing the probabilityweighting scheme, however, as the selec-tion of probability factors can significant-ly affect the ultimate fair value conclusion.Care must also be taken to ensure that thefinancial projections utilized to determinethe fair value of the earn-out are consistentwith those used to estimate the fair valuesof the acquired intangible assets, which areoften developed from similar income-basedapproaches.

Not only is the determination of thefair value of an earn-out critically impor-tant for allocating the purchase price at thetime of the transaction, but it is also sig-nificant for the acquirer’s future goodwillimpairment testing. Exhibit 2 presents theimplications of SFAS 141(R) as it relatesto goodwill impairment testing. If the tar-get business successfully achieves the earn-out payments, the final amount of good-will will actually be lower under SFAS141(R) than it would under prior GAAP.This lower amount is placed on the acquir-er’s balance sheet immediately, however,which may expose the acquirer to a high-er likelihood of potential goodwill impair-ment charges in the event the earn-outtargets are not achieved and the businessexperiences other challenges. The higher

39MARCH 2009 / THE CPA JOURNAL

Projected

Seller Projections and Earn-out Actual Year 1 Year 2 Year 3 Year 4

Sales $25,000 $32,500 $40,000 $47,500 $55,000EBITDA 5,000 7,500 10,000 12,500 15,000

Earn-out Target EBITDA $7,500 $10,000 $12,500Earn-out Payments 1,000 1,500 2,000

Income Approach Year 1 Year 2 Year 3 Year 4

Earn-out Payments $1,000 $1,500 $2,000 $0Discount Period 1.0 2.0 3.0 4.0Discount Rate 15.0% 0.870 0.756 0.658 0.572Present Value of Cash Flow $870 $1,134 $1,315 $0Fair Value ((Rounded) $3,300

EXHIBIT 1Fair Value of Earn-out

Page 4: Earn Out Valuation

amount of goodwill finally recorded underprior GAAP, in contrast, is placed on thebalance sheet only after the earn-out tar-gets have been reached. The payment ofthe earn-outs could indicate that the post-combination business is enjoying somedegree of success, which might lessen thepotential likelihood for goodwill impair-ment charges, all else being equal.Moreover, the amount of goodwill initial-ly recorded under current GAAP providesa “cushion” to the acquirer in the eventprofit expectations do not materialize. Thatis, the probability of having a goodwillimpairment charge is lower under priorGAAP because the goodwill related tothe earn-out elements has not yet beenplaced on the balance sheet.

Including the fair value of an earn-out in the purchase price also has impli-cations beyond financial reporting.Because valuation multiples impliedfrom earn-out transactions under SFAS141(R) will necessarily be higher thanthose under current GAAP, comparisonsto prior transaction multiples or indus-try rules of thumb will require a morecomplicated analysis. To the extent an

earn-out represents a significant compo-nent of the purchase price, investorsand analysts may pressure acquirer man-agement teams for comprehensive dis-closures regarding the nature of the earn-out and the assumptions used to deter-mine its fair value.

Acquired ContingenciesM&A transactions often include

acquired contingencies on both sides of thetarget company’s balance sheet: assets andliabilities. One of the more notable exam-ples on the left-hand side is an indemnifi-cation asset, whereby the seller contractu-ally indemnifies the acquirer for the out-come of a contingency or uncertainty relat-ed to all or part of a specific asset or lia-bility. One of the more notable exampleson the right-hand side is pending or threat-ened litigation.

These and other contingencies are gen-erally governed by SFAS 5, Accountingfor Contingencies, which defines a con-tingency as an existing condition, situa-tion, or set of circumstances involvinguncertainty as to possible gain or loss toan entity that will ultimately be resolved

when one or more future events occursor fails to occur. While SFAS 5 techni-cally deals with assets (gains) and liabil-ities (losses), contingencies that mightresult in gains usually are not reflectedon the balance sheet, since to do so mightbe to recognize revenue prior to its real-ization. As such, in practical terms, SFAS5 deals mainly with the world of contin-gent liabilities.

A contingent liability under SFAS 5must meet two criteria: 1) it is probablethat a liability had been incurred (or anasset had been impaired) at the measure-ment date; and 2) the amount of loss canbe reasonably estimated. Current GAAPpermits deferred recognition of acquired(pre-acquisition) contingencies until theserecognition criteria are met. SFAS 141(R),however, has less stringent criteria in rec-ognizing acquired contingencies and fur-ther segments between contractual and non-contractual contingencies. Specifically, con-tingent liabilities related to contracts(referred to as contractual contingencies)are measured at fair value as of their acqui-sition date. For all other noncontractualcontingencies, the acquirer must recognize

MARCH 2009 / THE CPA JOURNAL40

Current GAAP

Initial Interim Final SFAS 141(R) Difference

Purchase Price $23,000 $ 0 $23,000 $23,000Earn-outs 0 4,500 4,500 3,300 (1,200)Total Transaction Value 23,000 4,500 27,500 26,300 (1,200)Net Tangible and Intangible Assets 9,000 9,000 9,000 0Goodwill $14,000 $18,500 $17,300 ($1,200)

$ 0

Current GAAP

Initial Interim Final

)002,1$(003,71$005,81$000,41lliwdooGNet Tangible and Intangible Assets 9,000 9,000 9,000 0

$ 0$ 23,000 $ 0 $ 23,000 $ 23,000Purchase PriceEarn-outs 4,500 $ 4,500 3,300 (1,200)0Total Transaction Value 4,500 27,500 26,300 (1,200)

SFAS 141(R) Difference

$ 23,000

EXHIBIT 2Recording of Goodwill

Page 5: Earn Out Valuation

a liability only if it is more likely than not(i.e., greater than 50%) that a liability existsat the acquisition date. SFAS 141(R) elim-inates the condition that the liability be rea-sonably estimable. If it is deemed morelikely than not, the noncontractual liabili-ty is recorded at fair value as of theacquisition date, consistent with the treat-ment of contractual contingencies. Whilethe ultimate reality might be different, thepresumption of most readers of SFAS141(R) is that noncontractual contingen-cies will be identified and valued more fre-quently than under prior GAAP.

Consider pending litigation as an exam-ple. While more complex models certainlyexist, lawsuits and other contingent claimsare often valued utilizing a decision-treeanalysis. As the name suggests, a decisiontree generally incorporates various futureoutcomes along as many potential branch-es as the user deems appropriate. As thebranches diverge over time, probabilityfactors are assigned at each of the nodes

representing the likelihood of each poten-tial path occurring. In the case of a law-suit or other financial claim, paymentamounts are also estimated for the vari-ous outcomes. As illustrated below, thesum of the probability-weighted pay-ment amounts serves as an indication ofthe fair value of the claim underlying thelawsuit.

While this simple framework is useful indemonstrating an effective quantificationtechnique, the valuation of a pending claimin the real world is more complex andrequires thoughtful consideration and an anal-ysis of the facts and circumstances of boththe parties and the case. Other factors alsowarrant consideration, including expectedlegal costs and the time value of money, aswell as the impact from the general disrup-tion to the business and the diversion of man-agement’s time and attention during the lit-igation. The complexities of such analysesoften prompt companies to seek outsideassistance from lawyers and valuation spe-

cialists when developing reasonable and sup-portable fair value estimates.

Public companies have the added sen-sitivity of financial statement disclosuresrelated to acquired contingencies, whichcan greatly influence a company’s legalstrategy. SFAS 141(R) states that, for lia-bilities arising from contingencies, man-agement should disclose the following:■ The amounts recognized at the acqui-sition date, or an explanation of why noamount was recognized. ■ The nature of recognized and unrec-ognized contingencies. ■ An estimate of the range of outcomes(undiscounted) for contingencies (recog-nized and unrecognized); if a range cannotbe estimated, that fact and the reasonbehind it should be disclosed.

SFAS 141(R) allows an acquirer in atransaction involving multiple acquiredcontingencies to aggregate disclosures forliabilities (and assets) arising from similarcontingencies. While the aggregation of

41MARCH 2009 / THE CPA JOURNAL

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Page 6: Earn Out Valuation

information would limit the counterparty’sability to glean information about thelawsuit, the disclosure of any sensitiveinformation is likely to be met withstrong resistance by an acquirer’s man-agement and legal counsel.

Increased Complexity From a purely academic perspective,

M&A transactions should be evaluatedaccording to their underlying economics—net present value, investment return, eco-nomic value added, or some other cash-flow-based financial metric—and not judged bythe financial statement impact caused byGAAP accounting requirements. M&Atransactions are not completed in the class-room, however, and earnings-per-share fig-ures are not ignored by investors. SFAS

141(R) will likely improve the consistencyand transparency of financial reporting forM&A transactions, but it does so with theadded cost of certain complexities, particu-larly as they relate to earn-outs andacquired contingencies. Management shouldbe aware of the changes SFAS 141(R) rep-resents, as it will be increasingly importantto assess the initial and subsequent finan-cial statement implications as early as pos-sible when structuring an M&A transaction.

The treatment of acquired contingent lia-bilities in SFAS 141(R) was the subjectof significant debate leading up to itsrelease. The FASB responded onDecember 15, 2008, with a proposedFASB Staff Position (FSP) that wouldamend SFAS 141(R) to require that con-tingent assets and liabilities be recognized

at fair value per SFAS 157, Fair ValueMeasurements, if the acquisition-date fairvalue can be reasonably determined. Ifthe fair value cannot be reasonably deter-mined, then the acquirer would follow theguidance set forth in SFAS 5. While theFSP had not been finalized at the time ofthis publication, if approved as currentlydrafted, the effect of the FSP would gen-erally be a reversion back to current prac-tice under SFAS 141 regarding acquiredcontingencies. ❑

Marc Asbra, CFA, is a a senior vice pres-ident in Houlihan Lokey’s Los Angelesoffice. Karen Miles, CPA, heads HoulihanLokey’s financial opinions and advisoryservices business for Southern California.

MARCH 2009 / THE CPA JOURNAL42

Payment

Conditional Nominal Probability

Probabilities Amount Weighted

0$0$)%1(wardhtiW

000,83$000,002$)%91(eltteSnoitagitiLClaim

0$0$)%04( )%08(niW

LitigateHigh (80%) (60%) (25%)

Damages

Lose

Medium (80%) (60%) (50%)Damages

Low (80%) (60%) (25%)Damages

Total Expected Value

1%

19%

80%40%

60%25%

50%

25%

$1,000,000 $120,000

$500,000 $120,000

$250,000 $30,000

$308,000

EXHIBIT 3Lawsuit Decision-Tree Analysis