Exposure Draft on the Valuation of Contingent Consideration (Earnouts): Our Comments
An Appraisal Foundation working group comprised of professionals from 3 of the big 4, as well as other valuation firms, has developed an exposure draft on the valuation of contingent consideration. The group released the draft on February 28 and is gathering comments until April 28. The draft covers several key points outlined below:
- This guidance points to the use of scenario-based modeling for simpler consideration, such as regulatory approval or earnouts, which are linear payouts based on metrics.
- For more complicated earnouts, including caps, floors, or multiple periods, option style models or Monte Carlo simulation is required.
- Key inputs of concern include capturing the appropriate discount rate and volatility for the target metric, as well as having defensible projections and probabilities for the target metric.
- For a more thorough discussion of these changes, listen to the playback of our recent webcast here. Or, contact Josh Schaeffer to discuss your specific case.
Equity Methods has submitted a comment letter in response to this draft. The comment letter is below.
To whom it may concern:
Our firm has reviewed the Working Group’s First Exposure Draft on Valuation of Contingent Consideration. We appreciate the time and effort that has gone into the draft and we have four comments which we hope can improve the draft’s applicability and usefulness.
I. It would be useful to have a section discussing other contingent payouts (e.g., guarantees, other contingent cash flow assets and liabilities) to which these principles may apply.
II. The draft would be improved by sample calculations illustrating the top-down approach and bottom-up approach for determining a discount rate. This is a core component of the model that is subject to substantial preparer judgment.
III. In some cases, the uncapped upside of a lognormal distribution is simply not reflective of the target metric, causing valuation issues substantively different than downside issues addressed in the draft. A capped upside may be necessary depending on supply or demand considerations, for example:
a. Based on demand considerations: A medical device impacting late stage disease patients cannot generate revenue in excess of the number of people with that disease multiplied by the device cost.
b. Based on supply considerations: A manufacturer may be limited to current factory capacity over the term of the contingent consideration arrangement.
As a result, the draft could benefit from some mention of applying a distribution with an effective cap as well as best practices in doing so (e.g., reconfiguring the distribution to confirm the volatility and mean are still appropriate).
IV. The example beginning on line 1369 may cause confusion, as a seemingly linear earnout based on EBITDA is actually not linear for a company that is not guaranteed profitability over the earnout period. Amending the example to revenue and mentioning this potential problem with EBITDA would alleviate this concern.
Thank you for your consideration of our views. If you have any questions regarding these comments, please contact Josh Schaeffer.