The Appraisal Foundation Has Issued Its Final Guidance on Valuation of Contingent Consideration

In February, the Appraisal Foundation released the final version of their 2017 draft guidance on contingent consideration (earnouts).

This guidance reflected—and helped guide—a move away from ad hoc modeling, uninformed guesses of probability, and difficult-to-support discount rates. Instead, the foundation called for a more formal valuation methodology based firmly on option theory, using the market for real options. We’ve also seen this guidance prove useful in modeling and valuation across a number of other contingent payments including compensation[1] and guarantees.

The final guidance, which preserves the exposure draft’s core principles on methodology and assumption, also solidifies a generally accepted framework for the valuation of these instruments. Any holdouts hoping for a return to simpler methods will be sorely disappointed.

What’s New in the Final Version

What the final guidance does offer is a large number of real-world examples to further show how the methodologies work and how they can apply to a number of different situations. I believe these additions make for a very usable guide for practitioners to base their analysis on. They also help lay readers looking to understand why this methodology is appropriate.

Other noteworthy changes include:

A description of the market participant for contingent consideration. This is of particular interest because the company that pays only when things are going well may see an earnout differently from a hypothetical buyer who may be looking for exposure to the subject company. The guide clarifies that the market participant is an external party.

A framework for applicability to contingent consideration in other GAAP, such as ASC 946. We’ve found this useful in multiple areas where future payments depend on firm performance (outside of ASC 718 where performance conditions are scoped out of the fair value exercise).

A dramatic expansion of the discussion on the scenario-based model and option pricing model. An understanding of the meaning and application of both of these models, part of the focus of my CPA Journal article, is crucial to understanding the value of earnouts. By adding substantive material on both, the guidance is much more thorough about explaining why the OPM is needed in most earnout cases.

More details on the estimation of inputs. For example, the guidance increases discussions of how to estimate metric volatility, correlations, and discounting premiums. It also talks about ways to consider potential biases in management assumptions.

Beyond that, the final guidance takes into account related comments from Equity Methods’ comment letter and subsequent discussions with working group members. These include:

  • The addition of examples on calculation of the discount rate in section 5.2.3
  • An explanatory footnote dealing with a potential issue in an example
  • An additional section dealing with our biggest concern about metrics with different distributions

Answers Will Still Vary

Like any valuation problem, working on earnouts often requires careful consideration of specific facts and circumstances, and different practitioners may apply the guidance differently. Even with the standardization coming from this guidance, individual earnouts will continue to require special consideration and discretion. For example:

  • When the earnout involves multiple metrics (e.g. EBITDA and revenue)—or is based on a financial metric and pays out in shares—the correlation between these variables is a crucial input, yet very difficult to estimate based on limited data. The guidance discusses management assessments; however, correlations are hard to reasonably assess without statistical knowledge and consideration.
  • Market volatility and risk metrics may be long-term in nature, but earnouts are often based on shorter terms, sometimes with locked-in purchase or construction contracts mitigating risk. As such, thoughtful adjustments of these metrics may be necessary.
  • After the transactions, understanding the changes in the underlying risk profile of the earnout is crucial, so mark-to-markets require careful consideration.

As with any valuation, earnout models are part science, part art. Taking the time to understand the rules, inputs, and models helps to develop the best estimates. We expect that earnouts will continue to be a fundamental component of intercompany transactions and their valuation will spark some lively discussion for years to come.

[1] A key accounting difference between earnouts and compensation for financial reporting is that in compensation, performance conditions on EBITDA and the like are removed from the fair value calculation. However, we’ve found many firms are very interested in how these performance metrics may impact the actual payouts related to their awards.