Insight

Does your business combination agreement have ‘earnouts’?

Determining whether earnouts are consideration or compensation for services under IFRS® Standards.

Kevin Bogle

Kevin Bogle

Principal, Advisory, Accounting Advisory Services, KPMG LLP

+1 212-872-5766

From the IFRS Institute – March 11, 2022

In 2021 global Mergers and Aquisitions (M&A) activity reached its highest level in years, with over $5.1 trillion worth of transactions1. The purchase price specified in M&A agreements can take many forms, including contingent payments that are frequently in the form of an earnout. Although earnouts are typically negotiated concurrently with the M&A transaction, such payments do not always relate to the acquirer obtaining control over the acquiree. In this article, we summarize key considerations in evaluating whether earnouts are consideration or compensation for future services.

What is part of a business combination transaction?

An earnout is a contractual mechanism in a M&A agreement, which provides for contingent additional payments from the acquirer to employees or selling shareholders. Earnouts are typically ‘earned’ if the business acquired meets certain predetermined financial or other milestones after the acquisition is closed.

Under IFRS 32, the accounting for contingent payments like earnouts depends on whether the payments are part of the consideration for the business combination or represent a separate transaction.

Consideration
(part of the business combination)
Compensation
(not part of the business combination)

Earnouts determined to be part of the business combination (i.e. consideration) are measured at fair value at the acquisition date, and enter into the calculation of goodwill. 

After the acquisition, accounting for changes in the fair value of earnouts depends on whether they are classified as equity or liability.

If the earnouts do not represent consideration, the payments are accounted for under other relevant standards and do not enter into the calculation of goodwill. They are not generally accrued at the acquisition date, but instead are typically treated as compensation for post-combination services received from the employees or selling shareholders.


Evaluating arrangements for earnouts to employees or selling shareholders

It is not always clear whether earnouts to employees or selling shareholders represent consideration or compensation. To assist in this determination, IFRS 3 provides the following indicators, one of which is determinative.

Determinative Description

1. Continuing employment – automatic forfeiture

  • If an earnout is automatically forfeited on termination of employment, the payments are considered compensation for post-combination services – i.e. not part of the business combination.
  • This indicator is determinative regardless of other factors that may indicate the payments are more like consideration. See below, The continuing employment indicator.


If the first indicator is not met, the acquirer makes a determination by applying judgment in considering all of the following indicators.

Indicators Description

2. Continuing employment – no automatic forfeiture

If employment termination does not affect the earnout, it may be consideration.

3. Duration of continuing employment

When the required employment period equals or is longer than the earnout payment period, the earnout may be compensation.
4. Level of remuneration If employee remuneration, excluding the earnout, is reasonably comparable to that of other key employees in the post-combination entity in similar positions, the earnout may be consideration.
5. Incremental payments to employees If the earnout paid to selling shareholders who do not become employees is lower on a per-share basis than the one paid to selling shareholders who do become employees in the post-combination entity, the incremental payment may be compensation.
6. Number of shares owned
  • If substantially all the shares of the acquiree were held by selling shareholders who continue as key employees, the earnout may be compensation.
  • However, if selling shareholders who continue as key employees held only a small proportion of the acquiree’s shares and all selling shareholders receive the same earnout on a per-share basis, the earnout may be consideration.
7. Linkage to the valuation
  • If the initial consideration transferred in the business combination is based on the low end of a valuation range for the acquiree and the earnout formula links to the valuation approach, the earnout may be consideration.
  • In contrast, the substance of the payment may be compensation if the earnout formula is not directly linked to the valuation approach – e.g. the earnout formula is similar to prior profit-sharing arrangements.
8. Formula for determining earnout 
  • When the earnout is determined with reference to items that establish or verify the fair value of the acquiree (e.g. multiple of earnings), it may be consideration.
  • Alternatively, an earnout based on post-combination profits (e.g. specified percentage of earnings) is similar in substance to a profit-sharing arrangement and may be compensation.
9. Other agreements and issues
  • Other arrangements with selling shareholders and the income tax treatment of earnouts are also considered in evaluating their substance.
  • Common examples of other arrangements include non-compete arrangements, executory contracts, consulting agreements and leases.
  • If the payments specified in these other agreements are consistent with market terms, that may indicate the earnout is consideration whereas significantly below-market terms may indicate the earnout is compensation.


The continuing employment indicator

If the earnout is automatically forfeited if employment terminates, it is considered compensation for post-combination services, regardless of whether some or all of the other indicators suggest the payments may be consideration for the acquisition - e.g. even if the relevant employee is entitled to compensation at rates comparable to those earned by people in similar roles.

Example: Payments forfeited

ABC Corp. acquires all of the outstanding shares of Target in a business combination. Target had four shareholders with equal shareholdings, two of whom were also senior-level employees of Target.

  • The non-employee shareholders each receive 100.
  • The employee shareholders each receive 60, plus an additional payment of 150 to 200 based on a multiple of earnings over the next two years. Each of these shareholders forfeits their additional payment if they leave Target's employment at any time during the two years following its acquisition by ABC; and each of them also receives a salary that is considered reasonable remuneration for their services.

Some might propose that of the total amount of 210 to 260 payable to each employee shareholder (60 + 150 to 200), 100 can be attributed to consideration in exchange for their share of the acquired business and not compensation. This is because 100 is the fair value of a shareholding only, evidenced by the amount paid to the non-employee shareholders. However, this would not be an appropriate conclusion under IFRS 3.

The additional consideration of 150 to 200 represents compensation for post-combination services, because this part of the payment is forfeited if the former shareholder does not remain in the employment of Target for two years following the acquisition – i.e. only 60 is attributed to consideration. Any evaluation of other factors related to the arrangement would not change this conclusion.

When evaluating the continuing employment indicator, the following are additional points to consider.

  • We believe that earnouts forfeited at the discretion of the acquirer if employment terminates are also compensation. This is because it is generally the fact that continuing employment is required to be provided by the recipient of the earnout that is relevant.
  • When a related party of an employee or selling shareholder is the beneficiary of an earnout, careful consideration is required to determine whether, in substance, the payment is for post-combination services rendered by the employee or selling shareholder.

Comparison to US GAAP

Like IFRS Standards, an arrangement that compensates employees or former owners of the acquiree for future services is an example of a transaction that is not part of the business combination.

Like IFRS Standards, contingent payment arrangements that potentially benefit employees or former owners of an acquiree are evaluated to determine whether they constitute consideration issued in the business combination or are separate transactions. The automatic forfeiture of payments when employment is terminated always leads to the conclusion that the payments represent compensation for post-combination services, like IFRS Standards.

However, if the earnout is determined to be consideration, the classification as equity or liability may differ from IFRS Standards because of different classification requirements; this will have a consequential effect on the subsequent accounting.


The takeaway

Earnout provisions are an effective tool to help the parties to an M&A transaction agree in upfront price negotiations. In our experience, typically the structure of forfeiture clauses has sound economic reasons designed to help the newly acquired business to integrate and succeed under its new ownership. However, an understanding of the accounting consequences will help avoid a surprise regarding the financial reporting.

Generally, companies will find it desirable to account for such payments as consideration because when payments represent compensation for post-combination services, the earnout is recognized as compensation cost in the post-combination financial statements, usually resulting in lower EPS.

However, if the payments represent consideration, they are included in the measurement of goodwill. If the contingent consideration is equity-classified, there is no ongoing remeasurement whereas if the contingent consideration is liability-classified, it is remeasured to fair value at each reporting date with changes in the fair value recognized in profit or loss.

These earnout arrangements are often highly specific to the transaction and subject to extensive negotiations, and therefore the accounting should be carefully considered before the transaction closes.

Contributing authors

Julie Santoro

Julie Santoro

Partner, Dept. of Professional Practice, KPMG US

+1 212-954-1086
Amit Singh

Amit Singh

Director, Accounting Advisory Services, KPMG US

+1 212-954-6019
Kelly Coyne

Kelly Coyne

Manager, Accounting Advisory Services, KPMG US

+1 212-954-2081

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