Does your business combination agreement have ‘earnouts’?

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.

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.

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

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.

1. KPMG Insights: 2021 was a blowout year for M&A – 2022 could be even bigger
2. IFRS 3, Business Combinations