Accounting for Earnouts PDF

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Accounting for Earnouts Accounting 30280 Background An earnout is a contract that requires an acquiring firm to make a future payment (or payments) to target shareholders if the target meets specified performance criteria after the M&A transaction closes. Such a contract is beneficial to target shareholders and acquiring firms when adverse selection or moral hazard problems create uncertainty about the value of the target firm.1 Tying an additional payment to future performance helps the two parties come to an agreement. The contingent payment allows target shareholders to receive higher compensation (if the future performance criteria is achieved), while protecting the acquirer from over-paying (if the future performance criteria is not achieved). Accounting standards for earnouts changed significantly in 2008. Effective for fiscal years beginning after December 15, 2008, SFAS 141(R) required (1) recognition of the expected earnout liability at fair value, and (2) periodic remeasurement of the liability’s fair value, with resulting gains and losses recognized in net income.2 Under the previous accounting standard (1) no liability was recognized and (2) earnouts had no net income effect because they were simply recognized as additional goodwill when paid. Figure 1 displays the accounting for earnout contracts before and after SFAS 141(R). Note that the accounting for earnouts is distinct from the general accounting for contingent liabilities that you learned in M&D1. Earnout Contract Shark Corporation paid $5 million to acquire Minnow Manufacturing, Inc. The acquisition also required Shark Corporation to make one contingent payment (an earnout) two years after the acquisition date, based on the level of Minnow’s total earnings before interest, taxes, depreciation, and amortization (EBITDA) over the 24-month period following the acquisition date. If total EBITDA is below $8.5 million, no payment needs to be made. For total EBITDA equal to or greater than $8.5 but less than $10 million, 10 percent of the total EBITDA will be paid to target shareholders. For total EBITDA equal to or greater than $10 but less than $12 million, 12.5 percent of the total EBITDA will be paid to target shareholders. For total EBITDA equal to or greater than $12 million, 15 percent of the total EBITDA will be paid to target shareholders, with the payment not to exceed $3 million in any case.

1 Adverse selection occurs when acquirers suspect that target companies are inflating their financial health or performance. Acquirers thus discount their offers, which could make the truly strong targets reject offers. Thus, either no deals get done, strong targets are underpaid, or acquirers overpay for weak targets. Moral hazard involves incentives for one party to shirk after the other party has performed. In the context of an acquisition, once the acquirer becomes unconditionally obligated to purchase the target, the target’s managers may have little incentive to stay with the company, be cooperative in the transition, or work hard (particularly if the managers are major shareholders of the target). 2 The accounting standards for earnouts are now found in Accounting Standards Codification 805.

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Modeling Considerations To value the earnout contract, Shark constructs a model to forecast Minnow’s EBITDA over the 24 months following the acquisition. Shark also wants to incorporate variation in EBITDA to better understand the potential earnout payments and their probabilities. Shark believes that, in general, the current month’s EBITDA (EBITDAt) for Minnow can be reasonably modeled as a linear function of the previous month’s EBITDA (EBITDAt-1). Thus, Shark seeks to estimate the following regression: EBITDAt = a + b*EBITDAt-1 + et where et is a random residual term with E(et) = 0. Your task is to estimate the model parameters (a, b, and the distribution of et) using Minnow’s EBITDA from the prior 36 months, which can be found in the spreadsheet EBITDA.xls. Hint: You should find that the intercept (a) is $7019.39. Then use the parameter estimates to project the next 24 months of EBITDA. Build variation into the projections by applying a random realization of et each month. Do not assume that et is normally distributed. Instead, after you estimate the regression using the 36 months of past data, compute the actual et’s for the past 36 months and use @Risk to determine which distribution best fits the data (i.e. “Fit” the distribution). Then use this distribution to draw a random et each month over the 24 future months.

Shark wants to know the distribution of a) total EBITDA for the 24 month period following the acquisition, b) the earnout payment to be made to the target shareholders, and c) the present value of the earnout payment at the time of the acquisition (use an 8 percent annual discount rate). Run Monte Carlo simulations to obtain these three output distributions, using 10,000 iterations. At the closing date of the acquisition, the monthly EBITDA for Minnow Manufacturing was $375,619. In the spreadsheet, this is shown as the EBITDA for month 0. After you estimate the regression, forecast EBITDA for months 1 to 24 on a separate worksheet, using $375,619 as EBITDA in month 0. Base the earnout payment on months 1 to 24 (do not include month 0).

Requirements (1) What is the 95 percent confidence interval for the following a. Total EBITDA for Minnow Manufacturing for the 24 month period following the acquisition b. The cash payment to the target shareholders for the earnout 24 months following the acquisition c. The present value of the contingent cash payment to the target shareholders? (2) What is the amount to be recorded as a liability for the earnout on the books of Shark

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Corporation at the time of the acquisition for a. Pre-SFAS141(R) accounting treatment? b. Post-SFAS141(R) accounting treatment? (3) What is the probability at the time of the acquisition that the actual future cash payment will be lower than the initial fair value recorded? In other words, what is the probability that Shark Corporation will record a subsequent net gain on the earnout under a. Pre-SFAS141(R) accounting treatment? b. Post-SFAS141(R) accounting treatment? (4) What is the probability at the time of the acquisition that the actual future cash payment will be higher than the initial fair value recorded? In other words, what is the probability that Shark Corporation will record a subsequent net loss on the earnout under a. Pre-SFAS141(R) accounting treatment? b. Post-SFAS141(R) accounting treatment? (5) What is the probability that the entire liability, recorded at the time of the acquisition, will be written off? (6) Six months after the acquisition, Minnow Manufacturing had an accumulated EBITDA (for months 1 through 6) of $2,250,000 and recorded an actual EBITDA of $375,000 for the sixth month alone. Using the same model and parameter values that you estimated above, project EBITDA for months 7 through 24. Revalue the earnout contract and determine the adjusting journal entry, if any, that needs to be made at the end of month 6 under a. Pre-SFAS141(R) accounting treatment? b. Post-SFAS141(R) accounting treatment? (7) Assume the same facts as in (6) above, except that Minnow Manufacturing recorded actual EBITDA for month 6 of $600,000 and actual accumulated EBITDA (for months 1 through 6) of $3,037,500. Using the same model and parameter values that you estimated above, project EBITDA for months 7 through 24. Revalue the earnout contract and determine the adjusting journal entry, if any, that needs to be made at the end of month 6 under a. Pre-SFAS141(R) accounting treatment? b. Post-SFAS141(R) accounting treatment? (8) If the facts for the first six months turn out as in (7) above, do you think it is appropriate to continue to project monthly EBITDA over months 7 through 24 using the same model and parameter values that you have been using? Why or why not? Provide some numeric support for your answer (an extensive numeric analysis is not required). (9) Assume the earnout liability for Shark Corporation was initially recorded as in 2b above and adjusted as in 7b above, with no further adjustments. What would be the journal entry to record a payment of $1,000,000 to the target shareholders at the end of the 24-month period under a. Pre-SFAS141(R) accounting treatment? b. Post-SFAS141(R) accounting treatment? (10) Given the accounting changes brought about by SFAS141(R), do you expect that acquiring firms will be more likely or less likely to use earnouts when making acquisitions after December 15, 2008? Why?

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Presentation Preparation Your team has been hired by Shark Corporation as consultants to better understand the requirements discussed above. Prepare a 10-12 minute presentation to Shark Corporation’s Board of Directors, including an executive summary of the problem and your key findings, followed by a more detailed explanation of your approach, analysis, and results. Visualization of your findings, including relevant plots, might be important or necessary to make your points in the presentation. You are required to upload your PowerPoint presentation slides and your Excel work to Sakai by 12 PM on the due date.

Be sure that one member of your group submits one Excel file (please do not save the results from @Risk, but copy relevant parts into your Excel file) and one PowerPoint file for your group, and please list the names of each group member at the beginning of each submitted file. Be sure the Excel file shows your regression output and the column of residuals for the 36 past months. Please name the files Earnout followed by your Group # (e.g., EarnoutGroup7.xlsx or .docx). When the submission has been graded, comments and points earned will be provided directly on the file and saved (with a G added to the end of the filenames) to your Assignments folder in Sakai.

In addition, once the files have been submitted for your group, each member of your group should submit the Peer Evaluation - Earnouts (in Sakai through Tests & Quizzes) for this assignment. The peer evaluation will request an effort score for each member in your group (including a self-rating). The average effort score assigned for the entire group must be 10 on each project. In other words, if someone in your group receives a score above 10 (for extraordinary effort) then someone else in your group must receive a score below 10. Expectations for effort on group assignments should be discussed and established at the start of the project and group participation problems should be addressed by the group as problems develop. Submitting peer scores not equal to 10 should be viewed as a last resort. Individual scores for the assignment may be adjusted based on input from peers. Not submitting a peer evaluation by the due date will reduce the individual grade by 5 points.

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