Valuation of an Earnout Provision in Acquisition

Type of Matter:

Valuing a business certainly is not always straightforward.  Sometimes it requires thinking outside the box to develop an approach that works for the particular situation.  Such was the case when Arxis Financial was recently engaged in an acquisition that was about to get ugly with potential litigation.

A business owner sold their business and the negotiations involved how much would be paid after the close of the transaction and how much would be based on the future performance of the company. It is typical that such payments (earnout provisions) are put in contracts to incentivize the seller to work towards the buyer’s success. It also allows for the possibility that the seller can make some extra money on the sale than they might otherwise be paid.

For tax and litigation reasons, Arxis Financial was contacted in this particular case to value the earnout provision. The seller needed to know the fair market value of the potential earnout cash flow as of the date of sale.

Arxis Work:

For the valuator, an earnout element adds to the complexity of determining and quantifying the differences between value, price, and proceeds.  In this particular case, we knew the price but the actual value of the business and proceeds of the transaction were unknown.  Potential earnout payments were based on future performance that may or may not materialize.  Also, there were questions whether the company would actually be able to meet the required payments without permanently damaging the company.

Valuing a transaction as of the close date, when there are potential additional future payments, presents great difficulty in determining the Fair Market Value of the business as of that date.  There is no real alternative to using the income approach since the cash flows are complex, uncertain, and maybe even speculative, depending on the negotiations and terms. Variations on the income approach range from a clear-cut discounted cash flow approach to complex Monte Carlo Simulation models addressing the probability that cash payments will be earned and paid out. It is also common to see probability-weighted return methodology applied within an income approach to valuing earnouts.  The additional difficulty was that actual future performance could not be considered in valuing the earnouts.  Only facts known or knowable as of the date of the sale could be considered in the valuation of the earnout.

In this case, the potential future benefit streams were probability weighted and then discounted using a discount rate that was derived from the actual transaction and then adjusted.  The adjustments included consideration of additional risk factors such as transaction risk (the risk that the relationship between seller and buyer would deteriorate and/or that the additional compensation to the seller will actually be difficult for the company to honor) and performance risk (the risk that the business simply cannot achieve growth rates that exceed those contemplated in the original deal).

Result:

An opinion of value was determined and accepted. The case settled and expensive litigation was avoided.