
Valuing Contingent Considerations Three primary sources of risk that should be considered in estimating the discount rate to be used to value an earnout. May 23, 2011 
Companies entering into transactions often specify that a certain portion of the consideration to be paid will be contingent on the realization of certain favorable outcomes. Examples of common contingent consideration or earnout structures are a fixed payment upon achievement of certain earnings thresholds or technical milestones, such as successful completion of a development project or receipt of regulatory approval for a new drug. Similarly, earnouts may entail a payment equal to a percentage of earnings above a threshold rather than a fixed payment.
Earnouts often entail multiple contingencies over multiple time periods.
Companies rely on contingent consideration as a means to resolve disagreement regarding the value of the enterprise by postponing payment of a portion of the consideration until some of the uncertainty regarding the future performance of the target is resolved. Earnouts may also be used as a means to retain key personnel and in some cases, as a means of seller financing.
Earnouts are used by companies across a broad range of industries and deal sizes.
Under certain circumstances and in accordance with the Financial Accounting Standards Board (FASB) Accounting Standards Codification Topic 805, “Business Combinations”, companies are required to estimate the fair value of an earnout as of the transaction date and as of subsequent measurement dates. The valuation of contingent consideration poses a number of complexities including the estimation of the earnout’s expected cashflows and of the appropriate discount rate to present value those expected cashflows.
Earnout structures often incorporate nonlinearities in the payoff function. These nonlinearities arise from contractual terms that typically specify that no payment will be made if a contingency is not met and a positive payment will be made if it is. Since the payoff function is not linear, it is not appropriate to consider only the earnout associated with the expected underlying outcome (i.e. the mean of the distribution of possible outcomes). Instead, the payment associated with each point on the distribution of possible outcomes must be considered in order to estimate the expected earnout.
Given an estimate of the expected earnout, one must then estimate its present value. Probability weighting cashflows and discounting those probability weighted cashflows are two distinct steps in any valuation. Just as the weighted average cost of capital (WACC) is an appropriate riskadjusted discount rate used to present value expected cashflows in the valuation of a business enterprise, so an appropriately chosen riskadjusted discount rate should be used to present value to the expected earnout.
There are three primary sources of risk that should be considered in estimating the discount rate to be used to value an earnout. They are:
Risk of Earnouts and Its Functional Form
The following examples illustrate the relationship between the risk of the earnout and its functional form as well as the interaction with the probabilities of achieving the earnout contingencies.
Consider an earnout in which the target receives $1 million if earnings are greater than $10 million and zero dollars otherwise. If the probability of achieving the earnings threshold of $10 million is 100 percent then the appropriate discount rate would be the acquirer’s cost of debt that reflects time value and the acquirer’s credit risk. If the probability is lower than 100 percent, then the payoff is riskier and a discount rate higher than the cost of debt would be appropriate.
Alternatively, consider a different functional form in which the target receives 10 percent of earnings if earnings are greater than $10 million and zero dollars otherwise. If the probability of achieving the earnings threshold of $10 million is 100 percent, then the appropriate discount rate would be the deal IRR (receiving 10% of the earnings entails the same risk as the earnings themselves) plus the acquirer’s credit spread. If the probability is lower than 100 percent, then the payoff is riskier and a discount rate is higher than the deal internal rate of return (IRR) plus credit spread would be appropriate.
The time remaining to the resolution of the earnout is also a factor in assessing the riskiness of the earnout cashflows. If a high degree of uncertainty regarding achieving the contingency is still present when there is little time remaining, the cashflows would be considered to be riskier than if there were the same degree of uncertainty but a longer remaining time period.
The greatest challenge in estimating the discount rate is quantifying the adjustment to the IRR to reflect the risk associated with the functional form of the earnout. Option pricing theory provides a useful framework for quantifying these adjustments. An earnout based on a fixed payment is similar to a binary option. An earnout based on a variable payment that is proportionate to earnings is similar to a call option. Most earnout structures can be engineered as a combination of call and binary options. For example, an earnout based on a fixed percentage of incremental earnings above a threshold that is capped at a fixeddollar amount for earnings above a second threshold can be expressed as a long position in a call option with a strike at the first earnings threshold and a short position in a call option with a strike at the second earnings threshold.
We know that a call option on an underlying outcome is always at least as risky as the underlying outcome and that a binary option may be more or less risky than the underlying depending on the probability of achieving the threshold (i.e. the strike price). Optionpricing theory addresses the difficulty of quantifying the increment or decrement to the IRR by employing a riskneutral framework. Optionpricing methods therefore provide a useful basis for estimating the value of an earnout.
Adapting optionpricing methods to value earnouts does, however, pose some additional challenges. When valuing an option on equity, the current stock price is an appropriate starting point as the stock price represents the present value of expected future cashflows and is therefore a forward looking measure. Current earnings, however, may or may not be an accurate representation of expected future earnings. Therefore, when valuing an earnout, consideration should be given to management’s expectations regarding the expected distribution of future earnings in the specification of the optionpricing model.

Daniel Kahn, PhD, is principal in Ernst & Young’s Transaction Advisory Services Practice where he is the national leader of the Complex Securities Valuation Practice. He will be speaking at the AIPCA Fair Value Measurement and Reporting Conference, June 6 and 7 in Las Vegas, NV.