When negotiating the sale of a business, contingent consideration provisions are oftentimes incorporated as a component of the total purchase price to close the disparity between the buyer’s and the seller’s expectations regarding the target company value. Additionally, contingent consideration provisions allow buyers and sellers to: (1) defer a portion of the purchase consideration to a later date, (2) incentivize and motivate sellers post-transaction, (3) provide a mechanism to allocate a portion of a transaction’s risk and reward from the buyer back to the seller, and (4) offset a portion of the buyers’ (equity and debt) capital needed at closing. Buyers may be more willing to pay a higher total price for a business if the seller is willing to make a portion of the value contingent on the target company’s ability to achieve certain milestones post-acquisition. At the same time, the seller may be more willing to accept a lower base price if they are confident that the company can achieve certain performance goals, thereby realizing the contingent consideration and higher total price.
Contingent consideration may represent either an obligation for the acquirer to transfer additional cash, other assets or equity interests to the former owner (an “earn-out”) or an acquirer’s right to recapture previously transferred (typically) non-cash consideration, i.e. seller notes (a “clawback”), if pre-specified events occur or, alternatively, if certain results are not achieved in the future. From the acquirer’s perspective, an earn-out= may be accounted for as a liability, while a clawback may be accounted for as an asset. However, for valuation purposes, whether the contingent consideration represents an earn-out or a clawback, it is appropriate to frame the valuation of contingent consideration as the valuation of an asset. Whether the contingent consideration represents an earn-out or a clawback, each form carries with them unique tax considerations outside the scope of this white paper. The consideration itself may take the form of cash payments, additional shares in the acquirer or an enhanced return prerogative, similar to a 1.5x or 2.0x preferred return in a security received in exchange. For discussion purposes, the balance of this white paper addresses contingent consideration in the form of cash payment(s). However, if there are enhanced rollover equity proceeds, the valuation of those securities ought to be considered in conjunction with the uncertainty of achieving the contingent component of the contingent consideration.
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