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There are a couple of techniques on how to hide away future expenses. We are going to discuss some of them in this and in future blog articles. Starting point today is the case of the so called earn-out clauses which grant the seller in a transaction a later purchase price adjustment if certain benchmarks of corporate performance are met in the future.<\/p>\n\n\n\n
An earn-out\nis a quite reasonable purchase price adjustment clause in M&A transactions\nas it helps to overcome typical information asymmetries between the seller\n(knows the company very well) and the buyer (usually has an information\ndisadvantage despite thorough due diligence). The earn-out works as follows: <\/p>\n\n\n\n
A certain\npart of the purchase price is withhold by the buyer and subject to the actual\nfuture performance of the company. So if the (well-informed) seller promises a\nblue-sky future of the target company and it does not happen he or she gets a\nlower total consideration. If however, his projection is right (or even better\nthan expected) then he or she gets a higher total consideration. This clearly\nlimits the risks of a (not so well-informed) buyer and also motivates the\nseller to be honest in the whole transaction process.<\/p>\n\n\n\n
As long as\nwe do not know whether the performance targets of the earn-out-clause are met,\nthe potential future purchase price adjustment hast to be treated as a\nliability for the buyer \u2013 valued at the expected present amount of future price\nadjustments. While the concrete valuation is also a tricky task it still\nfollows normal rules of pricing future expected outflows. So far so good from a\nfinancial accounting point of view.<\/p>\n\n\n\n
But what if\nthe seller is not really an ultimate seller but rather part of the future\ncombined company? We see this quite often when companies are buying start-ups\nwith a founding-management with specialist know-how. In these cases, taking\nover the former management is often mandatory for supporting the future success\nof the transaction. But we also see it in bigger transactions where the (at\nleast partial-) owner-management of the target company finds \u2013 for good reasons,\ne.g. because of the recent track record \u2013 a new management place in the now\ncombined company. In all these cases it is no longer that clear what the \u2018earn\nout\u2019 is really about because the seller still impacts the fate of the new\ncompany. But then: what is the nature of this earn-out clause in such cases from\nan economic point of view?<\/p>\n\n\n\n
There are two\npossibilities: 1) it is really an earn-out, just reducing the effects of the\nforecasting uncertainty of the buyer (unfortunately rather rarely the case if\nthe target owner-management stays in an operating role). 2) it is some sort of\nan incentive for the newly integrated, former target company owner-management\nor \u2013 even more often the case \u2013 it is an outright part of the salary of the former\ntarget company owner-management. This second possibility is what we rather see\nas a typical case in target-owner-management-stay-in transactions.<\/p>\n\n\n\n
But why is\nthis all important for financial analysis and business valuation? Here is the\nclue: If in economic terms buyer-companies want to incentivize the\ntarget-management for performing in their operating role or if they simply want\nto pay them for working then it is no longer an earn-out in the strict sense.\nIt is rather an ongoing salary component in the periodic business of the newly\ncombined company. And \u2013 again from an economic point of view \u2013 it should show\nup as personnel expenses in the years after the acquisition closing \u2013 therefore\nreducing the future earnings of the company.<\/p>\n\n\n\n
But with the earn-out clause communicated to investors it all seems as if the company has quite high earnings in the future (because they are now not impacted negatively by these personnel expenses) but has to suffer a bit from purchase price adjustments for a couple of periods \u2013 in the eyes of the investors: because the new company is so successful. What a different picture this is now, isn\u2019t it? And this means for our real world: if companies can paint such a colourful picture for investors by making future expenses rather being part of the original transaction \u2026. they will do it!<\/p>\n\n\n\n
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The list of real world examples of this trick is very long. Below, for reasons of illustration I provide a couple of recent ones which I became aware of \u2013 which is certainly only a tiny part of the total.<\/p>\n\n\n\n
In 2017, Tabula\nRasa Healthcare Inc. took over the medication management company Sinfon\u00edaRx\nInc. for 35 mio USD in cash plus potential up to 85 mio USD of earn-outs. The\nfounder and long-term CEO of 2006-established Sinfon\u00edaRx now serves as part of\nthe management team of Tabula Rasa which makes the major part of the so called\nearn-out a normal remuneration component as part of the former CEO\u2019s salary.<\/p>\n\n\n\n
Also, in 2017,\nGerman life science specialist Sygnis AG (today: Expedeon AG) acquired the\nUK-based provider of bioconjugation products and services Innova Bioscience Ltd.\nfor 10.8 mio Euros plus an expected earn-out of roughly 2.2 mio Euros\n(according to the Sygnis 2017 balance sheet). One of the founders of Innova\nbecame chief technical officer in Expedeon \u2013 and presumably will receive a non-negligible\npart of the variable \u2018purchase price adjustments\u2019 for his performance as an\nemployee in the years after the acquisition \u2013 i.e. from an economic point\nof view as part of his salary.<\/p>\n\n\n\n
In 2016,\nthe B2B media company Ascential Plc. bought the US-based data analytics company\nOne Click Retail LLC for an initial cash consideration of 44 mio USD plus up to\n181 mio USD (!) of \u2018earn out payments\u2019. Ascential informed the capital market\nthat \u201ca portion of the earn-out payments is also subject to founders remaining\nin employment with the company\u201d and that the payment of earn-outs depends on\nsome performance targets. <\/p>\n\n\n\n
It was also\nin 2016 when Italian media company Digitouch SpA acquired the SEO-specialised\nweb agency Optimized Group for 1.35 mio Euros plus up to 430 thousand Euros\nearn-out in case the company reaches some performance targets. One of the co-founders\nof Optimized stayed with the company to become the new managing director of the\nnow-subsidiary and also took the role of Head of International\nDevelopment of Digitouch.<\/p>\n\n\n\n
Only a\ncouple of months ago, at the end of 2018, Mayville Engineering Company Inc. finished\nthe acquisition of Defiance Metal Products (DMP), a manufacturer of component\nparts for heavy and medium-duty commercial vehicles for a cash payment of 114.7\nmio USD plus an additional earn-out payment of up to 10 mio USD which will be\npaid if DMP meets certain performance metrics in 2019. Although we do not know\nfor sure yet in this case, we think it is highly probable that the former DMP\nCEO, who is now Chief Operating Officer of Mayville, also benefits from this\n\u2018earn-out\u2019 as a compensation for his services as an employee of the newly\ncombined company. We come to this conclusion as he was also part of the\nmanagement team of the selling-vehicle that was build-up by the DMP former\nmajority owner Taglich Private Equity.<\/p>\n\n\n\n
Lots of\nexamples! And the list is far from exhaustive. In this context I often get the\ncomment from e.g. auditors that this earn-out trick is not a real problem as\nnothing gets lost here. They argue: Perhaps there is a slight economic\nmisclassification but if we add it up there are still all expenses or cash-outs\nin the numbers.\n\nBut as I already wrote above: this point of view\nis certainly not the right one for somebody who wants to make investment\ndecisions. The problem here is that our accounting system is not only about\nhistoric numbers but \u2013 even more important \u2013 it should bring the addressee into\na situation of being able to value the company (decision usefulness). This\nmeans for equity valuation reasons: It should allow or at least set the basis\nfor a proper forecast of future earnings or cash flows. And this is a big\nproblem if investors fall for this earn-out trick! If investors do not\nrecognise that future cash flows or earnings are somehow affected by certain\nnegatives (here: personnel expenses) but rather think that this negative\nrelates to a past transaction \u2013 the acquisition itself \u2013 then there is the risk\nthat they overstate the real value of the company because of overstated\nforecasted future cash flows\u2026 and this is exactly what happens quite often in the\nreal world cases.\n\n\n\n<\/p>\n","protected":false},"excerpt":{"rendered":"
M&A accounting is certainly one of the trickiest playing fields in accounting for a couple of reasons: 1) It is […]<\/p>\n","protected":false},"author":4,"featured_media":54451,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[75],"tags":[],"class_list":["post-54447","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-english-contributions"],"yoast_head":"\n