February 2010

Mergers & Acquisitions A snapshot

Change the way you think about tomorrows deals * Stay ahead of the new accounting and reporting standards for M&A

Summary
Accounting for contingent consideration- Don't let earnouts lead to earnings surprises What has changed? Initial classification Liability classified earnouts Equity classified earnouts Other accounting considerations Fair value considerations Moving forward

Accounting for contingent consideration Don't let earnouts lead to earnings surprises
Often times when the buyer and seller cannot agree on the total purchase price in an acquisition, the two parties agree to an additional payment, or contingent consideration, based on the outcome of future events. These payments are commonly referred to as earnouts and are typically based on revenue or earnings targets that the acquired company must meet after the acquisition date. The accounting for these arrangements under the M&A Standards1 represents a significant change from past practice. This volume of Mergers & Acquisitions A snapshot discusses the accounting for earnouts from a buyer's perspective, and how the accounting guidance may impact the buyer's acquisition accounting and introduce a level of volatility in the buyer's earnings in post acquisition periods that results from the earnout arrangement.

Accounting Standards Codification 805 (which incorporates FAS 141(R), Business Combinations), is the US Standard on M&A, and Accounting Standards Codification 810 (which incorporates FAS 160, Noncontrolling Interests in Consolidated Financial Statements, an amendment to ARB No. 51), is the US Standard on consolidations (collectively the "M&A Standards").

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What has changed? In the past, earnouts were generally accounted for as part of the cost of the acquisition when settled. That is, no accounting was done at the acquisition date. Rather, when the buyer paid the seller pursuant to the earnout arrangement, the buyer would record that amount as additional purchase price. It did not matter that the buyer and seller could not agree on the amount at the acquisition date, since the amount would be accounted for as additional purchase price when it was paid. Under the M&A Standards, buyers must recognize earnouts on the acquisition date. Therefore, even though the buyer and seller do not agree on the total purchase price, the buyer is now required to determine the fair value of the earnout and recognize that amount in the purchase price on the acquisition date. In addition, the buyer will be required to recognize the change in the fair value of most earnouts in earnings. Fair value changes from period to period will introduce an element of earnings volatility in the buyer's post acquisition financial reporting. Initial classification of earnouts On the acquisition date, buyers will typically classify earnouts in one2 of the following categories: General Categories Liability Nature of Arrangement Buyer is obligated to pay cash or transfer other assets to the seller. Buyer is required3 to issue its shares to the seller. However, the requirement to issue shares may not always result in equity classification.

Why classification matters The initial classification of earnouts may significantly impact the buyer's post acquisition earnings. For liability classified earnouts, changes in fair value subsequent to the acquisition date are recognized in earnings each reporting period until the arrangement is settled. However, changes in fair value of equity classified earnouts are not remeasured, even if the fair value of the arrangement on the settlement date is different. Liability classified earnouts Generally, liability classified earnouts require the buyer to pay cash or transfer other assets to the seller if certain conditions are met. The following example highlights a typical liability classified earnout on the acquisition date.

Example 1 - Cash settled earnout - liability classified Company A purchases Company B for $40 million. Company A and Company B agree that if revenues of Company B exceed $250 million in the year following the acquisition date, Company A will pay $5 million to the former shareholders of Company B. Analysis: The arrangement requires Company A to pay cash. Therefore, Company A should determine the fair value of the arrangement on the acquisition date and classify it as a liability. Further, changes in the fair value of the liability will be recognized in Company A's earnings until the arrangement is settled.

Equity classified earnoutsNot so fast! Although a buyer may settle3 an earnout by issuing equity shares, the arrangement is not necessarily an equity classified earnout for accounting purposes. An arrangement that is settled with a variable number of a buyer's equity shares and that creates (i) a fixed obligation known at inception, (ii) an obligation, the amount of which varies inversely to changes in the fair value of the buyer's equity shares, or (iii) an obligation, the amount of which varies based on something other than the fair value of the buyer's equity shares, will generally be liability classified.

Equity

In certain transactions, a buyer will have a contingent right to receive a return of consideration paid (i.e., contingently returnable consideration). This arrangement is recognized as an asset and is also measured at fair value. 3 An arrangement may explicitly require settlement in the buyer's equity shares or the buyer may have the option to elect settlement in equity shares. 2 Mergers & AcquisitionsA snapshot

The following example illustrates a share settled arrangement that would require liability classification. Example 2 - Share settled earnout - liability classified Company A purchases Company B by issuing 1 million common shares of Company A stock to Company B's shareholders. At the acquisition date, Company A's share price is $40 per share. Company A and Company B agree that if the common shares of Company A are trading below $40 per share one year after the acquisition date, Company A will issue to Company B's former shareholders additional common shares sufficient to protect against price declines below $40 million (i.e., the acquisition date fair value of the 1 million common shares issued).

Second, the settlement provisions must be fixed and cannot vary for anything other than an input used to determine the fair value of a fixed option arrangement. For example, share settlements that vary based on increases in revenues would not meet this requirement. The following example highlights an earnout that could be classified within equity on the acquisition date.

Example 3 - Fixed share settled earnout - equity classified Company A purchases Company B by issuing 1 million common shares of Company A stock to Company B's shareholders. At the acquisition date, Company A's share price is $40 per share. Company A and Company B agree that if Company B's revenues equal or exceed $200 million during the one-year period following the acquisition, Company A will issue an additional 100,000 common shares to Company B's former shareholders.

Analysis: The guarantee arrangement creates an obligation that Company A would be required to settle with a variable number of Company A's equity shares, the amount of which varies inversely to changes in the fair value of Company A's equity shares. For example, if Company A's share price decreases from $40 per share to $35 per share one year after the acquisition date, the amount of the obligation would be $5 million. Therefore, the guarantee arrangement would require liability classification on the acquisition date. Further, changes in the liability will be recognized in Company A's earnings until the arrangement is settled.

Analysis: The performance target is based solely on Company B's operations (i.e., Company B's revenues) and the arrangement creates an obligation that Company A is required to settle with a fixed number of Company A's equity shares. Therefore, the equity share settled earnout could be classified as an equity arrangement. In contrast, if the performance target was based on increases in Company B's revenues relative to its competitors, the arrangement would not be based solely on the buyer's operations. Liability classification would be required and changes in the fair value of the liability would be recognized in the buyer's post acquisition earnings until the arrangement is settled.

Equity classified earnout considerations Earnouts based on the post acquisition performance of the buyer and that will be settled in a fixed number of the buyer's shares may be equity classified if they meet two conditions. First, the performance target must be based solely on the buyer's operations (e.g., revenues, earnings or EBITDA) and cannot be based on an external index, such as the S&P 500 Index. The buyer's operations can be limited to the operating performance of the acquiree, which is often the case for most earnouts.

In most cases, earnouts settled in a variable number of the buyer's shares will be liability classified. The following example highlights one case in which an earnout settled with a variable number of the buyer's equity shares may be equity classified.

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Example 4 - Variable share settled earnout - equity classified Company A purchases Company B by issuing 1 million common shares of Company A stock to Company B's shareholders. At the acquisition date, Company A's share price is $40 per share. Company A and Company B agree that Company A will issue to Company B's former shareholders an additional 50,000 common shares if Company A's share price is equal to or greater than $45 per share (but less than $50 per share), or 100,000 additional shares if Company A's share price is equal to or greater than $50 per share, on the one-year anniversary following the acquisition. Analysis: The performance target is based solely on the post acquisition performance of Company A's share price. The arrangement creates an obligation that Company A is required to settle by issuing a variable number of its equity shares, the amount of which varies directly with changes in the fair value of Company A's equity shares. Although the settlement provision is variable (i.e., the settlement amount varies based on Company A's share price) the settlement provision is based on Company A's share price, which is an input used to determine the fair value of a fixed option arrangement. Therefore, the equity share settled arrangement could be classified as an equity arrangement. In contrast, if the settlement provision was based on Company B's post acquisition operations (e.g., 50,000 shares if Company B's revenues exceed $250 million and 100,000 shares if Company B's revenues exceed $300 million), liability classification would be required since Company B's post acquisition operations are not inputs used to determine the fair value of a fixed option arrangement. Changes in the fair value of the earnout would be recognized in the buyer's post acquisition earnings until the arrangement is settled.

If an earnout fails to meet any one of the conditions required for equity classification, the earnout should be liability classified. As a result, liability treatment for most earnouts will be likely under the M&A Standards, including those that are required to be settled in a buyer's own shares. Purchase price or employee compensation? Sometimes, the selling shareholders may become employees of the combined entity. In those cases, it is important to determine whether any portion of the earnout represents compensation to those employees. Often, the substance of the arrangement will be clear, for example, when there is a requirement for continuing employment. In those instances, the cost of the arrangement is reflected as compensation expense in the buyers financial statements after the transaction. When there is no requirement for continuing employment, a buyer must consider a number of indicators to determine whether the payments represent part of the purchase price or are separate transactions to compensate employees. These indicators would include whether all selling shareholders will receive the same per share payment regardless of employment, or whether employee compensation other than the contingent payments is at reasonable levels. If the arrangement is deemed to be compensation, the accounting for the arrangement would follow the applicable compensation guidance, rather than the accounting for contingent consideration under the M&A Standards. Successful and underperforming acquisitions may lead to unexpected results Recognition of additional purchase price for the fair value of contingent consideration will often result in higher balances of goodwill than would have been recorded initially under the previous guidance. In the past, additional goodwill was only recognized upon achievement of the relevant targets, which given the successful performance, made impairment less likely. However, under the M&A Standards, additional goodwill is generally created immediately upon acquisition, resulting in higher carrying values and thus higher hurdles to overcome in impairment testing. To the extent that performance does not meet original expectations, companies may experience a goodwill impairment charge. Further, the results of accounting for contingent consideration classified as a liability after initial measurement may be counterintuitive. Underperforming acquisitions will likely require a reduction of the liability recorded at acquisition, resulting in a gain reported in earnings. On the other hand, successful acquisitions will likely require an increase

Equity classified - still not done Finally, even if an earnout could be equity classified, the earnout must also meet the other criteria to be classified in shareholders' equity. For example, the buyer must consider if it has a sufficient number of authorized shares available to settle the earnout. This assessment requires the buyer to evaluate not only the earnout, but all of the buyer's outstanding potentially dilutive arrangements. In addition, the earnout must be assessed at each financial statement reporting date to determine whether equity classification remains appropriate. If the earnout no longer meets the conditions for equity classification, it would be reclassified to a liability at its then current fair value.
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in the liability recorded at acquisition, resulting in additional expense post acquisition. Fair value considerations Recognizing earnouts at fair value presents a number of valuation challenges. The valuation of earnouts is an area for which there is limited practical experience and guidance. Buyers will need to consider the key inputs of the arrangement and market participant assumptions when developing the projected cash flows that will likely be used to determine the fair value of the arrangement. This will include the need to estimate the likelihood and timing of achieving the relevant milestones of the earnout. Buyers will also need to exercise judgment when applying a probability assessment for each of the potential outcomes. On the acquisition date, it is unlikely a buyer will be able to use a 100% (i.e., certainty) or 0% (i.e., impossible) weighted scenario, because under these scenarios it is likely that the two parties would have just agreed to the consideration arrangement. The fair value of liability classified earnouts will need to be updated each reporting period after the acquisition date. Changes in fair value measurements should consider the most current probability estimates and assumptions, including changes due to the time value of money. So how does a buyer value these arrangements?

above the $250 million threshold, a payout would result. For those below this threshold, there would be no payout. Each of these discrete payout scenarios could then be assigned a probability and the probability-weighted average payout could be discounted based on market participant assumptions. For illustrative purposes, consider the following probabilityweighted alternative that could be utilized in determining the fair value of the arrangement presented in Example 1.

Example 1 - Cash settled earnout valued utilizing the probability-weighted approach

Scenario 1 2 3 4 5 Total

Rev. Level $200 225 250 275 300

Payout $0 0 0 5 5

Probability 10% 15 15 40 20 100%

4

Prob.-Weighted Payout $0 0 0 2 1 $3 6% $2

Discount rate Fair Value

Valuation methods for earnouts often range from familiar discounted cash flow analyses to more intricate Monte Carlo simulations. The terms of the arrangement and the payout structure will influence the type of valuation model used by the buyer. In the cash settled earnout in Example 1 above, buyers would most likely consider a best estimate discounted cash flow methodology. The key question is: What discount rate best represents the risks inherent in the arrangement? In reality, there is more than one source of risk involved. For example, both projection risk (the risk of achieving the projected revenue level) and credit risk (the risk that the buyer may not have the financial ability to make the arrangement payment) need to be considered. Each of these risks may be quantifiable in isolation. But when the two risks exist in tandem, consideration should be given to factors such as the potential correlation between the two risks and the relative impact of each risk upon the realization of the arrangement. One alternative approach to determine the fair value of the cash settled earnout in Example 1 above would be to develop a set of discrete potential scenarios for future revenues. Some scenarios would show revenue levels above the $250 million performance target and some would be below. For those scenarios showing revenues

For simplicity of presentation, assume the buyer has appropriately considered the inherent risks in determining the discount rate used in this example from a market participant perspective.

In the share settled earnout in Example 2 above, the best estimate or the probability-weighted approach will likely not be sufficient. In addition to the quantification of projection and credit risks, Example 2 requires the modeling of Company A's share price. The following factors are relevant in performing a valuation for such earnouts:
What are the potential outcomes for Company A's financial results next year? What are the potential outcomes for Company A's share price returns over the coming year? How are the distributions of the financial results and share price returns correlated and how can this correlation be quantified and modeled? What are the potential outcomes for other market events that could impact the overall stock market? What discount rate adequately reflects all of the risks (e.g., projection risk, share price return estimation risk, Company A's credit risk) inherent in a valuation of this kind?
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These types of earnouts will likely require a valuation approach incorporating some form of option pricing techniques to adequately incorporate these risks. As the examples illustrate, each arrangement has its own specific features requiring different modeling techniques and assumptions. Additionally, for liability classified earnouts, the model will need to be flexible enough to handle changing inputs and assumptions that need to be updated each reporting period. Therefore, it may be wise for buyers to consult with valuation experts early in the process to help navigate these areas. Moving forward Earnouts in an acquisition require close examination. Determining fair value is now an important part of the accounting for these arrangements. Regularly updating liability classified earnouts can be challenging. Navigating the accounting requirements to obtain equity treatment can be difficult. Buyers that don't focus on these matters when negotiating terms of an acquisition may be surprised by the impact of earnouts on financial reporting, including the unintended financial volatility in the periods subsequent to the acquisition. Don't let earnouts lead to earnings surprises!

Mergers & AcquisitionsA snapshot

PwC has developed the following publications related to business combinations and noncontrolling interests, covering topics relevant to a broad range of constituents. 10 Minutes on Mergers and Acquisitionsfor chief executive officers and board members What You Need to Know about the New Accounting Standards Affecting M&A Dealsfor senior executives and deal makers Mergers & AcquisitionsA snapshota series of publications for senior executives and deal makers on emerging M&A financial reporting issues Business Combinations and Consolidationsthe new accounting standardsan executive brochure on the new accounting standards A Global Guide to Accounting for Business Combinations and Noncontrolling Interests: Application of U.S. GAAP and IFRS Standardsfor accounting professionals and deal makers DataLine 200801: FAS 141(R), Business Combinationsfor accounting professionals and deal makers DataLine 200802: FAS 160, Noncontrolling Interests in Consolidated Financial Statementsfor accounting professionals and deal makers DataLine 200827: FASB Proposed Amendments To The Accounting For Acquired Contingencies under FAS 141(R) for accounting professionals and deal makers DataLine 200830: Key Considerations for Implementing FAS 141(R) and FAS 160for accounting professionals and deal makers DataLine 200835: Nonfinancial Asset Impairment Considerationsfor accounting professionals and deal makers DataLine 200916: New Guidance for Acquired Contingencies for accounting professionals and deal makers DataLine 200934: Accounting for Contingent Consideration Issued in a Business Combination for accounting professionals and deal makers DataLine 201001: Accounting and Reporting for Decreases in Ownership of a Subsidiary for accounting professionals and deal makers

PwC clients who would like to obtain any of these publications should contact their engagement partner. Prospective clients and friends should contact the managing partner of the PwC office nearest you, which can be found at www.pwc.com. For more information on this publication please contact one of the following individuals: John P. McCaffrey U.S. Transaction Services Leader (646) 471-1885 john.p.mccaffrey@us.pwc.com Raymond J. Beier Strategy Analysis Group Leader (973) 236-7440 raymond.beier@us.pwc.com Lawrence N. Dodyk U.S. Business Combinations Leader (973) 236-7213 lawrence.dodyk@us.pwc.com Jay B. Seliber Business Combinations Implementation Leader (408) 817-5938 jay.seliber@us.pwc.com John R. Formica Jr. National Professional Services Group Partner (973) 236-4152 john.r.formica@us.pwc.com Donna L. Coallier Transaction Services Partner (646) 471-8760 donna.coallier@us.pwc.com Dimitri B. Drone Transaction Services Valuation Group Partner (646) 471-3859 dimitri.b.drone@us.pwc.com

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