Earn-Out Valuation in Financial Reporting — the Associated Complexities and Best Practices

What is an Earn-out and why does it exist?

Earn-out valuations — challenges:

  • We rely on scenario-based valuation models in scenarios where either the performance metric is independent of the broad economy/market risks, e.g., regulatory or non-financial milestones, or when the pay-off is strictly linear, e.g., percentages of revenue or EBITDA
  • A number of valuation professionals use scenario-based models for non-linear/asymmetric pay-offs based on a single performance metric and period. We rely on adjusted option pricing models, as they correctly capture the pay-off structure and also eliminate subjective decisions related to probabilities and forecasts
  • We rely on stochastic models such as Monte Carlo simulations for complex path-dependent scenarios with multiple performance metrics/periods where the pay-off for one performance metric/period changes based on the occurrence of others, e.g., aggregate caps/floors, threshold catch-up amount in the final year for amounts not earned in prior years
  • Valuation techniques that rely on option pricing models or Monte Carlo simulation require the volatility of the performance metric. Amid this high level of uncertainty, it becomes really important to correctly identify the peer companies. We at Acuity Knowledge Partners use the most recently available financial data for re-levering volatility, which is adjusted for the term due to the short-term nature of Earn-outs
  • Using a correct volatility measure is very important for valuations depending on performance metrics, as it can impact the fair value to a large extent. We take this into account in our analyses and use equity volatility for equity value-/net income-based Earn-outs, asset volatility for enterprise value-/EBITDA-/EBIT-based Earn-outs and asset volatility adjusted for operational leverage for revenue-based Earn-outs
  • While there are multiple approaches to estimating the discount rate applied on the risk of the performance metrics (i.e., forecasts), we rely on either a top-down or bottom-up approach
  • In the top-down approach, the discount rate is the deal’s rate of return adjusted for the difference in market risk between the performance metric and the overall enterprise value. Adjustments reflect many factors, such as the general risk of the performance metric, leverage, term, size premium, and company-specific risk. In the bottom-up approach, the discount rate is the performance metric adjusted for the term, size, company-specific risk and other relevant valuation factors. Since the bottom-up approach relies on a statistical analysis of the performance metric from the company or its peers, we use statistical tools to estimate this
  • We make sure the discount rate applied on the risk of the performance metrics is adjusted for the term of the Earn-out and is applied using a mid-period convention, as it captures the actual risk with the underlying variable, which is typically achieved over the whole period. The mid-period convention essentially assumes uniform earnings of financial metrics and fixes a particular point during the year when the entire value of the yearly metric is assumed to be realised
  • Earn-out pay-offs are typically a junior subordinated, unsecured obligation of the company. As such, they should be discounted based on a rate that would be applied for such an obligation. There are, however, a few noteworthy exceptions. One is if the payment is held in an escrow account, guaranteed or provided through a senior security
  • We estimate the discount rate to be used for Earn-out pay-offs as the sum of the risk-free rate and the credit spread (reflecting the credit risk of the buyer)
  • Credit spread estimation becomes really complex when the companies are not rated. In such cases, use of an appropriate shadow credit rating model is recommended. Credit spread can be estimated from multiple sources such as Bloomberg or Reuters, using the credit spread data for publically traded companies for all credit ratings
  • We make sure the credit spreads are adjusted for the term of the Earn-out and, most importantly, for seniority (a junior subordinated, unsecured obligation). We prefer to use a statistical risk-neutral valuation model for adjustment of credit spread for seniority. However, many valuation professionals use an approximation, i.e., a credit rating notch-down approach, for this
  • We at Acuity Knowledge Partners make sure the Earn-out valuations are aligned with the broader valuation for purchase price allocation. For example, the average projection used is the same as that used in the deal model. The discount rate, likewise, is consistent with the company as a whole, adjusting for metric and time differences. Similar adjustments are made for size, and company- and country-specific risk

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Acuity Knowledge Partners

Acuity Knowledge Partners

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We write about financial industry trends, the impact of regulatory changes and opinions on industry inflection points. https://www.acuitykp.com/