Earnout Accounting in M&A Deals and Merger Models (21:49)

Earnout Accounting: What Are Earnouts, and Why Do Companies Use Them?

Instead of paying for a company 100% upfront, the buyer offers to pay some portion of the price later on – *if certain conditions are met.*

Example: “We’ll pay you $100 million for your company now, and if you achieve EBITDA of $20 million in 2 years, we’ll pay you an additional $50 million then.”

Earnouts are VERY common for private company / start-up acquisitions in tech, biotech, pharmaceuticals, and related “high-risk industries.”

EA acquired PopCap for $750 million upfront, and offered an earnout that varied based on PopCap Games’ cumulative EBIT over the next 2 years. The schedule was as follows:

• 2-Year Earnings Under $91 Million: Nothing
• 2-Year Earnings Above $110 Million: $100 million
• 2-Year Earnings Above $200 Million: $175 million
• 2-Year Earnings Above $343 Million: $550 million

Why Use an Earnout in an M&A Deal?

You see them most often when the buyer and the seller disagree on the seller’s value or expected financial performance in the future.

Earnouts are a way for the buyer and seller to compromise and say, “We don’t really know how we’ll perform in the future, but if we reach a target of $X in revenue or EBITDA, you’ll pay us more for our company.”

The buyer will almost always want to base the earnout on the seller’s standalone Net Income, while the seller prefers to base it on revenue, partially so the seller can spend a silly amount to reach these revenue targets.

As a compromise, EBIT or EBITDA are sometimes used.

Earnout Accounting on the Three Financial Statements

Balance Sheet: Earnouts are recorded as “Contingent Consideration,” a Liability on the L&E side.

Income Statement: You record changes in the value of the Contingent Consideration here, i.e. if the probability of paying out the earn-out changes, you show it as a Loss or Gain here. It’s a Loss if the probability of paying the earn-out increases, and a Gain if the probability decreases.

Cash Flow Statement: When the earn-out is paid out in cash to the seller, it’s a cash outflow here. You also have to add back or subtract changes in the Contingent Consideration value here, reversing what is listed on the Income Statement.

Earnout Accounting: Purchase Price Allocation and Sources & Uses

Earnouts do not affect the Sources & Uses schedule for the initial transaction since no cash is paid out yet.

Earnouts *increase* the amount of Goodwill created in an M&A deal because they boost the Liabilities side of the Balance Sheet, which, in turn, requires higher Goodwill on the Assets side to balance it.

Earnout Accounting on the IS, BS, and CFS in a Merger Model

You tend to leave the Income Statement impact blank in a merger model unless you have detailed estimates for the seller’s future performance.

You SHOULD factor in the cash payout of the earnout on the combined Cash Flow Statement – you can assume a 100% chance of payout, or some lower probability.

The payout will appear in Cash Flow from Financing and reduce cash flow and the company’s cash balance.