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Contingent Consideration in a Business Combination

Our company has does acquisitions of professional organizations. The purchase price is determined as a mutliple of EBITDA.We pay the Target with a combination of cash, promissory notes and earnout agreements. I just started here a few months ago, so I was not involved in the original computations to determine goodwill, etc or the treament. In reviewing the agreements and backup, it seems that we are accounting for the promissory notes and earnouts as if they are part of the purchase price (and we FMV'd them in accordance with 141(r) and treating them as contingent consideration). For example, we agree to a price of $500k to buy the Target. We assume no liabilities, and the assets of the practice are $100k. The result would be goodwill and other intangibles of $400k. The $500k is paid by us in the form of $250k at closing and an additional $250k will be paid via a promissory note ( of 2 installments, $125k each in 1 and 2 years from now, contingent on a the owner/seller of Target stays on in same capacity during the entire duration of the note & b) revenue stays the same.) Additionally, we will pay the owner/seller an additional earn out bonus of $100k in one year from now if 1) the owner/seller of Target stays on in same capacity during the entire year and 2) revenue increases 5% over last year. So we take the promissory note and earn out and FMV them as contingent considerations in accordance with ASC 805 / FASb 141(r). However, in all the literature I have read, if there is a condition of employment attached to the note or earnout, it should be treated as compensation expense and not a contingent consideration of the deal. It is essentially carved out. This is a potentially significant accounting error if in fact there is not a way to consider the promissory note and earnout as a contingent consideration and not compensation expense. Does anyone have any intelligence of how it could possibly NOT be compensation, give the seller must be employed by us to receive the payout (if terminated all payments under the signed agreements are void). I have read the other factors to determine what to treat it as, but everything seems to come back to the question of employment. P.S. Have not had discussion with CFO or our new auditors yet, as I want to make sure I fully understand all the info as to why we may be doing something wrong! Would prefer to be confident in my assertion. This is a new industry for me I have never had to deal with business combinations with contingent liabilities.

Answers

EMERSON GALFO
Title: CFO
Company: C-Suite Services
LinkedIn Profile
(CFO, C-Suite Services) |

Clarify the wordings and most importantly THE INTENT of the sale agreement with your legal counsel (if not the owner of the buying company). Some agreements may NOT reflect the original/real intent of the buyer/seller.

1. I THINK you are confusing the "employment"side and the "sale" (price) side of the agreement. You did NOT say if the owner will still receive salary during the 2 years. Then employment "consideration/remuneration" is separate from the sale price. I read that the $100k is just what it is....a bonus. Example, I do not think you can deny the last $125k if the owner was terminated say...1-2 days short of the last year (exaggerating here).

2. What are the OUT clauses? or the clauses that define what is non-compliance and the corresponding results of non-compliance and remedies of both parties?

Contracts as reviewed by the CFO should ensure that it not only include the covenants but also what I call the "out clauses" (as wide ranging scenarios as possible...the what if's) and should be discussed with your legal counsel.

Anonymous
(CFO/Board Advisor) |

Its compensation expense, at least according to PwC. I went to the mat with this exact issue two years ago. The facts were almost identical. In our situation, 95% of the purchase price was in Notes and Stock (vested in quarterly installments over 18 months), which required the Seller to remain in the employ of the company during the payout period; 5% was paid in Cash at closing. In addition to the Notes and Stock, the Seller was paid an above market salary and bonus during the employment period.

This issue went all the way to PwC's National office. Bottomline - its compensation expense. Any requirement or condition of employment attached to a note, vesting of stock, or earnout, MUST be treated as compensation expense and not as contingent consideration of the deal. Once down this path, under purchase accounting we also ended up with a negative goodwill situation requiring us to recognize income on the "bargain purchase" price (difference between FMV of net assets acquired, and amount paid - the 5% Cash paid at closing.)

This is ivory-tower GAAP accounting, and while all agreed it didn't reflect either the intent or spirit of the parties, it must be accounted for in this manner. PwC went so far as to say, even if the Cash at closing was $1, and the balance of the purchase price of $13 million was paid in Notes and Stock, a condition of employment in order for the Notes to be paid or the Stock to vest, mandated the recognition of negative goodwill, and compensation expense.

My advice, if you have a Big 4 Audit firm, or one of the other National or large Regional firms, and need an audit, you need to be prepared to re-do the accounting.

EMERSON GALFO
Title: CFO
Company: C-Suite Services
LinkedIn Profile
(CFO, C-Suite Services) |

Another opinion that makes you scratch your head where form trumps substance. I can just imagine the reaction of the seller when he was informed that he will be taking a tax hit!

EMERSON GALFO
Title: CFO
Company: C-Suite Services
LinkedIn Profile
(CFO, C-Suite Services) |

The PwC opinion that is.

Anonymous
(Director) |

The owners do get paid seperately under another agreement.. Yes, the intended sprit, I believe, from our side was to incentivize/ bonus the seller. I am an ex-PwC Sr Mgr. so my training tells me what this is instinctively, and when I read the technical lanaguage I keep going back to it being comp, with no legitimate way to say otherwise. But now I am on the other side of the table, so to speak,l as the client. P.S. We just switched to D&T for our auditors. P.S.S. Ivory tower accounting - I love it - so true!

Anonymous
(CFO/Board Advisor) |

First, thank you for the Ivory tower accounting compliment. Second, now that the accounting is settled, the real issue to address is: How do you "hand-cuff" the Seller, with real consequences should they leave early, to remain during an earnout or integration period, without tying it to Note payments or Stock vesting, and thus the comp expense issue?

Topic Expert
Linda Wright
Title: Consultant
Company: Wright Consulting
(Consultant, Wright Consulting) |

I agree with the comp assessment, given my M&A experience.

EMERSON GALFO
Title: CFO
Company: C-Suite Services
LinkedIn Profile
(CFO, C-Suite Services) |

Anon (CFO).... Isnt admitting that the comp ruling is NOT in the spirit and intent of the agreement giving more ammo to the seller and can be used to back off the agreement?

I am STILL struggling with the PwC opinion (but it is what it is) especially when Anon (Director) said that the owner/seller is being paid (presumably the compensation part) separately under a separate agreement.

The seller has been placed in a NO WIN situation. He losses both ways. The only way to "hand cuff" him is to show him the lesser of two evils (at least for him).

The buyer can also opt to pay (in some form) the Tax gap as a result of the Comp ruling. But the only winner here is Uncle Sam.

Please excuse my ever questioning mind.

Anonymous
(CFO/Board Advisor) |

Emerson...All agreed that it wasn't in the spirit and intent of the agreement. In our situation too, there was a separate employment agreement, which in fact paid above market salaries and bonuses during the employment period. And while all of this did add "ammo" to our position, it was not enough to overcome the accounting literature and GAAP requirements. Thus, my Ivory tower accounting comment.

Robert Price
Title: CFO/Board Advisor
Company: Not Disclosed
(CFO/Board Advisor, Not Disclosed) |

The tax treatment doesn't have to, and most likely will not, follow the GAAP treatment. This is merely a GAAP financial accounting and reporting issue. For tax purposes the Purchase/Sale Agreement and Employment Agreements will govern. This is well settled by the courts under tax law. As such, the Tax treatment doesn't care that the payment of the Notes are contingent upon continued employment. In fact, the IRS may want to have the sale recognized as capital gain, as it may want to have a taxable event at both the entity and individual level, or it may give rise to AMT, if capital gain versus compensation. Also, if compensation under tax law, the Buyer would be able to take a compensation expense deduction upon payment of the Notes, versus amortizing the excess purchase price allocated to intangibles and goodwill over a 15 year period. As such, the character and timing of recognition of income for tax purposes, will be different than the GAAP treatment of the transaction.

EMERSON GALFO
Title: CFO
Company: C-Suite Services
LinkedIn Profile
(CFO, C-Suite Services) |

Robert, the missing piece in my thought process.....thank you!

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