Basic Concepts Valuing Earn-outs: Part II
- 1. BE IN A POSITION OF STRENGTHSM withum.com By Howard Krieger, ASA Healthcare and Basic Concepts on Valuing Earn-Outs: Part Two To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. Howard Krieger, ASA Valuation Specialist T (201) 265 2800 hkrieger@withum.com Picking up and summarizing where we left off in Part I, valuing earn-outs and other contingent liabilities are the subject of fierce debate in the valuation community. What’s often cited as a common sense approach to valuing a financial metric-based earn-out is as follows: Step 1: Identify the financial metric which triggers the contingent payment (e.g. Next Year’s Revenue, EBITDA, etc.) Step 2: Guess a few likely earnings scenarios and resulting contingent payout outcomes Step 3: Think about the probability of each scenario occurring, and Step 4: Estimate the payout by applying each probability to each outcome. We hear frequently this thought process when folks are talking through what they think an earn-out is “worth.” While this process may provide a good guess regarding the amounts to be paid or received, it does not provide a fair value estimate suitable for tax reporting or financial reporting purposes. When estimating a contingent liability’s fair value for tax or financial reporting purposes, there are generally two practical questions appraisers seek to address: 1. Do I have a value which multiple parties would agree represents what one would reasonably exchange for the liability or asset given the payer’s obligations and risks? And, 2. How does one apply business valuation concepts to a lEiability that is effectively a gamble on the seller’s future performance? The second question considers the valuation practice’s tendency to encourage the valuation of complex arrangements using methods consistent with those used for simpler asset and liabilities. I’m generalizing here, but the parties crafting these contingent arrangements work through a comprehensive negotiation to develop the earn-out’s terms and conditions. Dealmakers may rely on previous deals or conjure up “what-if” scenarios to find something mutually agreeable. Understandably, there’s pushback to putting more science into determining a regulatory definition of value than went into crafting the earn-out in the first place! Unfortunately, the very nature of a contingent liability and it being subject to probabilistic outcomes and non-linear payouts forces the appraiser’s hand to employ sophisticated methods to achieve a reasonable answer.
- 2. BE IN A POSITION OF STRENGTHSM withum.com The approaches and methods described in the following sections are becoming the new normal to meet these regulatory hurdles and, from experience, once you get your arms around some of the conceptual challenges, implementation of a valuation framework for this type of liability is not difficult. At 10,000 feet, the earn-out is a probabilistic future benefit stream, and its value proposition bears more similarity to a security than to a whole business. We’ll introduce the different valuation methods here, and then in future articles delve into the mechanics, pros and cons of each. Friendly reminder: This article deals with earn-outs where the trigger is a financial metric (e.g. revenue, EBITDA, net income, etc.) and not a non- financial metric (e.g. customer count, channels, SKU codes, etc.) We assume the reader has a basic understanding of what an earn-out is. One of the things we will not cover is the accounting for earn-outs or other contingent liabilities. However, if that point is of interest, there are practitioners at WithumSmith+Brown, PC which focus on that area. The earn-out provides the seller a right or obligation to sell (or a buyer to buy) the remaining portion of equity, or receive additional proceeds for the equity previously purchased, upon achievement of some hurdle. Hopefully this description conjures thoughts around the similarity between an earn- out and a call option or other derivative asset. The value of the earn-out is conditionally tied to the event occurring and the ability of the payer to fulfill its obligation. Out of the standard Income, Market and Cost approaches, the cost approach is instantly disregarded as not applicable. The rationale is similar to its inapplicability when valuing securities. For earn-outs and other contingent liabilities the Market approach is highly unlikely to be applicable. The only exception would be a case where one has an observable, bona fide arm’s- length transaction involving some part of the earn-out as a basis for the conclusion. This would be rare to find, and the transfer of part of an earn-out obligation, if even allowed, would be difficult to prove as being arm’-length. Most practitioners would ignore this approach and only inquire as to whether any part of the earn-out had been transferred or assigned, to make sure disconfirming evidence of their conclusion was not lying around somewhere. The Income approach is applicable because it allows the appraiser to estimate value based on an expected benefit stream and risk associated with that benefit stream. Further, there are multiple methods under the Income approach from which the conclusions can be used as a check against each other. As appraisers, it is nice when various methods are available to ply against one another so that variances may be understood, explained or used to uncover missing information. The methods under the Income Approach we see applied are as follows: • Single Outcome Discounted Cash Flow (“DCF”); • Probability Weighted Expected Return Method (“PWERM”) or Multi- Outcome DCF method; and • Option Pricing Method (“OPM”) Short of the payout being a sure thing, as in a 99.999% chance of the payout occurring or not occurring, the use of a single probability applied against a single earnings scenario to value an earn-out should be considered unacceptable. Single Outcome DCF models, therefore, will not be discussed further. You should familiarize yourself with both remaining methods, because the results can be used to test one another and both are used with equal frequency. The Probability Weighted Expected Return Method is generally performed in a risk- adjusted framework (meaning, you include risk in the cash flows and discount rate), and the Option Pricing Method requires a risk neutral framework (the opposite). Please note: The PWERM can be run in a risk-neutral framework, and often is. I’m thinking of the Longstaff-Schwartz Method for pricing options and its frequent usage and applicability here, as an example. PROBABILITY WEIGHTED EXPECTED RETURN METHOD The PWERM is a method whereby the appraiser: 1. Predicts multiple outcomes, 2. Probability weights the outcomes, and 3. Discounts the result at an appropriate risk adjusted rate. If the terms of the contingent consideration describe or the assumptions underlying the contingent consideration assume complex behavior, a PWERM or an open form option model (read: Monte Carlo Simulation) should be preferred to simpler valuation methods. Simpler models may not be able to reflect the complexities. The key considerations when applying the PWERM include: • The number of scenarios the appraiser uses with respect to the form of the payout, the amount of the payout (e.g., single value, or sliding based on the relationship of the metric amount and the contractual threshold), and who controls the payout; • The metric forecast distribution and any adjustments to be made given the confidence the appraiser has in the forecast, and in order to calibrate the forecast so that the entire method; and • The appropriate discount rate given the form of the earn-out, the risk associated with cash flows and optionality of the payout.
- 3. BE IN A POSITION OF STRENGTHSM withum.com We will walk through an example in the next article, but suffice to say a PWERM run in a risk-neutral or risk-adjusted framework should produce results which reconcile to each other Additionally, if you run a PWERM in a risk-neutral framework, and assume a lognormal distribution for the outcomes, you basically have the OPM. OPTION PRICING METHOD Option models are typically used to value equity options. The output from an option model is the present value of all possible positive payouts assuming a lognormal distribution of possible future values for the reference security. In our case, we assume a lognormal distribution for the reference financial metric, and the area above the hurdle rate is used to estimate the likelihood and magnitude of possible future payouts. In fact, when there are multiple milestones one can derive discrete discount rates for each milestone payment using a combination of risk-neutral, closed- form option to capture the uncertainty of each milestone being achieved. Here is an example of the inputs that would go into such an option model in a very simplistic contingent payout structure: The OPM uses five variables to estimate an option’s value: • Current Value of Metric – This assumption is based on underlying security’s (or metric’s) value today. The current value of the metric is the risk-neutral, present value of the forecasted metric. By eliminating management’s bias and the risk-free time value of money influence on the forecasted amount, what remains is equivalent to today’s value for that metric’s predicted future value: • Exercise Price – The metric amount which needs to be exceeded for the hurdle to have been met. This is contractual and so it is not adjusted in a risk-neutral or risk-adjusted framework. • Term – The time from the valuation date to the contingent liability measurement date. • Volatility – If the metric is revenue, then often asset volatility is used. If the metric is some other measure than revenue, consideration must go into whether the metric’s volatility would align with the value of the business as the whole or something else. • Risk-Free Rate – This assumption is the rate of return on a riskless security for the same term as selected above. The OPM methodology is preferred to the PWERM method because of challenges related to the appropriate Discount Rate selected. DISCOUNT RATE AND CLOSING THOUGHTS As with any valuation performed under the Income Approach the two challenges are properly estimating the future benefit stream and selecting the appropriate discount rate. Neither is obvious nor solved easily. However, as we will demonstrate in future articles, assets or liabilities with non-linear payouts are especially difficult to select discount rates for, because there are not readily observable sources for similar rates. If we are asked to value a debt instrument, then odds are we can pull up some examples of what current borrowing rates are. If we are asked to value a business, then we have myriad sources for multiples and the like. If we agree that a contingent consideration has a payout structure similar to an option, then there are no direct comparables we can rely on to develop our discount rates. In fact, as we shall see, the implied discount rates for options can get extremely high as one explores deeper and deeper out-of-the-money options. In conclusion, the most likely methods selected to value a contingent consideration or earn-out will be the PWERM or OPM (or both!) under the Income Approach. The application of the PWERM method is more intuitive since it still considers management’s forecast and probabilistic outcomes. The shortfall is the inability to likely select a reasonable discount rate. The OPM is harder to understand conceptually until you’ve really delved into the similarities between a contingent liability and an option, but easy to apply and review. Our next article will be about implied discount rates based on out-of-the money call options, since understanding that concept will help drive home the limitations of the PWERM in a risk-adjusted framework or application of any risk-adjusted framework to a non-linear expected payout problem. Please contact Howard Krieger at hkrieger@withum.com or 201.265.2800 for further questions or assistance.