Contingent Consideration
Definition§
Contingent consideration is a payment agreed upon during a business merger or acquisition that is contingent on the achievement of certain future performance milestones or events. Typically seen in earn-out agreements, contingent consideration helps align the interests of the buyer and the seller by tying a portion of the purchase price to the future results of the acquired business.
Examples§
Example 1: Earn-Out Agreement§
A company acquires a startup, and an earn-out agreement is included in the acquisition contract. Under the terms, the startup’s former owners will receive an additional $2 million if the startup achieves a revenue target of $10 million within two years of the acquisition.
Example 2: Milestone Achievement§
A pharmaceutical company acquires a biotech firm, agreeing to pay an additional sum of $5 million if the biotech firm successfully gets FDA approval for its new drug within a three-year period.
Frequently Asked Questions§
What is the purpose of contingent consideration?§
The purpose of contingent consideration is to bridge valuation gaps between buyers and sellers by tying part of the payment to the future performance of the acquired business. It aligns the seller’s incentive with the future success of the business.
How is contingent consideration accounted for in financial statements?§
Contingent consideration is initially recognized as part of the purchase price at its fair value at the acquisition date. Subsequent adjustments due to changes in fair value are typically recognized in the income statement.
What factors can contingent consideration be based on?§
Contingent consideration can be based on various factors such as revenue targets, profit margins, product development milestones, regulatory approvals, or retention of key customers or employees.
Related Terms§
Earn-Out Agreements§
An earn-out agreement is a provision in a business acquisition deal that provides the seller additional compensation based on the business’s future performance. Earn-out agreements often involve specific financial or operational milestones.
Purchase Price Allocation (PPA)§
Purchase Price Allocation refers to the process of assigning the purchase price paid in a business acquisition to the acquired company’s assets and liabilities at their fair values.
Goodwill§
Goodwill represents the excess of the purchase price over the fair value of an acquired company’s identifiable net assets. It reflects intangible factors such as brand reputation, customer relationships, and future earning potential.
Fair Value§
Fair Value is the estimate of the market value of an asset or liability based on what a knowledgeable, willing party would pay to acquire it or receive to transfer it. In contingent consideration, the fair value estimation considers the probability and timing of achieving milestones.
Online Resources§
- Investopedia: Contingent Consideration
- AccountingTools: Contingent Consideration
- Corporate Finance Institute: What is Contingent Consideration?
Suggested Books for Further Studies§
- “Mergers & Acquisitions For Dummies” by Bill Snow
- “Valuation: Measuring and Managing the Value of Companies” by McKinsey & Company Inc.
- “Accounting for M&A: Proven Strategies for Managing, Measuring, and Rewarding Valuation Driven Deal Economics” by Steven M. Bragg
Accounting Basics: “Contingent Consideration” Fundamentals Quiz§
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