What Does Contingent Consideration Mean?
Contingent consideration is the amount paid by the acquirer of a target company to the former owners of said company in case of the occurrence of certain future events. The exact events and their terms are outlined in the acquisition agreement entered into by both parties at the time of signing.
Divestopedia Explains Contingent Consideration
Contingent consideration, commonly known as earn-outs, is a common practice in mergers and acquisitions (M&A) deals as it helps to get the buyer and seller on the same page when it comes to valuation. The contingent consideration is paid over single or multiple periods and is often calculated based on many financial metrics such as revenue; gross profit; earnings before interest, taxes, depreciation and amortization (EBITDA); and profit before tax (PBT). In some specific industries, like pharmaceuticals, non-financial metrics are also used for calculating contingent consideration and these metrics include clinical trials, employee and customer retention targets, and development of software or other research and development (R&D) strategies.
The stipulated contingent consideration is paid either by cash or equity shares. However, a general rule is that contingent considerations that are settled by equity have more complex valuation when compared to contingent considerations that are paid by cash. In both cases, though, it is calculated based on the fair value and this value depends on the share price prevalent on the date of acquisition.
Many methods are used to calculate the value of contingent consideration: some of the more popular ones are discounted cash flow (DCF) and, the more complex, Monte Carlo simulation. The exact type of valuation will depend on the payout structure and the financial arrangements to make these payments. Besides the valuation method, contingent consideration also depends on the approach taken by both the buyer and seller.