Contingent Consideration

Contingent consideration is the sum paid by the acquirer of a target company to the company’s former owners in the event that certain future events occur. The precise sequence of events and their parameters are specified in the acquisition agreement signed by both parties.

Contingent compensation, sometimes referred to as earn-outs, is a common practice in mergers and acquisitions (M&A) transactions since it enables the buyer and seller to agree on a price. The contingent consideration is commonly computed using a variety of financial criteria, including revenue; gross profit; profits before interest, taxes, depreciation, and amortisation (EBITDA); and profit before tax (PBT). Non-financial metrics, such as clinical trials, employee and customer retention targets, and the creation of software or other research and development (R&D) plans, are also used to calculate contingent consideration in some specific industries, such as pharmaceuticals.

The contingent compensation is paid in cash or in the form of equity shares. However, as a general rule, contingent considerations settled in equity have a more complicated valuation than contingent considerations settled in cash. In all circumstances, however, it is calculated using the fair value, which is determined by the share price on the acquisition date.

Numerous approaches are used to determine the value of contingent consideration, the most prominent of which are discounted cash flow (DCF) analysis and, for the more sophisticated, Monte Carlo simulation. The precise nature of the value will vary according to the payout structure and the financial arrangements used to make these payments. Apart from the method of appraisal, contingent consideration is also dependant on the buyer’s and seller’s approach.

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