Earnout Modeling in M&A Deals and Merger Models

In this tutorial, you’ll learn how and why earn-outs are used in M&A deals, how they appear on the 3 financial statements, and how they impact the transaction assumptions and combined financial statements in a merger model.
By breakingintowallstreet.com/ "Financial Modeling Training And Career Resources For Aspiring Investment Bankers"
Table of Contents:
1:28 What Earn-Outs Are and Why You Use Them
7:46 How Earn-Outs Show Up on the 3 Statements
12:21 How Earn-Outs Impact Purchase Price Allocation and Sources & Uses
16:02 How Earn-Outs Affect the IS, BS, and CFS in a Merger Model
19:12 Recap and Summary
What Earn-Outs Are and Why You Use Them
Instead of paying for a company 100% upfront, the buyer offers to pay some portion of the price later on - if certain conditions are met.
Example: “We’ll pay you $100 million for your company now, and if you achieve EBITDA of $20 million in 2 years, we’ll pay you an additional $50 million then.”
Earn-outs are VERY common for private company / start-up acquisitions in tech, biotech, pharmaceuticals, and related “high-risk industries.”
EA acquired PopCap for $750 million upfront, and offered an earn-out that varied based on PopCap Games’ cumulative EBIT over the next 2 years. The schedule was as follows:
2-Year Earnings Under $91 Million: Nothing
2-Year Earnings Above $110 Million: $100 million
2-Year Earnings Above $200 Million: $175 million
2-Year Earnings Above $343 Million: $550 million
Why Use an Earn-Out?
You see them most often when the buyer and the seller disagree on the seller’s value or expected financial performance in the future.
Earn-outs are a way for the buyer and seller to compromise and say, “We don’t really know how we’ll perform in the future, but if we reach a target of $X in revenue or EBITDA, you’ll pay us more for our company.”
The buyer will almost always want to base the earn-out on the seller’s standalone Net Income, while the seller prefers to base it on revenue, partially so the seller can spend a silly amount to reach these revenue targets.
As a compromise, EBIT or EBITDA are sometimes used.
How Earn-Outs Show Up on the 3 Statements
Balance Sheet: Earn-Outs are recorded as “Contingent Consideration,” a Liability on the L&E side.
Income Statement: You record changes in the value of the Contingent Consideration here, i.e. if the probability of paying out the earn-out changes, you show it as a Loss or Gain here. It’s a Loss if the probability of paying the earn-out increases, and a Gain if the probability decreases.
Cash Flow Statement: When the earn-out is paid out in cash to the seller, it’s a cash outflow here. You also have to add back or subtract changes in the Contingent Consideration value here, reversing what is listed on the Income Statement.
How Earn-Outs Impact Purchase Price Allocation and Sources & Uses
Earn-outs do not affect the Sources & Uses schedule for the initial transaction since no cash is paid out yet.
Earn-outs increase the amount of Goodwill created in an M&A deal because they boost the Liabilities side of the Balance Sheet, which, in turn, requires higher Goodwill on the Assets side to balance it.
How Earn-Outs Affect the IS, BS, and CFS in a Merger Model
You tend to leave the Income Statement impact blank in a merger model unless you have detailed estimates for the seller’s future performance.
You SHOULD factor in the cash payout of the earn-out on the combined Cash Flow Statement - you can assume a 100% chance of payout, or some lower probability.
The payout will appear in Cash Flow from Financing and reduce cash flow and the company’s cash balance.
RESOURCES:
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[@cpey87]

This was very helpful, I was curious how to properly accrue earn-outs on the balance sheet.

[@financialmodeling]

Thanks. Earn-outs are not that complicated, the main difficulty is estimating the change in the fair value of earn-outs, but you don't really worry about that when advising on deals since it happens after the fact.

[@rajeshgandhi4486]

Very nice crash course :)

[@financialmodeling]

Thanks for watching!

[@addawg2306]

Thanks for the video! Can you do a video on how to analyze different LOIs. For example, If you were to have LOI A that assumes all cash upfront vs. LOI B which assumes a portion of purchase price is in a form of a earn out vs. LOI C which assumes a PE buyer who wants the seller to have residual interest in the pro forma company, how would you go about analyzing and presenting different LOIs via excel, kind of like a net proceed analysis of some kind.

[@financialmodeling]

We don't have anything like that, but it's not that complicated... come up with a few operational scenarios for the company and explain the PV of the proceeds in each scenario. You can use probability-weighting for the scenarios if you want. It's inherently speculative because the results depend on how the company performs, so it comes down to building a 3-statement or simplified cash flow model with support for multiple scenarios.

[@basketball5678]

Hi Brian. Great video as always. I might have missed this, but on the balance sheet, what line item on the asset side will correspond with Contingent Considerations?

[@financialmodeling]

When it's first created in an M&A deal, Goodwill balances it. If some of the Contingent Consideration gets paid out to the Target, Cash balances it. If there's a change in the fair value of Contingent Consideration but no Cash payout, Cash and Equity balance it since that change will affect Net Income and flow through everything else.

[@365Pancakes]

You allude to taxes around 12:10. Do changes in the value of contingent consideration actually affect cash taxes? Any other considerations around tax treatment? Thank you!

[@financialmodeling]

Potentially, yes, but it depends on how the earn-out is classified when it is first recorded, and it gets into issues that go beyond the scope of this tutorial. No deferred tax items change as a result of the contingent consideration first being recorded because if it's actually paid out in the future, it appears as a cash outflow on the CFS and skips the Income Statement entirely. So, it's *not* like an Intangible Asset where you end up creating DTLs because the write-downs or amortization appears on the IS but are not deductible for cash-tax purposes.

[@xuxinyexu1296]

Super helpful. A quick question, when you say "reduce the fair value," does that include the payout? For example, if initial fair value of earnout was 20 over 2 years, and in year 1, you pay out 5, does that show up on the income statement ?

[@financialmodeling]

Payouts do not show up on the Income Statement, they appear on the Cash Flow Statement and directly reduce the Earnout line item on the Balance Sheet.

[@wahidalishah2785]

useful video

[@financialmodeling]

Thanks for watching!

[@AmitGupta-lx4gu]

When you make the $25 Million dollar adjustment to the income statement and then make the opposite ($25 M) adjustment on the cash flow statement, is there a change in overall cash flow because of taxes? E.g. (1-20%)*25 = $20 increase in net income which flows to cash flow, -$25 M operating cash flow, gives an overall -$5 change in cash flow

[@financialmodeling]

We simplified it here, but in reality, something like the Change in Fair Value of Contingent Consideration would not affect the company's cash taxes. So any difference in the book taxes on the IS would be reversed on the CFS in the Deferred Income Tax line item (could be positive or negative depending on what was shown on the Income Statement). So here, yes, there is an impact because of taxes, but in real life there would be no cash impact if you set it up in a more complex way.

[@tylersmith3887]

I know this is 7y old - but haven’t the GAAP and IFRS rules changed about PPA to goodwill when it comes to earnouts?

[@financialmodeling]

The exact setup shown here is not quite correct, but an Earnout still increases the amount of Goodwill required in the deal because an Earnout always creates a "Contingent Consideration" liability on the other side of the Balance Sheet.

[@capredo]

Thanks for the content! Can you tell the name of good books of this subject, pls?

[@financialmodeling]

I don't know of any books that cover earn-out modeling. We do cover the topic with a newer/better example in our main financial modeling course, but the example here gives you a decent introduction to it.

[@celebrationsgrand9308]

Hi. How would the S&U change if out of the 825 EV, it was agreed to pay 50% upfront at time of transaction closing and the remaining 50% as an earnout over the next 2 years?

[@financialmodeling]

The treatment shown here is not quite right, so don't go by it. It's an older video that needs a revision/update. To answer your question, the Cash/Debt/Stock should still be shown for the 50% upfront component in Sources, and the remaining 50% should be "Deferred Consideration," also in Sources. So the full amount should be shown in Sources, but it should be split up by the upfront vs. deferred payments.

[@josekobori-pessoal3185]

I bought the BIWS Premium course and I didn't find this worksheet in the material.

[@financialmodeling]

Please see the Bonus Case Studies section and the M&A/LBO lessons there.

[@venkatkrishna7025]

Please do PPA MODEL

[@financialmodeling]

There are many examples of the Goodwill calculation already in this channel.

[@joysalabi3639]

Who are you paying to as 'the seller' if you are already now combined? Who is now getting the money? I hope this makes sense

[@financialmodeling]

The seller's former shareholders would receive the money (whether they're institutions or individuals or some combination of both).

[@joysalabi3639]

Mergers & Inquisitions / Breaking Into Wall Street Right! Thanks

[@venkatkrishna7025]

What is asset purchase vs stock purchase

[@financialmodeling]

Google it and look at the results... we have a free guide floating around somewhere that deals with this concept

[@michaelballard7809]

This is great, as usual! Are you going to make the excel spreadsheet available?

[@financialmodeling]

Click "Show More". Scroll to the bottom. Click the links under "Resources."

[@michaelballard7809]

I really hate to be a pest and apologize, but the excel model isn't there did I miss something? Starting from top to bottom 1) Your powerpoint. 2) Jazz Pharma 10K financials 3) EA Buys PopCap Games For As Much As $1.3B 4) Electronic Arts buys PopCap for $750M 5) Earn-outs in M&A Transactions Key Structures and Recent Developments from M&A Journal.

[@sweetness4j1]

hey.. i still don't get it. especially when the purchase consideration comes in part shares at the acquisition date and money after the consolidation date. .Then there is a market price and fair value price at the respective dates

[@financialmodeling]

What is your question? The % cash vs. % stock in the upfront purchase price don't matter... you still calculate Goodwill, the Contingent Liability, etc. based on the same equity purchase price.