Earnout Modeling in M&A Deals and Merger Models

[@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.

[@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.

[@saifulisfree]

1) If the earn out if pegged for year 5 do you adjust the income statement and the corresponding entry cash flow from ops section every year 2) if it’s paid out in year 5 you see a cash flow from financing impact but will there be a cash flow from operations impact that year as well?

[@financialmodeling]

If it's a 5-year earnout, yes, potentially there could be an adjustment on the statements every single year between Year 1 and Year 5. But there could also be nothing if the payout probability does not change in that year. If there is a payout in Year 5, it should appear within Cash Flow from Financing, not Cash Flow from Operations.

[@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.

[@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.

[@rajeshgandhi4486]

Very nice crash course :)

[@financialmodeling]

Thanks for watching!

[@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.

[@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.

[@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.

[@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.

[@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.

[@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

[@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.

[@wahidalishah2785]

useful video

[@financialmodeling]

Thanks for watching!

[@venkatkrishna7025]

Please do PPA MODEL

[@financialmodeling]

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

[@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.

[@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

[@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.