Was reading through this post on modeling earn-outs in a LBO scenario, and I think I understand it, but have 2 quick questions:
I (sponsor) am purchasing a company at 10x EBITDA = $1,000m. I agree to an earnout with the seller's shareholders saying, if EBITDA reaches $150m by Year 3, the seller shareholders receive a $20m earnout.
I don't include the $20m earnout in my S&U (not being paid out at close), but do account for $20m contingent consideration on the L&E side when calculating goodwill to make sure B/S balances.
At the end of Year 1, if I (sponsor) think the likelihood of the company reaching the target decreases, I'd write down the value of the contingent consideration to say $18m (write-down flows through I/S under operating expenses; subtract on CFS as non-cash)
1) In the event the company reaches $150m EBITDA in Year 2, the earnout that needs to be paid is $20m, even though the value of the contingent consideration on my B/S is $18m, right? And this would be financed using either the company's cash flows / revolver drawdown?
2) If the by Year 3 the company doesn't meet $150m EBITDA, I write-down the remaining value of the earn-out?
Thanks a lot guys, really appreciate it!
You have it correct. As you revalue the liability you push the deltas through the income statement and then remaining liability (if any) gets removed when it gets paid off in cash.
One small note (wouldn’t suggest for a model test, just an FYI) - GAAP would have you value the liability on an NPV basis based on the company’s cost of capital at close. GAAP may also have you probability weight it. So it wouldn’t be $20M liability at close, something lower.
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