Hi, let's assume that a deal was structured as such that a $5MM in earnout would be paid if the company hit a certain EBITDA target in yr 3, and $10MM if a company achieved EBITDA target for yr 4.
I understand that at yr 0 when the transaction was first recorded, it would have ~15MM in earnout liability.
Now let's assume it's yr 3 and the company has met the earnout hurdle, how will this be recorded on the 3 statements?
Income Statement No Change CFS Financing Activities - Less Earnout Payment of $5MM So cash down by 5 BS On assets side, Cash Down by Earnout Payment $5MM On L&E side, earnout liability down by 5 so it balances
Is the above correct, or do we need to record any changes to the value of "contingent consideration / earnout payable" (for yr 4?) on the Income Statement now that the probability of earnout payment has gone through? And just to confirm my understanding that earnout payments cannot be tax-deducted?
Looking at someone like @Rover-S" who can chime in on this. Thanks in advance!
I would say it's not an on-balance liability at transaction date, because it's uncertain > but pls check with an accountant on this.
Tax treatment of earn out is country specific, but in general I would assume it to be non deductible.
Earnouts are on-balance sheet liabilities. There are a few different purchase accounting treatments, but typically if the company's M&A forecasts (also used for purchase accounting) have earnings sufficient for an earnout to be payable, the earnout will receive a very high probability weighting, and then the liability will be NPV'd from date payable back to the closing date at some reasonable cost of capital.
The liability gets revalued over the period up or down depending on if the earnout becomes more or less likely, and the NPV discount goes down. This revaluation does get pushed through the income statement, however I agree none of this should be taxable so likely creates a tax asset or liability.
Then gets taken off the balance sheet as OP suggested on payment with no IS impact, just CF.
To add to this, and do correct me if I’m wrong, in the case where the criteria for the earn out is not met, the liability is written off as a gain in the P&L (no impact on cash flow). On the tax side, personally I’m not very well versed on tax law, however, I would presume that the written off earn out “gain” would not be taxable as there was no deduction taken in recording the earn out at the transaction close.
Additionally, keep in mind that when criteria for an earn out is not met, especially if the criteria is financial, then there may be impairment of goodwill as well.
Thanks for expanding on this, could you talk a bit more about how a tax asset or liability would be created in this case?
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