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.
Let's say we owe a $15M earn out in a year if EBITDA is over $10M.
Example 1: High probability of hitting $10M, but we have a 5% cost of capital, so we value the liability at $14.25M at close. Over the course of the year, the liability goes up by 5%. Additional liability = expense on the income statement, so my GAAP income statement has an additional $0.75M of expenses over the course of the year as I write up the liability. However, earnouts are purchase price and not taxable, so even though my GAAP income statement shows reduced taxes because of the earnout expense, my tax income statement will not, and therefore I have a deferred tax liability under GAAP.
Example 2: Business falls off a cliff and I'm not going to hit the earnout with any realistic probability, so I write off the $14.25M liability. This is $14.25M of income on the income statement. However, its not taxable (its just purchase price I don't have to pay), so my tax income will be less than my GAAP income. A deferred tax asset is created.