Question

Case 19-7

Accounting for Contingent Payments to Employees or Selling Shareholders in a Business Combination

Company G (G), an SEC registrant, is a global financial advisory and asset management firm. Company P (P), a private company, offers advisory services for (1) mergers, acquisitions, and divestitures; (2) capital structure (including initial public offerings); (3) government advisory, including strategic, finance and capital markets related policy considerations; and (4) restructurings.

Case Facts

On September 18, 20X8, (the “Closing”), G and P executed an acquisition agreement (the “Agreement”) whereby G acquired 100 percent of the outstanding shares of P (the “Acquisition”). At the time of close, P had 10 employees that had over 200 combined years of financial and strategic advisory experience. Company P was owned as follows:

• Founder — 85 percent.

• Senior advisor — 10 percent.

• Other employees (four in total) — 5 percent.

  The purchase price was calculated using a revenue multiple that was established using market data at the midpoint and transferred in exchange for 100 percent of the outstanding shares to the Founder ÷ employees who owned 100 percent of P (collectively, the “Shareholders”) on a pro rata basis. The total purchase price comprised the following:

  • Cash = $1 million.

  • Shares = 100,000 shares in G (worth $3.3 million).

  • Delayed Consideration = 120,000 G shares, but issued to the Shareholders under the terms below (value assuming a 4-year vesting restriction = $5 million; assuming a 10-year vesting restriction = $4 million).

o Delayed consideration is held by an independent third party (Exchange Co) and on the fourth anniversary of the Closing, Exchange Co shall release the Delayed Consideration to the Shareholders, subject to the Shareholder being employed on such date.

o If a Shareholder is no longer employed on the fourth anniversary, the Delayed Consideration issued to such Shareholder will continue to be held by Exchange Co until the tenth anniversary of the Closing, at which point Exchange Co shall release the Delayed Consideration to the Shareholders.

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Case 19-7: Accounting for a Contingent Payments to Employees or
Selling Shareholders in a Business Combination Page 2

• Earnout Consideration = Up to 600,000 shares (valued at total of $20 million).

o The Earnout Consideration will be contingent upon achievement of revenue hurdles over a period beginning on September 18, 20X8, and ending on December 31, 20X2 (“Earnout Period”).

o To the extent the performance targets below are achieved, Exchange Co shall deliver the relevant Earnout Shares to the Shareholders on a pro rata basis. However, if and to the extent certain performance targets described below are not achieved, in whole or in part, no Earnout Consideration will be paid.

•  First Earnout Consideration — If revenue exceeds $10 million in the Earnout Period, the Shareholders will be entitled to 200,000 shares.

•  Second Earnout Consideration — If revenue exceeds $20 million in the Earnout Period, the Shareholders will be entitled to an additional 200,000 shares.

•  Third Earnout Consideration — If revenue exceeds $30 million in the Earnout Period, the Shareholders will be entitled to an additional 200,000 shares.

o The Shareholders are still entitled to the Earnout Consideration in the event that targets are met, but they are not employees of G at the time the Earnout Consideration is earned.

Other Key Facts

• Company P meets the definition of a business under ASC 805.

• Each employment agreement executed by G and the Shareholders contains compensation that is commensurate with the service each respective Shareholder is providing to G.

• The Shareholders have at-will employment agreements with G.

• If the Shareholders were to leave, G would be able to replace them with an existing G investment banker; therefore, the Shareholders are not integral to the future success of the acquired business.

• The fair value of P was determined to be $24 million.

• The Earnout Consideration is not being treated as compensation expense for tax purposes.

Required:

Does the Delayed Consideration represent purchase consideration in exchange for the Acquisition or compensation for postcombination services? Is it contingent consideration? How much of the Delayed Consideration (if any) should be consideration for postcombination services?

Answer 1

ASC 805 deals with contigent consideration where a part of the consideration is contingent on certain conditions like future performance target or market condition etc or the continuation of employment is one of the criteria for the payout. Such conditions can be part of the acquisition agreement or compensation agreement or other documents. This is complex exercise to evaluate the accounting based on ASC 805.

Standard requires contingent consideration to be accounted for either an equity or liability at fair value on the combination date. Liability shall be revalued at each reporting date until settlement occurs with resulting change being recognised in profit and loss.

Further, standard provides that where contingent consideration is classified as equity, it is not subsequently remeasured. When the contingency is settled, it is accounted for within equity with no impact on profit or loss.

However, where a continuing employment is essential contigent condition for payment of consideration requires to be accounted as post combination compensation expenses. Standard provides that the terms of continuing employment by the selling shareholders who become key employees may be an indicator of the substance of a contingent consideration. A contingent consideration arrangement in which the payments are automatically forfeited if employment terminates is compensation for postcombination services.

In the given case, the accelerated payment is linked to continuation of association of the former owners and in the event of ceasation of association, former shareholders shall receive the delayed compensation.

Since it is possible for the former oweners to receive a payment even if they are no longer employed by new owners, it is appropriate for new owner to isolate the element that is contingent on continuing employment and account for that element as compensation in its postcombination financial statements from the contingent consideration.

Hence, both elements i.e. contigent consideration for exchange of acquisition and post combination compensation expenses should be seperated & accounted accordingly.

It is difficult to estimate the amount as this exercise requires fair value expert to measure the liability or equity and post combination expenses.