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hello and welcome to another tutorial video we're gonna continue with the theme that we've been using these past few lessons and answer a question that was submitted the other day and also a question that is very common about a topic that we think causes a lot of confusion so here's the question that came in one of our students wrote in and said can you explain what happens with an urn out in an M&A deal how do you model it how do you factor it into the purchase price allocation schedule the sources in use and schedule and possibly other schedules in the model and then where does it show up on the three financial statements now the truth is that there have been books written about this topic and very long academic papers so we can't go into all that here what I want to do though is give you the short crash course version of this topic so that you know the key points to cover it we're gonna start off by telling you a little bit about what urn outs are and why you use them then we'll go through how they show up on the three financial statements then we'll look at how they impact the purchase price allocation and sources and use of schedules in an M&A deal and then I'll show you how we're now its effect the income statement balance sheet and cash flow statement in a merger model so let's go to point one first which is what burn outs are and why you use them but simply an earn out means that instead of paying for company 100 percent upfront when you go to acquire it you or the buyer will offer to pay some portion of the price later on if certain conditions are met so for example let's say that you're at Facebook or Oracle or Microsoft or Google and you see an interesting startup out there and you go to them and say we'll pay you a hundred million dollars for your company right now and if you achieve eBay da of 20 million dollars in two years from now we'll pay you an additional 50 million that that would be an example of an earn out because you pay some portion of the price up front but then you pay the remainder only if they achieve this goal of EBIT ah of 20 million in two years from now this is very common whenever private companies are acquired you see it a lot with tech startups biotech startups pharmaceutical companies here's a real-life example of where burnout popped up with a tech deal Electronic Arts acquired this company for 750 million and if you look at some of the press releases they say that the consideration was six hundred fifty million in cash and a hundred million in stock with a multi-year earn-out bonus now some of the press releases didn't have many details about it but some of them actually did and as you can see in this press release that I'm highlighting they spell out the terms of the earn out right here if 2 year cumulative earnings are 91 million or less the sellers won't receive anything and then they have another level where they get 100 million and then another level where they get 275 million and then another level where they get 515 million so this earn out is not based on EBIT on revenue but rather on earnings in other words net income from the seller and depending on what it is cumulatively over two years they receive a different amount of consideration so this slide just spells out exactly what I told you but it is pretty striking to look at all these numbers line up and especially the last one now this last one might be for a case where say the management team of the seller PopCap Games has very very high expectations Electronic Arts doesn't really believe them but they say you know what if you achieve those expectations and you actually earn close to 315 million in earnings over these next two years we will pay you a very high amount an amount that's equal almost to the entire upfront purchase price for your company if you actually achieve that goal so earn outs can potentially be very lucrative if the seller does well but if the seller doesn't do well you can see what happens they get a far lower purchase price and this is part of the reason why sellers don't necessarily like earn outs but sometimes they have to agree to them anyway why would you use in turnout as you just saw usually it's because the buyer and the seller have very different views about the sellers value and their financial projections so with this Electronic Arts and pop cup example maybe PopCap thinks that they're gonna earn five hundred million over two years Electronic Arts doesn't really buy into their estimates they think that maybe they'll earn a hundred or two hundred million or something like that so when that happens the buyer will often say we don't believe your projections maybe you'll get to fifty percent of what you think but you're not going to hit a hundred percent of those numbers the seller will say no no no we're pretty confident look at us we can execute so well we're gonna make so much money when this happens instead of just walking away from the deal you can use an earn out to compromise and the buyer can say well no one knows the future we don't really believe your estimates but if you're right you deserve to get a higher price for your company if you're wrong we'll still pay you something but we're not going to pay you as much as if you had achieved the goals that you set out for so that is how you might use an earn out to compromise in this situation now with earn-out structures there are a couple points to mention usually the buyer wants to base the earn out on the sellers stand alone profitability in other words their net income and of course the buyer wants to do this because all they care about is how much in profit the seller actually contributes they're running a business they're trying to boost their own profits and they want to get profits by acquiring this other company now the seller will usually want to basically earn out on revenue or combined revenue or assisted revenue so going back to this example of popcap games and Electronic Arts the seller will argue that as a result of being acquired now they can earn even more revenue by using Electronic Arts resources and distribution networks and relationships with suppliers and so on and so forth so we should base it on the revenue number the buyer doesn't like that in most cases because often it encourages the seller to spend a ridiculous amount of money to achieve certain revenue levels so as another compromise often you will see EBIT or EBIT ah targets used if you look at the pop cap example here they say that earnings really means certain non-gaap earnings before interest in tax in other words EBIT earnings before interest and tax so they're actually basing it on a bit here as a compromise solution you can also have many tiers and levels with earn outs the PopCap one has a couple different tiers but you can make it even more complicated than this you can have a target based on revenue and a beta and net income and you can have levels for what happens if you go 20% above or 40% above or 60% above and you can extend it over many years at a time so this subject can get very complex but this is an introduction to the fundamentals of how or announce work with that said let's take a look at how earn outs show up on the three financial statements I'm going to be using this example from jazz pharmaceuticals because their biotech and pharmaceutical company that has been very acquisitive and they have a number of references to earn outs on their three statements on the balance sheet you will see announced recorded as contingent consideration sometimes the name is slightly different but usually contingent is somewhere in the title and this will be a liability on the liabilities and equity side so for Jazz pharmaceuticals we see this modern contingent consideration and it was around 50 million in one period and then I went to zero meaning that it was paid out to the seller to the company that they acquired in this case on the cash flow statement you see two items number one when the earn out is actually paid out in cash you see that as a cash outflow but then when the value of the contingent consideration changes you also see that on the cash flow statement let's go and take a look at this for jazz from the zoodles within the financing activities section you see this line item payment of contingent consideration and that represents exactly what it sounds like the payment to the seller they achieve their EBA da or revenue or net income target and in our receive payment from the parent company you will also see this other item that change in the fair value of contingent consideration and this is used for cases where they estimated the earn out at one level say 50 or 60 million but then they realize that maybe there's a lower chance than they expected of actually paying it out because the seller isn't doing as well as they wanted or maybe it's doing better than they expected what it really means is that the probability of actually paying out this earn out has changed now on the income statement this is where you actually record that change and the way it works as I say here is that you record changes in the value of the contingent consideration on the income statement and if the value goes down you'll actually record it as a gain or a positive on the income statement if the value goes up because it's a liability you record it as a negative on the income statement and then on the cash flow statement you adjust and reverse the sign and so this 4500 right here this 4.5 million means that they reduced the value on the income statement by 4.5 million and now they're reversing it here and adding it back so as I say right here the company always has to keep track of the chances of actually paying this earn-out and initially let's say they have 100 million for the earn-out and they think it'll be paid out in two years so initially that contingent consideration might be 100 million but after a year maybe the acquired company misses its financial goals it misses its targets and so the buy reduces the contingent consideration by 25 percent meaning that now they think there's a 25 percent lower chance of paying out erna which means that it's gonna go down by 25 million and it's actually gonna be 75 million after all is said and done so on the income statement you would actually record that as a positive 25 million because you're writing down a liability now on the statements of Jazz pharmaceuticals they don't actually have a separate line item for this but typically it would be embedded somewhere within operating expenses we don't know which category exactly but usually would show up somewhere here and it would affect their operating income so you sure that as a positive 25 million and then on the cash flow statement you would subtract back out that 25 million and cash flow from operations so going back down here in this case jazz actually did the opposite they're adding it back meaning that they recorded a negative on the income statement but if we had it positive on the income statement we'd be showing it as a negative here and subtracting it back out and then the balance sheet you just reduced the contingent consideration by 25 million and cash and retained earnings will balance that change net income is going to change and taxes are going to change taxes will affect cash and that is how everything balances out here so that takes to the end of point number two how we're now it's our reflected on the three statements let's go into point number three earn outs and the purchase price allocation and sources and uses schedule so in the sources and uses schedule announced actually make no impact because they're not paid out in cash initially so if you go and look at a company or an M&A deal with earn outs as we have right here and you look at the sources and uses of fun schedules there's nothing about her doubts here because remember earn outs are deferred payment you don't pay for it upfront the sources and user schedule is all about that upfront payment so you can have a lot of things going on here but you're never going to see an earn out in these sources and uses for the initial transaction of course they will make an impact on the purchase price allocation schedule because of what we mentioned before that the contingent consideration is recorded as a liability on the balance sheet and so it's therefore going to impact goodwill now to show you exactly how this works I'm gonna pull up one of our case studies on Joseph a bank and Eddie Bauer this is a failed M&A deal where Joseph a bank announced plans to acquire Eddie Bauer which is a private company at the time it didn't go through Joseph a Bank end up merging with another company but it is part of one of our case studies so let's just take a look at what actually happens here we haven't earned out of 50 million based on even target and this comes directly from the press release announcing the deal we don't have detailed information on Eddie Bauers financials but we do know that they had a 50 million dollar earn out place they're gonna pay around 825 million for the company upfront and it was a private company so we're gonna consider enterprise value and equity value to be the same because we don't have better information on it as I mentioned there's no impact on sources and uses but in the purchase price allocation schedule you list that equity purchase price in the beginning you subtract the book value of the seller and you write off any of the sellers goodwill you add that to the calculation and that takes you to your allocable purchase premium and then when you move on from there take a look what happens you have the normal write-ups for PPE and intangibles you adjust for deferred tax liabilities you create the new deferred tax liability but you also have this new item the contingent consideration liability and initially if the company is pretty confident that they're gonna pay out this earn out in one year or two years based on EBIT target you might assume that it's worth the full amount you might say that this contingent consideration is worth a hundred percent of this earn out and that's exactly what we've done here and you can see the impact which is that goodwill will increase as a result of this because you're adding something to the liability side if you didn't have this goodwill would be significantly lower but since we do have this it pushes up the goodwill that's required to balance it on the asset side so as I say over here goodwill will increase as a direct result of this if the earn out is worth more goodwills gonna go out buy even more if it's worth less goodwill will not increase by as much so that's how you deal with it in a purchase price allocation and sources and use and schedules and then of course in the balance sheet you go through all the normal adjustments you'd adjust for the cash the write down of the sellers shareholders equity the debt stock in cash used you would reflect the new goodwill and you'd create this new item for the contingent consideration liability so that's point number three let's go in to point number four now and take a look at the rest of the merger model and what happens with earn outs there so step one what we just did was to create this liability in the purchase price allocation schedule and it may not be a hundred percent of the earn outs value you may multiply by 50% or 75% or some other number based on your best guess for how much will actually be paid out and then you have to factor in the earn out on the income statement cash flow statement and balance sheet on the income statement you will tend to leave the corresponding item blank you don't really know how the earn outs of value or potential value is gonna change over time unless you can see into the future and you know exactly how the seller's gonna perform but on the cash flow statement you should factor in some type of future payout let's go back to our Excel model on the combined income statement we do have this slide item for the change in contingent consideration value I've set it to zero here because we just don't know how this is gonna change now if you wanted to you could try to do something where you link it to the other company's revenue and EBIT ah and depending on how its EBIT Dazs projected maybe you can make this value go up or down by a certain percentage to be honest it's a bit of a waste of time because it's a non-cash charge anyway and so it's not going to affect a whole lot in the model at least in terms of debt repayment and cash flow and things like that so we don't really think it's worthwhile but you could make that type of adjustment if you do that you also have to be careful then to add it back on the cash flow statement and to have this lot item changing contingent consideration value where you just flip the sign of whatever is on the income statement and then if you had a full balance sheet here you would link this in and you would make the contingent consideration go up or down based on what is here that step is really optional but what you have to do is reflect the actual payout somewhere on the cash flow statement so here I've shown it in cash flow from financing and you can see that in year two we are assuming the full payout from this fifty million and you can see the impact it actually turns our cash flow negative for the year and it means that we actually have to borrow something and take on additional debt in this year as a combined company because we came up short and this payment pushes us down into cash flow negative territory so that's how it works as I say here you could try to probability weight this and assume less than the full amount or you could link it to the projections for the seller and look at their EBIT on year two and your one and try to link it to conditions there or if you want to be really conservative you could just assume the full payout amount and say that in the worst case this is what will happen so we might as well assume that and assume that the company's cash flows will go down by a certain amount when this gets paid out you are gonna reduce the corresponding liability in the balance sheet you'll actually wipe it out it'll go away and cash on the asset side will change as a result now just to summarize what we went through briefly earn outs are used when the buyer and seller cannot agree on value and the projected financial performance of the seller their uses a compromise where the buyer pays some portion of the consideration later on depending on how the seller has performed on the three statements as we saw before on the balance sheet you record the contingent consideration as a liability to represent what the earn out is going to be worth when it's paid out in the future on the income statement when the value or expected value of that earn out changes you have to record changes there you reverse those changes on the cash flow statement and then in cash flow from financing you also show the actual payout of the urn out there in an M&A deal the urn outs will not impact the sources and use of schedule but they will impact the purchase price allocation schedule they'll change the amount of goodwill you create a higher contingent consideration liability means more goodwill a lower liability means less good well and then in a merger model you typically don't assume much of a change to the fair value of it on the income statement or cash flow statement but you do have to assume something for the cash payout on the cash flow statement which may change the company's cash and debt levels and will also change the contingent consideration itself on the balance sheet so that's it for this lesson we really just scratched the surface of our not modeling in this short crash course but next time we might look at multi-year earn-out scenarios and tears different revenue and EBIT de targets and projections and scenarios or even how the buyer and seller might negotiate and earn out so let us know where you're interested in and we hope to cover more on this topic soon