Planning to sell your business?
Contingent considerations are worth exploring if you and the prospective buyer can’t agree on a fair value sales price.
In this post, I’ll walk through what contingent considerations are, why they’re important for business owners looking to sell, and how they can be used effectively.
What is Contingent Consideration in a Business Combination?
Contingent consideration is a term used to describe a part of the purchase price of a business that is contingent on certain conditions being met.
In general, contingent considerations are promised once future events occur or performance targets have been achieved following the acquisition date or merger transaction.
These clauses limit risk for buyers and sellers by mediating between what an acquiring company is willing to pay for a business and what a seller believes the company is worth.
For example, a buyer might agree to an additional contingent payment if the acquired company achieves a certain level of revenue or profit within a specified timeframe. It may be paid one lump sum or multiple payments over time and can take many forms—from cash bonuses to stock options.
Is Contingent Consideration Part of the Purchase Price?
Generally speaking, contingent consideration is an amount that may be added to the purchase price if certain conditions are met or events occur.
These conditions and events are usually specified in a purchase agreement between the buyer and seller and can include a variety of factors, i.e.:
- Performance targets being reached
- Planned restructuring taking place
- Key personnel continuing employment
- Regulatory approval being granted
Contingent Consideration Examples
The types and payment structures for contingent consideration can vary depending on the deal and the parties involved.
Contingent consideration can take many forms, including:
- Performance-based payments: where the buyer pays an additional amount if the business reaches certain financial targets (cash flow, gross profit etc.)
- Milestone-based payments: where the buyer pays an additional amount if the business reaches certain future events and milestones, such as launching a new product.
- Equity-based payments: where the buyer agrees to issue additional shares in the company if certain conditions are met.
Sometimes buyers use contingent consideration as part of their strategy to incentivize former owners beyond just pricing during an acquisition negotiation.
For example, if a deal includes stock awards based on future financial performance of acquirer post-closing – such as revenue growth or EBITDA targets – these awards can constitute contingent consideration payments.
Contingent Consideration vs. Earnouts
Earn outs and contingent consideration arrangements are similar in that they both involve payment that is dependent on certain conditions being met. However, there are some key differences between the two.
Contingent consideration is an incremental payment in a business sale that is dependent on certain conditions or targets (i.e. financial metrics) being met after the sale.
Earn out payments are a scenario in which the buyer pays the seller a portion of the purchase price based on the future performance of the business after the sale.
This allows the buyer to reduce the upfront purchase price, while giving the seller an incentive to continue to grow the business after the sale has taken place.
Risks of a Contingent Consideration Arrangement
- Insufficient due diligence: If inadequate research is done prior to signing the acquisition agreement, then the transaction could run into unforeseen complications that can delay closings or even lead to failed deals.
- Unexpected changes in circumstances: Contingencies can be impacted by external factors like changing laws, economic disruptions, and market behaviors which are out of both parties’ control. This could leave either party feeling betrayed if unexpected costs arise during the process.
- Misinterpretation of contractual language: Negotiations can quickly become confusing when trying to decipher the exact meaning behind each phrase used in a contract. Without proper guidance from legal and M&A advisors, there is potential for misinterpretation which could result in costly disputes down the line.
- Lack of enforceability: If an agreement doesn’t include clear requirements and deadlines for completing certain tasks within a set timeframe, then it may not be deemed as legally binding even if both parties agree to its terms.
- Counterparty risk: Regardless of how specific contingencies are outlined in an agreement, there is always potential for either party not fulfilling its obligations due to a lack of trust between them or financial problems on one side. Make sure you assess this risk before committing to any deals.
Other Factors to Consider
- Size of business: a larger company may have a more established track record and a greater ability to absorb risk, making them less likely to need an earn out or escrow.
- Complexity of business: A complex business with many moving parts may require a more detailed and sophisticated set of contingencies to ensure that the transaction is completed successfully. This can include using escrows or holdbacks to manage risk and ensure that the buyer takes the necessary steps to maximize the value of the business.
- Industry type: in a rapidly evolving industry, it may be difficult to predict future trends, making earnouts a valuable tool for aligning incentives and managing risk. On the flipside, in a mature industry with a stable outlook, contingencies may not be necessary.
- Bargaining power: a stronger bargaining position for either the buyer or seller can impact the use of contingencies. As an example, if the buyer has a strong bargaining position, they may be able to negotiate more favorable terms, such as a larger earnout or a longer holdback period.
- Cultural fit of the buyer and seller: the relationship between the buyer and seller will have a significant impact on the success of the transaction, so it’s important to consider whether they share a similar vision and values. This can impact the use of contingencies and the terms of the transaction.
Frequently Asked Questions
Why are contingent considerations important in a business sale?
- Helps fill a valuation gap and mediate between what an acquiring company is willing to pay vs. what the seller believes the company is worth.
- Limits risk and aligns incentives for both buyers and sellers
- Provide additional protection by defining further payment terms based on how the acquired business performs post-transaction. This could include bonuses or incentives that are paid out upon meeting predetermined milestones.
Is contingent consideration the same as compensation?
No, contingent consideration is not the same as compensation. Both deferred compensation and contingent consideration involve additional payments made by buyers after acquisitions close but there are subtle differences between them.
Deferred compensation involves periodic payments made regardless whether specific milestones were achieved.
Contingencies refer mainly towards potential cash/equity rewards when predetermined objectives were successfully completed within given timeframe post-closing.
Can a contingent payment be customized to fit the needs of a specific business sale?
Absolutely, each business sale is unique and contingent considerations can be tailored to meet the specific needs of the buyer and seller.
There is no ‘one size fits all’ and contingent considerations can be structured as a fixed amount or a percentage of the sale price, depending on the goals of the buyer and seller.
What types of conditions or targets can trigger a contingent consideration payment?
Conditions or targets that can trigger a contingent consideration payment could include:
- Revenue targets
- Profitability targets
- Milestones related to product development or market penetration
- Customer satisfaction targets
How are contingent considerations accounted for in a business sale?
Contingent considerations are typically accounted for as a liability on the balance sheet of the buyer until the conditions or targets are met and the payment is due.
The contingent consideration liability is usually valued at fair value and is periodically re-valued at each reporting date to determine its fair value. Changes to the value of this consideration are included in the income statement during the period after the completion of the combination.
How should I use contingent considerations strategically when selling my business?
Understanding all available types of contingent considerations and how they may be used strategically will enable you to negotiate more effectively during the sale of your business.
You should also think carefully about which aspects stand out as most desirable and what would be accepted by potential buyers given market forces at play over any given period time itself.
What should business owners consider when negotiating contingent considerations?
Think about factors such as the length of the contingency period, performance metrics, and the method for calculating the adjustments to the sale price. It’s also important to ensure that the contingencies are legally binding and enforceable.
How do contingent considerations impact the closing process in a business sale?
Contingent considerations can impact the closing process in a business sale by requiring the buyer and seller to agree on the specific terms of the contingent considerations and to include these terms in the sale agreement.
Wrap Up
Contingent considerations are an important part of the sale process, as they provide additional protection for both buyer and seller in business combinations. They can also be tailored to meet specific needs and help ensure that the terms of the agreement are met.
I hope you found this post helpful and that it cleared up some confusion.
When negotiating contingent considerations, I recommend you consult with your lawyer and M&A advisors to ensure that all conditions are fair, legal, and enforceable.
If you’re interested in diving deeper, this post is part of a series I’ve created to help you sell your business:
