Case 19-7
Accounting for Contingent Payments to Employees or SellingShareholders in a Business Combination
Company G (G), an SEC registrant, is a global financial advisoryand asset management firm. Company P (P), a private company, offersadvisory services for (1) mergers, acquisitions, and divestitures;(2) capital structure (including initial public offerings); (3)government advisory, including strategic, finance and capitalmarkets related policy considerations; and (4) restructurings.
Case Facts
On September 18, 20X8, (the “Closing”), G and P executed anacquisition agreement (the “Agreement”) whereby G acquired 100percent of the outstanding shares of P (the “Acquisition”). At thetime of close, P had 10 employees that had over 200 combined yearsof financial and strategic advisory experience. Company P was ownedas follows:
Founder — 85 percent.
Senior advisor — 10 percent.
Other employees (four in total) — 5 percent.
The purchase price was calculated using a revenue multiple thatwas established using market data at the midpoint and transferredin exchange for 100 percent of the outstanding shares to theFounder ÷ employees who owned 100 percent of P (collectively, the“Shareholders”) on a pro rata basis. The total purchase pricecomprised the following:
Cash = $1 million.
Shares = 100,000 shares in G (worth $3.3 million).
Delayed Consideration = 120,000 G shares, but issued to theShareholders under the terms below (value assuming a 4-year vestingrestriction = $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 theShareholders, subject to the Shareholder being employed on suchdate.
o If a Shareholder is no longer employed on the fourthanniversary, the Delayed Consideration issued to such Shareholderwill continue to be held by Exchange Co until the tenth anniversaryof the Closing, at which point Exchange Co shall release theDelayed Consideration to the Shareholders.
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Case 19-7: Accounting for a Contingent Payments to Employeesor
Selling Shareholders in a Business Combination Page 2
• Earnout Consideration = Up to 600,000 shares (valued at totalof $20 million).
o The Earnout Consideration will be contingent upon achievementof 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 theShareholders on a pro rata basis. However, if and to the extentcertain performance targets described below are not achieved, inwhole or in part, no Earnout Consideration will be paid.
? First Earnout Consideration — If revenue exceeds $10 millionin the Earnout Period, the Shareholders will be entitled to 200,000shares.
? Second Earnout Consideration — If revenue exceeds $20 millionin the Earnout Period, the Shareholders will be entitled to anadditional 200,000 shares.
? Third Earnout Consideration — If revenue exceeds $30 millionin the Earnout Period, the Shareholders will be entitled to anadditional 200,000 shares.
o The Shareholders are still entitled to the EarnoutConsideration in the event that targets are met, but they are notemployees 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 Shareholderscontains compensation that is commensurate with the service eachrespective 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 replacethem with an existing G investment banker; therefore, theShareholders are not integral to the future success of the acquiredbusiness.
The fair value of P was determined to be $24 million.
The Earnout Consideration is not being treated as compensationexpense for tax purposes.
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Case 19-7: Accounting for a Contingent Payments to Employeesor
Selling Shareholders in a Business Combination Page 3
Required:
If there was a change to the case facts, and the Shareholderswere no longer entitled to the Earnout Consideration if they werenot employees of G at the time the revenue targets were met, shouldthe Earnout Consideration to the Shareholders be accounted for aspurchase consideration in exchange for the Acquisition or ascompensation for postcombination services?
