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Valuation of Contingent Consideration Copyright © 2019 by the Appraisal Foundation

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Valuation of Contingent Consideration Copyright © 2019 by the Appraisal Foundation FEBRUARY 2019 VALUATIONS IN FINANCIAL REPORTING VALUATION ADVISORY 4: VALUATION OF CONTINGENT CONSIDERATION COPYRIGHT © 2019 BY THE APPRAISAL FOUNDATION. ALL RIGHTS RESERVED. VFR Valuation Advisory #4 Valuation of Contingent Consideration This communication is for the purpose of issuing voluntary guidance on recognized valuation methods and techniques. Date Issued: February 14, 2019 Application: Business Valuation Summary: When negotiating the purchase price of a business, contingent consideration is often used to bridge the price gap between what the seller would like to receive and what the buyer would like to pay. More generally, a portion of the purchase consideration may be contingent on the outcome of future events. For example, additional consideration may be paid if the acquired business meets certain targets (such as future revenue, margin, or profit targets), passes regulatory reviews, has successful litigation outcomes, meets covenants, or completes product development. The valuation of contingent consideration is inherently challenging due to dependence on the occurrence of future events and the often complex structure of the payoff functions. It has also been an area for which limited guidance exists, therefore making it a suitable topic for an undertaking such as this one. Valuation specialists strive to provide reasonably consistent and supportable fair value conclusions. To this end, it is believed that guidance regarding best practices on certain specific valuation topics would be helpful. The Appraisal Foundation selects topics based on those in which the greatest diversity of practice has been observed. To date, The Appraisal Foundation has issued three prior Valuations in Financial Reporting (VFR) Advisories as follows: VFR Advisory #1, The Identification of Contributory Assets and Calculation of Economic Rents (May 31, 2010); VFR Advisory #2, The Valuation of Customer Related Assets (June 15, 2016), and VFR Advisory #3, The Measurement and Application of Market Participant Acquisition Premiums (September 6, 2017). The Appraisal Foundation wishes to express its utmost gratitude to the Working Group on Valuation of Contingent Consideration for volunteering their time and expertise in contributing to this Advisory. Specifically, sincere thanks to the following individuals: Working Group on Valuation of Contingent Consideration Travis Chamberlain Tanuj Leekha CliftonLarsonAllen, LLP – Indianapolis, IN PricewaterhouseCoopers, LLP – New York, NY Ron Elkounovitch Ernst & Young, LLP – Atlanta, GA Alok Mahajan (Chair) KPMG LLP - Santa Clara, CA Lawrence J. Freundlich KPMG LLP – New York, NY Sorin Maruster KPMG LLP – Santa Clara, CA William A. Johnston Empire Valuation Consultants, LLC – New Gary J. Raichart York, NY Duff & Phelps, LLC - East Palo Alto, CA Daniel Kahn Lynne J. Weber Ernst & Young, LLP – Washington, DC Duff & Phelps, LLC – East Palo Alto, CA Appraisal Practices Board Liaisons Adriana Berrocal, Galaz, Yamazaki, Ruiz Urquiza, S.C. (Deloitte) Jay E. Fishman, Financial Research Associates The Appraisal Foundation Staff David Bunton, President John S. Brenan, Vice President of Appraisal Issues Appraisal Practices Board Members (2016-2017) Shawn Wilson, Chair Lisa Desmarais, Vice Chair Adriana Berrocal Greg Franceschi Ernest Durbin Donna VanderVries The views set forth in this Advisory are the collective views of the members of this Working Group and do not necessarily reflect the views of any of the firms that the Working Group members are associated with. This Advisory was approved for publication by the Board of Trustees of The Appraisal Foundation on February 14, 2019. The reader is informed that the Board of Trustees defers to the members of the Working Group for expertise concerning the technical content of the document. Valuation of Contingent Consideration Table of Contents SECTION 1: INTRODUCTION.......................................................................................................................................... 6 1.1 SCOPE ....................................................................................................................................................................... 6 1.2 INTENDED USERS ......................................................................................................................................................... 7 1.3 MOTIVATIONS FOR STRUCTURING CONTINGENT CONSIDERATION ......................................................................................... 7 1.4 MOTIVATION FOR PROVIDING A GUIDE FOR THE VALUATION OF CONTINGENT CONSIDERATION .................................................. 8 1.5 RECOMMENDATIONS FOR CONTINGENT CONSIDERATION VALUATION METHODS ..................................................................... 8 SECTION 2: ACCOUNTING BACKGROUND ................................................................................................................... 11 2.1 CONSIDERATION TRANSFERRED IN BUSINESS COMBINATIONS ............................................................................................. 11 2.2 FAIR VALUE CONCEPTS ............................................................................................................................................... 12 SECTION 3: CHARACTERIZING CONTINGENT CONSIDERATION ................................................................................... 14 3.1 UNDERLYING METRIC(S) ............................................................................................................................................. 14 3.2 CONTINGENT CONSIDERATION PAYOFF STRUCTURES ........................................................................................................ 15 3.2.1 Common Contingent Consideration Payoff Structures ........................................................................... 15 3.2.2 Path Dependency ................................................................................................................................... 17 3.2.3 Multiple Underlying Metrics or Multiple Forms of Settlement ............................................................... 17 3.2.4 Buyer or Seller Choices ........................................................................................................................... 18 3.2.5 Currency ................................................................................................................................................. 18 3.3 SETTLEMENT TYPES FOR CONTINGENT CONSIDERATION .................................................................................................... 18 SECTION 4: KEY VALUATION CONCEPTS RELATED TO EARNOUTS ............................................................................... 20 4.1 MARKET PARTICIPANT ASSUMPTIONS ............................................................................................................................ 20 4.2 PROBABILISTIC FORECASTS AND EXPECTED VALUES .......................................................................................................... 21 4.3 DIVERSIFIABLE AND NON-DIVERSIFIABLE RISK ................................................................................................................. 23 4.3.1 Capital Asset Pricing Model Framework for Quantifying Non-Diversifiable Risk ................................... 24 4.4 THE RISK ASSOCIATED WITH THE CONTINGENT CONSIDERATION PAYOFF STRUCTURE .............................................................. 27 4.5 THE IMPACT OF PAYOFF STRUCTURE ON RISK: THE ANALOGY TO LEVERAGE .......................................................................... 30 4.6 RISK-NEUTRAL VALUATION ......................................................................................................................................... 32 SECTION 5: VALUATION METHODOLOGIES................................................................................................................. 36 5.1 VALUATION APPROACHES: INCOME APPROACH, MARKET APPROACH AND COST APPROACH .................................................... 36 5.2 KEY ELEMENTS OF AN INCOME APPROACH TO CONTINGENT CONSIDERATION VALUATION ....................................................... 37 5.2.1 Estimating Contingent Consideration Payment Cash Flows ................................................................... 37 5.2.2 Discount Rate and Market Risk Considerations ..................................................................................... 39 5.2.3 Methods for Estimating the Required Metric Risk Premium .................................................................. 43 5.2.4 Estimating Volatility ............................................................................................................................... 55 5.2.5 In-Period Discounting Convention .......................................................................................................... 60 5.2.6 Counterparty Credit Risk ........................................................................................................................ 62 5.2.7 Multiple-currency Structures .................................................................................................................. 63 5.3 THE SCENARIO-BASED METHOD (SBM) ........................................................................................................................ 65 5.3.1 When the SBM is Most Appropriate ....................................................................................................... 65 5.3.2
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