In February 2019, The Appraisal Foundation (TAF) released its fourth Valuation in Financial Reporting (VFR) advisory on the topic of the valuation of contingent consideration (the Advisory). Since the adoption of the revised Financial Accounting Standard Board (FASB) and International Accounting Standards Board (IFRS) requirements for business combination accounting in 2009, companies are required to book contingent consideration at fair value as of the acquisition date, and subsequently update the fair value estimate for most contingent consideration arrangements at each reporting period thereafter until resolution. Also, pursuant to Accounting Standards Codification (ASC) 946, an investment company may be required to estimate the fair value of assets it holds related to contractual rights arising from contingent consideration arrangements.
Valuation of contingent consideration can be challenging, as such assets or liabilities are rarely traded, usually rendering a market approach infeasible. Furthermore, contingent consideration arrangements are based on the outcomes of uncertain future events. Most such arrangements also include tiers, caps, and/or thresholds, which introduce option-like, leveraged structures that make assessment of the appropriate discount rate difficult. As such, there was great diversity in practice.
Recommendations in the Advisory
Contingent consideration payments are dependent on, and often complex functions of, uncertain future events. As a result, valuing contingent consideration generally requires a probabilistic model with assumptions about the full distribution of future outcomes, not merely the expected case. This is one of the key differences between valuing a business and valuing contingent consideration. The Advisory recommends two primary techniques to be used under different circumstances: scenario based models (SBM) and option pricing models (OPM).
Scenario based methods typically probability-weight the payments in various scenarios and discount the expected payoff cash flow at an appropriate rate. SBM is recommended when either (1) the underlying metric is diversifiable (i.e., non-systematic), such as in the case of R&D or technical milestones, or (2) when the contingent consideration payoff structure is linear (i.e., there are no tiers, thresholds or caps). In these cases, it is straightforward to estimate the discount rate. If the metric is diversifiable, the discount rate need only address the time value of money (e.g., using a risk-free rate) and the obligor’s credit risk (usually captured through a subordinate credit spread). If the metric is non-diversifiable (e.g., revenue or EBITDA) but the payoff structure linear, then the discount rate should also incorporate an appropriate risk premium. The Advisory provides guidance on how to estimate that required metric risk premium.
However, if the metric is non-diversifiable and the payoff structure is a nonlinear function, then the discount rate also needs to address the impact of the nonlinear structure on risk. Unfortunately, it is not easy to determine the amount of impact; it depends simultaneously on the structure, the metric, the metric’s volatility and the positioning of the mean of the metric forecast distribution relative to the payoff threshold(s) and cap(s).
The Advisory recommends OPM when the underlying metric is non-diversifiable and the contingent consideration payoff structure is nonlinear (e.g., there are thresholds, caps, or tiers). OPM uses a risk-neutral framework to avoid the difficulty of estimating the adjustment to the discount rate for the impact of a nonlinear structure on risk. An OPM translates the forecast into a risk-neutral framework by discounting at the required metric risk premium before applying any thresholds, tiers or caps. Rather than using scenarios to incorporate uncertainty, the expected payoff in an OPM is typically estimated assuming a lognormal distribution, based on the metric mean and its volatility. The Advisory provides guidance on how to estimate metric volatility, including adjustments for size and company- specific risk premiums. The Advisory also provides suggestions for how to handle situations when the payoff distribution is far from lognormally distributed. Finally, the risk-neutral expected contingent consideration payments are discounted to present value at a rate that captures the time value of money and credit risk.
The Advisory goes into further detail regarding the differences between the valuation of a business and the valuation of contingent consideration; the estimation of contingent consideration cash flows, the required metric risk premium and volatility; how to debias management assessments; how to handle multi-currency structures; and the importance of maintaining consistency with other related valuations. Numerous examples are provided to flesh out the concepts.
The Advisory has documented best practices so that companies, investors, regulators, auditors and independent valuation specialists can have a more consistent framework for valuing contingent consideration.