CHAPTER 12Valuation of Contingent Consideration

In the prior chapters, we have considered a sale of a business enterprise as a transaction that has the effect of a full “exit” event for the investor: the investor ceases to have an economic interest in the enterprise in exchange for a certain quantity of cash or noncash consideration at closing. In most early stage enterprise (ESE) sales, however, the seller's exposure to the enterprise's business does not end at closing. In fact, a significant component of the sale price often consists of proceeds that are contingent upon the company's achievement of certain performance or other targets after the closing has taken place under an “earnout” or “contingent consideration” provision in the sale agreement. In some cases, the seller may have the obligation to return part of the proceeds from the sale if specified conditions are met under the terms of a “clawback” provision.1

Earnout and clawback provisions in a sale agreement may help bridge a price gap during negotiations and provide an incentive for the seller to support the transition of ownership. An earnout provision may serve as a tax deferral tool, by spreading the cash proceeds from a transaction over multiple fiscal years. It may also provide a financing tool, by deferring certain cash payments to future periods. Earnout provisions are especially common in ESE sale transactions that involve significant postacquisition uncertainty for circumstances that may have a material ...

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