In mergers and acquisitions (M&A), CFOs must identify whether payments are contingent consideration or postacquisition compensation to inform financial reporting.
As we continue to navigate 2025, some in the industry are forecasting a rebound in deal activity as a result of anticipated falling interest rates, lower inflation, and easing regulatory hurdles. As part of a proposed acquisition, a buyer (private equity group) may enter an arrangement to make a contingent payment or payments to the seller(s) once the acquired company achieves certain benchmarks (financial or nonfinancial) after the close of the acquisition. These contingent payments or seller earnouts have become common in purchase price negotiations and might help both parties reach an agreement on the seller company’s valuation.
Why it matters
While it is not always advisable to let accounting implications drive business decisions, understanding how contingent consideration is accounted for might be a factor to consider prior to finalizing an acquisition. The following outlines some implications, depending on whether contract terms result in arrangements determined to be contingent consideration (part of the purchase price) or posttransaction compensation expense.
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Posttransaction compensation |
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“Contingent payments” can refer to many different types of arrangements, some of which are not obvious. For example, if a seller receives rollover equity with vesting conditions, the equity would be included in the scope of contingent payments and require further analysis. Types of arrangements that need to be considered include but are not limited to:
- Earnouts
- Rollover equity, seller notes, or other forms of consideration in which vesting or employment conditions are present
- Employment arrangements with sellers, including bonus arrangements
- Preexisting (preacquisition) relationships, such as existing share-based payment plans, including plans that continue in the postacquisition period or include postacquisition service requirements.
Once the transaction closes, the buyer must navigate the complexities of Accounting Standards Codification (ASC) 805, “Business Combinations,” including the analysis of and proper accounting for contingent consideration arrangements.
In determining whether an arrangement is accounted for as contingent consideration or postcombination compensation expense, accounting and finance teams also should understand whether the buyer or seller was the initiator and the purpose of entering into the contingent payment arrangement. If the purpose of the arrangement is to primarily benefit the acquirer rather than the seller or the selling shareholders, then such amounts could be considered to be for postcombination services and recorded as compensation expense.
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Indicators of contingent consideration versus posttransaction compensation
According to ASC 805-10-55-24, “Whether arrangements for contingent payments to employees or selling shareholders are contingent consideration in the business combination or are separate transactions depends on the nature of the arrangements.”
If it is not clear whether an arrangement for payments to employees or selling shareholders is part of the exchange for the acquiree or is a transaction separate from the business combination, the acquirer should consider indicators from the following excerpts of ASC 805-10-55-25:
a. Continuing employment. The terms of continuing employment by the selling shareholders who become key employees may be an indicator of the substance of a contingent consideration arrangement. The relevant terms of continuing employment may be included in an employment agreement, acquisition agreement, or some other document.
Arrangements in which contingent payments are automatically forfeited if the seller’s employment terminates would be accounted for as compensation for services provided after the business combination is executed.
These factors apply to employment arrangements in which contingent consideration is not forfeited upon termination of employment, as well as consulting, transition service, and similar nonemployment arrangements.
b. Duration of continuing employment. If the period of required employment coincides with or is longer than the contingent payment period, that fact may indicate that the contingent payments are, in substance, compensation.
Careful attention needs to be paid to postemployment contracts of the selling shareholders. For example, say there is an earnout with an earnout period of two years and that the seller entered into an employment contract as well. A contract term of two years or longer is an indicator that the payment is compensation expense. However, if the seller’s employment term is less – say, one year – it could be an indicator that the earnout is considered purchase consideration.
c. Level of compensation. Situations in which employee compensation other than the contingent payments is at a reasonable level in comparison to that of other key employees in the combined entity may indicate that the contingent payments are additional consideration rather than compensation.
Acquirers would need to consider whether selling shareholders have duties or responsibilities comparable to those of other key employees and use judgment to evaluate the reasonableness of compensation.
d. Incremental payments to employees. If selling shareholders who do not become employees receive lower contingent payments on a per-share basis than the selling shareholders who become employees of the combined entity, that fact may indicate that the incremental amount of contingent payments to the selling shareholders who become employees is compensation.
Companies would need to determine if contingent payment arrangements are given only to selling shareholders that remain as employees of the postcombination entity. Such arrangements would appear to be an indicator of postcombination compensation expense.
e. Number of shares owned. The relative number of shares owned by the selling shareholders who remain as key employees may be an indicator of the substance of the contingent consideration arrangement. For example, if the selling shareholders who owned substantially all of the shares in the acquiree continue as key employees, that fact may indicate that the arrangement is, in substance, a profit-sharing arrangement intended to provide compensation for postcombination services.
The relative ownership held by selling shareholders is one of the indicators considered when determining whether the contingent payments represent compensation expense or purchase consideration. When the contingent payment is more closely linked to the valuation method or formula used to negotiate the transaction, it could be an indicator that the additional payment is consideration.
f. Linkage to the valuation. If the initial consideration transferred at the acquisition date is based on the low end of a range established in the valuation of the acquiree and the contingent formula relates to that valuation approach, that fact may suggest that the contingent payments are additional consideration.
The more closely linked the contingent payment is to the valuation method or formula used to negotiate the transaction, the more likely it could be an indicator that the additional payment is consideration. If the selling shareholders forfeit the contingent consideration upon termination of employment, then the linkage to the valuation is not relevant and the arrangement would be considered postcombination compensation expense.
g. Formula for determining consideration. The formula used to determine the contingent payment may be helpful in assessing the substance of the arrangement. For example, if a contingent payment is determined on the basis of a multiple of earnings, that might suggest that the obligation is contingent consideration in the business combination and that the formula is intended to establish or verify the fair value of the acquiree.
Arrangements for payments based on a multiple of earnings such as EBITDA are more likely to be contingent consideration arrangements, while payments made on a percentage of earnings are more likely to be profit-sharing plans and would be accounted for as postcombination compensation expense.
h. Other agreements and issues. The terms of other arrangements with selling shareholders (such as noncompete agreements, executory contracts, consulting contracts, and property lease agreements) and the income tax treatment of contingent payments may indicate that contingent payments are attributable to something other than consideration for the acquiree. For example, in connection with the acquisition, the acquirer might enter into a property lease arrangement with a significant selling shareholder. If the lease payments specified in the lease contract are significantly below market, some or all of the contingent payments to the lessor (the selling shareholder) required by a separate arrangement for contingent payments might be, in substance, payments for the use of the leased property that the acquirer should recognize separately in its postcombination financial statements.
Other arrangements or issues could include the selling shareholders with a contingent payment arrangement providing consulting services at a below-market rate. Such arrangements should be evaluated to assess whether they are at fair value. If not at fair value, further assessment would be needed to determine the appropriate accounting treatment.
Group scenarios
When contingent payments are to a group of individuals, it is important to consider each individual separately. For example, an agreement might be for an earnout payment to a group of individuals of $5 million, combined. Say the group includes shareholders and the CEO and that the earnout will only be paid to individuals who continue to provide services for one year following the transaction. In this scenario, the $5 million payment likely is considered compensation expense. These scenarios are often referred to as “last man standing” arrangements.
These scenarios are not to be considered all-inclusive. Any arrangements with employees or selling shareholders, regardless of whether those arrangements are directly related to the acquirer, need to be evaluated within the scope of ASC 805-10-55-25.
In summary
After the transaction is closed and the accounting for the transaction begins, accounting and finance teams should understand the purpose of the payment arrangement and should evaluate the indicators when analyzing whether the arrangement is for contingent consideration or postcombination services (compensation). If payment to the seller is contingent on the seller’s continued employment following the transaction (for example, the seller needs to remain employed through the payment date), this is typically viewed as persuasive evidence that the arrangement represents posttransaction compensation rather than contingent consideration. If payments are not forfeited upon termination of services, the factors outlined in ASC 805-10-55-25(b-h) need to be considered in evaluating the proper accounting treatment.
FASB materials reprinted with permission. Copyright 2025 by Financial Accounting Foundation, Norwalk, Connecticut. Copyright 1974-1980 by American Institute of Certified Public Accountants.
Content created by Crowe and originally published on cfo.com on April 29, 2025.
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