COMMENTARY · M&A & IFRS 3
Earn-outs appear in M&A operations as an alignment tool between buyer and seller. The accounting treatment decides whether they enter as financial liability or as contingent consideration in equity.
In M&A operation, when buyer and seller disagree on company value at moment of contract, earn-out is the bridge. Seller receives part of the price at signing and remainder conditioned to performance metrics in the following years (EBITDA, revenue, gross margin, customer retention).
The instrument is well-known. The accounting treatment is less obvious than it seems.
IFRS 3 / CPC 15 establishes that contingent consideration in a business combination must be recognized at fair value on the acquisition date and classified as either:
Financial liability, when there is contractual obligation to deliver cash or other financial asset.
Equity, when the obligation is settled by delivery of fixed number of own shares.
Asset, when buyer is entitled to recover part of the consideration paid (rare).
The classification has direct consequence on subsequent treatment. Earn-out classified as financial liability is remeasured to fair value through profit or loss in each closing. Classified as equity, it is not remeasured: variations in expected value do not affect result.
In an M&A transaction with R$ 50 million in earn-out projected for 24 months, with the metric being acquired-company EBITDA, the difference between financial liability and equity becomes visible after 12 months.
If acquired EBITDA exceeded projection (say, 30% above): financial liability is remeasured up, generating accounting expense in result. If acquired EBITDA was below: liability falls, generating gain in result.
This volatility in result, derived from acquired-company performance after acquisition, surprises buyer financial team and confuses analysts. The accounting prepared by an in-the-rush adviser does not capture this anticipated effect.
"Earn-out is not just a commercial instrument. It is a structuring decision with accounting consequence over years. Treating only the commercial side, leaving accounting for later, is recurring origin of surprise in M&A transactions."
Classification of earn-out as financial liability or equity is not a choice of buyer or seller. It is technical determination based on contractual terms. Earn-out in cash, conditioned to financial metrics: financial liability. Earn-out in fixed number of shares: equity. Earn-out in variable number of shares depending on stock price: financial liability.
Engaging fair value valuation of the earn-out at moment of structuring (and not only at conclusion of M&A) allows buyer to anticipate accounting impact and structure earn-out in a way that minimizes undesirable result volatility, without compromising the commercial alignment objective.