Over the past few years, there has been an increase in acquisition agreements that include clauses requiring certain conditions to be met before considerations are paid.
According to PwC, global activity in mergers and acquisitions has been at a low level during the first half of 2024[1].
Our observation is that this trend is a response to the somewhat uncertain economic environment, prompting companies to seek new ways to secure their deals. One such method is the use of earnouts, where additional payments are “earned” if the acquired company achieves certain predetermined financial or other objectives after the acquisition is completed. In this article, we provide a brief overview of some key considerations if such agreements are present in your group.
Under IFRS 3 Business Combinations, the accounting treatment of contingent payments, such as earnouts, depends on whether the payments form part of the consideration for the business combination, or represent a separate transaction.
Earnouts as Consideration in the Business Combination
Earnouts deemed to be part of the business combination (i.e., consideration) are measured at fair value at the acquisition date and included in the calculation of goodwill.
Earnouts as Compensation Outside the Business Combination
If earnouts do not represent consideration, the payments are accounted for under other relevant standards and are not included in the calculation of goodwill. These payments are typically not recognized at the acquisition date but are treated as compensation for post-acquisition services.
How is the assessment made when employees or selling shareholders are involved?
It is not always clear whether earnouts for employees or selling shareholders represent consideration for the business combination or compensation. To assist in this assessment, IFRS 3 provides the following indicators (in paragraphs B50 to B62), with one being decisive (B55), which we describe in more detail below.
| A. Continued employment – automatic forfeiture (B55) | If an earnout is automatically forfeited upon termination of employment, the payments are considered compensation for post-acquisition services – i.e., they are not part of the business combination. This indicator is decisive, regardless of other factors suggesting the payments are consideration for the acquisition. |
| Additional indicators – If the first indicator is not met, i.e., termination does not affect the earnout, the acquirer assesses the following factors: | |
| B. Duration of continued employment | If the employment period equals or exceeds the earnout period, this may indicate compensation. |
| C. Level of compensation | If employee compensation, excluding the earnout, is comparable to that of other key employees, the earnout may be considered compensation. |
| D. Incremental payments to employees | If the earnout per share is lower for non-employee selling shareholders than for those who become employees, this may indicate compensation. |
| E. Number of shares owned | If only key employees sell shares and all receive the same earnout per share, this may indicate compensation. |
| F. Link to valuation | If the initial consideration is based on a lower valuation and the earnout is tied to this, it may indicate consideration. |
| G. Earnout formula | If the earnout is based on performance metrics post-acquisition, this may indicate compensation. |
| H. Other agreements and issues | Conditions such as consulting agreements or non-compete agreements may influence the assessment. |
[1] Global M&A industry trends: 2025 outlook (15 min read)
By Amanda Nilsson
Application Consultant, AARO
