The earn-out formula applied to each outcome, weighted and discounted, with the shortcut that misprices it by 8.3 per cent and the remeasurement that follows.
The fair value of an earn-out is the probability-weighted payment, worked out scenario by scenario through the earn-out formula, then discounted to completion. An earn-out that pays three times every unit of year-two EBITDA above 10,000,000, capped at 9,000,000, has an expected payment of 3,600,000 and, discounted for two years at a 6.0 per cent cost of debt, a fair value of 3,203,987: 35.6 per cent of the headline cap. That figure, not the 9,000,000, is the part of the price the acquirer actually agreed to pay.
Worked in full in Mergers and Acquisitions by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
An earn-out carries four numbers at once: the maximum the seller talks about, the payment in each scenario, the expected payment, and its value today. Board papers and press releases quote the first. The acquisition accounts book the last, and remeasure it every reporting date until it is paid.
| Term | Value |
|---|---|
| Cash paid at completion | 90,000,000 |
| Earn-out metric | Year-two EBITDA |
| Threshold | 10,000,000 |
| Payment per unit of EBITDA above threshold | 3.0 |
| Cap on the payment (reached at 13,000,000 of EBITDA) | 9,000,000 |
| Paid at the end of year | 2 |
| Acquirer's cost of debt | 6.0% |
| Acquirer's WACC (for comparison only) | 10.0% |
Step 1: describe the outcomes, not one forecast. The earn-out pays nothing below the threshold and nothing more above the cap, so a single forecast hides exactly the shape that matters. Four scenarios for year-two EBITDA, with probabilities that sum to one:
| Scenario | Year-two EBITDA | Probability | Payment | Weighted |
|---|---|---|---|---|
| Downside | 9,000,000 | 25% | 0 | 0 |
| Low | 10,500,000 | 30% | 1,500,000 | 450,000 |
| Base | 12,000,000 | 30% | 6,000,000 | 1,800,000 |
| High | 14,000,000 | 15% | 9,000,000 | 1,350,000 |
| Expected | 11,100,000 | 100% | 3,600,000 |
Payment = MIN(cap, MAX(0, (EBITDA − threshold) × ratio))
In Excel, per scenario row: =MIN(Cap,MAX(0,(B5-Threshold)*Ratio)), then =SUMPRODUCT(Probabilities,Payments) for the expected payment.
The high case would compute 12,000,000 without the cap (4,000,000 above the threshold, times three); the cap cuts it to 9,000,000.
Step 2: discount the expected payment. The probabilities capture how likely the business is to underperform. Two risks remain: the risk that the acquirer, which owes the money, does not pay, which its cost of debt prices, and, strictly, a premium for the market risk in the EBITDA metric itself. This illustrative case treats the scenario probabilities as already risk-adjusted and discounts at the acquirer's cost of debt; where the probabilities are a plain best estimate, valuers add a metric risk premium, and for capped, option-like payoffs many prefer an option-pricing or Monte Carlo approach to a single rate.
Fair value = expected payment / (1 + kd)t = 3,600,000 / 1.062 = 3,600,000 / 1.1236 = 3,203,987
Excel: =SUMPRODUCT(Prob,Pay)/(1+Kd)^Years
The consideration for the acquisition is 90,000,000 of cash plus 3,203,987 of contingent consideration: 93,203,987. The headline "up to 99,000,000" adds the full cap and overstates the price by 5,796,013, of which 5,400,000 is the difference between the cap and the expected payment and the rest is two years of discounting. Under IFRS 3 and ASC 805 the 3,203,987 is recognised at completion and enters goodwill; a liability-classified earn-out is then remeasured at each reporting date through profit or loss.
Remeasurement is where the earn-out surprises the income statement. Suppose year one goes well and the probabilities move to 15, 30, 35 and 20 per cent. With one year left, the expected payment is 4,350,000 and the liability becomes 4,103,774: a charge of 899,786 against a fair value of 3,203,987 at completion, of which 192,239 is the unwind of one year's discount. The better the acquired business does, the larger the acquirer's loss on the earn-out line. With no change in the outlook, the liability would still accrete by that 192,239, to 3,396,226.
| Discount rate | Fair value |
|---|---|
| 5% | 3,265,306 |
| 6% (cost of debt) | 3,203,987 |
| 8% | 3,086,420 |
| 10% (WACC) | 2,975,207 |
| 12% | 2,869,898 |
| Outlook (downside/low/base/high, %) | Expected EBITDA | Fair value | Shortcut on expected EBITDA |
|---|---|---|---|
| Weaker (35/30/25/10) | 10,700,000 | 2,536,490 | 1,868,993 |
| As above (25/30/30/15) | 11,100,000 | 3,203,987 | 2,936,988 |
| Stronger (15/30/35/20) | 11,500,000 | 3,871,485 | 4,004,984 |
The rate matters less than people argue about: moving from the cost of debt to the WACC takes 228,781, or 7.1 per cent, off the value. The outlook matters more: shifting ten points of probability each way moves the value by about 667,500 in either direction.
On the seller's side the same earn-out is worth less again, because the seller discounts at its own rate and bears the risk of buyer adjustments to the metric; how much of an earn-out the buyer's accounting adjustments can remove prices that part. Goodwill is then measured against total consideration including the earn-out, as in how to calculate goodwill in an acquisition.
Price the earn-out scenario by scenario through its own formula, weight by probability, and discount at a rate consistent with where the risk is priced, here the acquirer's cost of debt: 3,203,987 against a 9,000,000 cap. Then expect it to move, and to charge the income statement when the acquisition succeeds. The free workbook for this case carries an earn-out at fair value inside a full acquisition, with its effect on the price and the value created.
If the scenario probabilities are already risk-adjusted, the main risk left is that the acquirer does not pay: its cost of debt. In the illustrative case 6.0 per cent gives 3,203,987. If the probabilities are an unadjusted best estimate, a premium for the metric's market risk is added; at a 10.0 per cent WACC the value is 2,975,207, 7.1 per cent less. Practice varies, so state the basis.
Yes, at fair value at completion. Under IFRS 3 and ASC 805 contingent consideration is part of the consideration transferred and enters goodwill. Here the price is 90,000,000 of cash plus 3,203,987 of earn-out, 93,203,987, not the 99,000,000 the headline with the full cap suggests.
A liability-classified earn-out is remeasured through profit or loss. If the outlook improves, the expected payment rises and the liability with it. In the case, stronger probabilities after year one lift the liability from 3,203,987 to 4,103,774, a charge of 899,786, even though the business is beating its plan.
This article is one calculation from Mergers and Acquisitions. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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