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How do you value deferred consideration in an acquisition?

Deferred consideration is a zero-coupon loan from seller to buyer: price it at the buyer's credit, then carry the unwinding into the buyer's earnings.

Julian R. Sterling · from Mergers and Acquisitions

Discount each deferred payment at the rate that reflects the buyer's credit risk and add the results to the cash paid at completion. On an illustrative 120.0 million deal with 20.0 million deferred by twelve months and 10.0 million by twenty-four, a 7.0 per cent discount rate gives a present value of 27.43 million for the 30.0 million deferred, so the real price is 117.43 million, 9.79 times EBITDA rather than the 10.0 times announced.

Worked in full in Mergers and Acquisitions by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →

Deferred consideration is the part of the price paid after completion with no condition attached: it is owed whatever the business does next. That makes it different from an earn-out, which depends on performance, and it makes valuing it a credit question rather than a forecasting one. The seller is lending the buyer part of the price at a zero coupon, and the discount is what that loan costs.

The assumptions

An illustrative private acquisition, figures in millions.

Input	Value
Headline enterprise value	120.0
Target EBITDA	12.0
Cash at completion	90.0
Deferred at 12 months	20.0
Deferred at 24 months	10.0
Discount rate: buyer's unsecured borrowing cost	7.0%

The deferred 30.0 million is 25.0 per cent of the headline. The discount rate is the yield at which the buyer could borrow unsecured for a similar term, because that is the claim the seller holds: an unsecured promise to pay, ranking behind the buyer's acquisition debt unless the sale agreement says otherwise.

The calculation, step by step

The result, on both sides of the table

For the seller, 120.0 million on paper is worth 117.43 million today, and that is before the risk that the buyer does not pay. If the seller wants 120.0 million in present value, the deferred amounts must rise by a factor of 30.0 ÷ 27.43 = 1.0939: 21.88 million and 10.94 million, 32.82 million in total, 2.82 million more than agreed.

For the buyer, the accounting already does the discounting. Under IFRS 3, consideration is measured at its acquisition-date fair value, so the deferred payments go into the purchase price at 27.43, not 30.0, and goodwill is smaller by 2.57. The difference comes back through the income statement as an unwinding charge in finance costs:

The deferred consideration liability, unwound at 7.0 per cent.

Year	Opening	Unwinding interest	Paid	Closing
1	27.43	1.92	20.0	9.35
2	9.35	0.65	10.0	0.00
Total		2.57	30.0

With identifiable net assets of 70.0, goodwill is 47.43 rather than the 50.0 a face-value booking would show. The buyer's earnings bear 1.92 of finance cost in year one, which belongs in any accretion model alongside the interest on the acquisition debt.

What if the rate or the structure changes?

Same 30.0 million deferred over twelve and twenty-four months.

Discount rate	PV of deferred	Price	EV/EBITDA	Lost to the seller
5%	28.12	118.12	9.84x	1.88
7%	27.43	117.43	9.79x	2.57
10%	26.45	116.45	9.70x	3.55
15%	24.95	114.95	9.58x	5.05

Same 120.0 headline at 7 per cent, structured differently.

Structure	Price in PV	EV/EBITDA	Discount to headline
All cash at completion	120.00	10.00x	0.00
90.0 now, 20.0 at 12 and 10.0 at 24 months	117.43	9.79x	2.57
90.0 now, 30.0 at 36 months	114.49	9.54x	5.51
60.0 now, 20.0 a year for three years	112.49	9.37x	7.51

The headline is the same 10.0x in every row. Deferring half the price over three years takes 7.51 million off it at 7 per cent, and a buyer whose unsecured paper would price at 15 per cent leaves the seller 5.05 million short of the headline, 2.47 million more than at 7 per cent, before any default.

Security changes the rate, not the method. A parent guarantee from a strong group, a bank guarantee or cash placed in escrow at completion moves the right discount rate towards that guarantor's credit, or towards the escrow's deposit rate. Cash in escrow is economically paid at completion: the buyer has parted with it, and the seller is waiting only for release.

The common mistakes

• Comparing bids on the headline. A 118.0 million all-cash bid beats 120.0 million with 30.0 deferred over twenty-four months at any discount rate above 5.3 per cent.
• Using the target's cost of capital. The seller no longer owns the target. Its risk is the buyer's credit, so the rate is the buyer's unsecured borrowing cost, not the target's WACC.
• Treating deferred and contingent consideration alike. A deferred payment is valued as debt; an earn-out needs a probability-weighted forecast first, as in the fair value of an earn-out.

Takeaway

Every deferred payment is a loan from seller to buyer at a zero coupon. Price it at the buyer's credit, put the present value into the multiple, as in the EV/EBITDA multiple paid in an acquisition, and carry the unwinding into the buyer's earnings. The same deal priced several ways, with live formulas, is in the free workbooks for Mergers and Acquisitions.

Questions readers ask

What discount rate should be used for deferred consideration?

The buyer's unsecured borrowing rate for a similar term, because the seller holds an unsecured claim on the buyer. At 7.0 per cent, 30.0 million paid over two years is worth 27.43 million; at 15 per cent it is worth 24.95 million. A bank guarantee or escrow moves the rate towards the guarantor's credit or the deposit rate.

How is deferred consideration accounted for under IFRS 3?

It is included in the consideration transferred at its acquisition-date fair value, which for a fixed future payment is its present value. In the example the buyer records 27.43 million, not 30.0, so goodwill is 2.57 million lower, and the discount unwinds through finance costs: 1.92 million in year one and 0.65 million in year two.

What is the difference between deferred and contingent consideration?

Deferred consideration is owed regardless of performance, so it is valued like debt of the buyer. Contingent consideration, such as an earn-out, depends on future results and needs probability-weighted forecasts before discounting. A 30.0 million deferred payment is worth 27.43 million at 7.0 per cent; an earn-out of the same face value is usually worth much less.

Also on this site

• How do you calculate the fair value of an earn-out?Weight each scenario's payment by its probability, then discount: a 9,000,000 earn-out cap is worth 3,203,987 at a 6.0 per cent cost of debt, 35.6 per cent.
• How do you calculate the EV/EBITDA multiple paid in an acquisition?Diluted equity at the offer plus net debt and other claims, over EBITDA: a 32.00 offer is 1,954,000,000 of EV, 9.77x LTM, not the 9.45x basic shares give.
• How do you calculate goodwill in an acquisition?Price less the fair value of net identifiable assets, after deferred tax on the step-ups: 150 million paid gives 66.5 million of goodwill, not 54.0.
• How do you value a cash-and-stock offer per target share?Cash plus the exchange ratio times the acquirer's price: 18.00 plus 0.40 shares at 45.00 is 36.00, a 28.6% premium, but only 34.00 if the acquirer falls to 40.00.
• Cash or stock: which should an acquirer pay with?Cash keeps all the synergy risk with the buyer, stock shares it. A 300 premium puts 7.50% of the acquirer's value at risk in cash and 5.66% in stock.
• How do you do a contribution analysis in a merger?Target metric over combined, levered for net debt: 42.86% of EBITDA is 39.21% of the equity, against the 36.95% a 0.9375 exchange ratio offers.

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