2.5 Business Combinations

In business combinations, the parties may agree to the contingent issuance of additional shares in the future or to a contingent return of shares. Contingent consideration is part of the total consideration transferred for the acquiree and therefore must be measured and recognized at fair value as of the acquisition date. Such arrangements permit the parties to proceed with a business combination without agreeing on the final purchase price. For example, the acquirer may agree to deliver a specified number of its own equity shares if the earnings of the acquired entity exceed a specified target in the year following the combination. Other examples of events that may trigger contingent consideration payments include reaching a specified stock price or reaching a milestone on a research and development project.

There is no scope exception in ASC 815-40 for equity-linked financial instruments that represent contingent consideration in a business combination. Accordingly, the acquirer determines whether contingent consideration should be classified as equity or as an asset or a liability in accordance with ASC 815-40 and any other applicable guidance (including ASC 480).

ASC 805-30-35-1 discusses how to recognize changes in fair value of contingent consideration other than measurement-period adjustments. Contingent consideration classified as equity is not remeasured, and its settlement is recognized in equity. Contingent consideration classified as an asset or a liability is remeasured to fair value in each reporting period, with changes in fair value recognized in earnings unless the consideration qualifies for recognition in other comprehensive income under the hedge accounting guidance in ASC 815.

Under ASC 805, adjustments made during the measurement period that pertain to facts and circumstances that existed as of the acquisition date are recognized as adjustments to goodwill. The acquirer must consider all pertinent factors in determining whether information obtained after the acquisition date should result in an adjustment to the provisional amounts recognized or whether that information was based on events that occurred after the acquisition date. For example, earnings targets that are met, changes in share prices, and FDA approvals are all changes that occur after the acquisition date. Changes in fair value resulting from these items are recognized in earnings and not as adjustments to goodwill.

Unless a scope exception applies, contracts that are only contingently exercisable (e.g., equity-linked financial instruments that become issuable or exercisable upon an initial public offering [IPO] or other contingent event) are not exempt from ASC 815-40. One scope exception applies to lock-up options in business combinations. ASC 815-40-15-6 specifies that such options are “not . . . considered issued for accounting purposes unless and until [they] become exercisable.” Effectively, this means that no accounting recognition is given to such options before they become exercisable.

As defined in the ASC master glossary, lock-up options are limited to certain contingent options exchanged by parties to a contemplated business combination. The purpose of such options is to promote the completion of the business combination between the parties. The options are meant to “lock up” the acquiree and prevent it from being sold to other potential buyers. For instance, lock-up options might give the potential acquirer in a business combination the right to purchase additional equity of the target company at a favorable price in the event a third party purchases a large interest in the target company. In this case, the options are designed to discourage third parties from buying a large interest in the target company. If the business combination proceeds as planned, however, the options never become exercisable.

In addition, lock-up options are not specifically limited to those arrangements for which no consideration is exchanged or firmly committed. Further, the guidance on lock-up options applies not only to freestanding financial instruments but also to embedded features (e.g., a lock-up option in a loan commitment).

As part of the merger negotiations, the SPAC and target may agree to enter into what is often referred to as an “earn-out” arrangement. Share-settleable earn-out arrangements may be established with the target’s shareholders, the SPAC’s sponsors, or both. Generally, share-settleable earn-out arrangements have the following characteristics:

• The combined company is required to issue additional shares of common stock if, during a specified period after the merger date, its stock price equals or exceeds a stated amount or amounts.
• Some or all of the shares not previously issued will become issuable upon the occurrence of a specific event (e.g., a change of control of the combined company).
• The settlement must occur in shares (i.e., the combined company or holder cannot elect cash settlement).

For share-settleable earn-out arrangements such as those in the example above, the accounting treatment of the shares awarded depends on the arrangements’ terms. In cases in which these types of earn-out arrangements are entered into with the SPAC’s sponsor, the shares are generally issued before the transaction; however, at the time of the SPAC transaction, they become subject to either transfer restrictions or forfeiture on the basis of one or more share price levels or the occurrence of a specific event (e.g., a change of control). Such shares may or may not be held in escrow. In either case, if the holder of the shares is subject to losing those shares (i.e., they would be forfeited if one or more conditions are not met), for accounting purposes, those arrangements are treated in the same manner as share-settleable earn-out arrangements that involve the conditional issuance of shares (i.e., they are treated as equity-linked instruments as opposed to outstanding shares). If, however, the owner legally owns the shares and is subject only to transfer restrictions that lapse upon the earlier of (1) meeting one or more specific conditions or (2) a stated date, such shares are considered to be outstanding shares of stock subject to transferability restrictions rather than equity-linked instruments. In other words, share-settleable earn-out arrangements that contain vesting-type conditions are treated as equity-linked instruments (regardless of whether the related shares have been issued), whereas earn-out arrangements that subject the holder only to transfer restrictions are treated as outstanding shares.

Share-settleable earn-out arrangements that represent equity-linked instruments are classified as either liabilities or equity instruments on the basis of ASC 815-40 unless such arrangements are within the scope of ASC 480 or ASC 718.4 Contracts that are classified in equity under ASC 815-40 are not remeasured. However, contracts classified as liabilities must be subsequently remeasured at fair value, with changes in fair value recognized in earnings.

To be classified as an equity instrument under ASC 815-40, a share-settleable earn-out arrangement must meet the indexation and equity classification requirements in ASC 815-40. The application of ASC 815-40 to these arrangements can be very complex. Before beginning the analysis, entities must ensure that they have a complete understanding of all the relevant terms. For example, in some cases, the main provisions are included in a separate section of the merger agreement, but there could be other agreements or “side letters” that modify or expand upon such terms. In addition, the terms of such arrangements may be affected by definitions that are difficult to interpret. Entities may need to consult with their legal advisers to obtain an understanding of such definitions.

Several considerations, including those related to the following, are relevant in the determination of how ASC 815-40 applies to an equity-linked instrument such as a share-settleable earn-out arrangement.

• The unit of account — The arrangement may be a single unit of account, or it may contain multiple units of account, depending on whether (1) the arrangement as a whole represents a freestanding financial contract or (2) there are multiple freestanding financial contracts within the overall arrangement. (See Section 3.2 for further discussion of the unit of account.)
• Whether the equity-linked instrument is indexed to the combined company’s stock under ASC 815-40-15 — Only share-settleable earn-out arrangements that are indexed to the issuing entity’s stock may be classified in equity. (See Sections 4.2.3.2 and 4.3.7.4 for further discussion of indexation requirements.)
• Whether the equity-linked instrument satisfies the conditions for equity classification under ASC 815-40-25 — Only share-settleable earn-out arrangements for which the entity controls settlement in shares may be classified in equity. (See Chapter 5 for further discussion of these classification requirements.)
• Whether the earn-out arrangement gives the holder nonforfeitable rights to dividends irrespective of the arrangement’s classification as an equity or liability instrument — If this is the case, the instrument is a participating security regardless of whether the combined company actually declares or pays dividends. (See Deloitte’s Roadmap Earnings per Share for discussion of participating securities and the two-class method of calculating EPS.)