D.7 Classifying Share-Settleable Earn-Out Arrangements
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.12 Earn-out arrangements may be entered into with the target’s shareholders, the
SPAC’s sponsors, or both. Generally, 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).
Example D-1
As additional consideration for a SPAC
transaction, 1 million common shares of the combined company
will be issued to the target’s shareholders for each of the
following share price levels achieved over the next five years:
- Level 1 — (1) The volume-weighted average price of the combined company’s common stock over any 20 trading days in a 40-day trading period is equal to or greater than $10 per share or (2) the combined company is acquired in a change of control at a price equal to or greater than $10 per share.
- Level 2 — (1) The volume-weighted average price of the combined company’s common stock over any 20 trading days in a 40-day trading period is equal to or greater than $15 per share or (2) the combined company is acquired in a change of control at a price equal to or greater than $15 per share.
- Level 3 — (1) The volume-weighted average price of the combined company’s common stock over any 20 trading days in a 40-day trading period is equal to or greater than $20 per share or (2) the combined company is acquired in a change of control at a price equal to or greater than $20 per share.
- Level 4 — (1) The volume-weighted average price of the combined company’s common stock over any 20 trading days in a 40-day trading period is equal to or greater than $25 per share or (2) the combined company is acquired in a change of control at a price equal to or greater than $25 per share.
If Level 4 is achieved, an aggregate of 4 million common
shares of the combined company (i.e., 1 million shares for
each level) will be issued on a pro rata basis to the
target’s shareholders on the basis of their pretransaction
ownership interests.
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. When such 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, the shares 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., the arrangements 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
718.13 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 two conditions:
-
The instrument is indexed to the issuer’s stock.
-
The instrument meets several conditions for equity classification (i.e., the issuer controls the ability to settle the instrument in shares; note that these conditions are relevant even if the contract requires settlement in shares).
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. Those considerations,
which are discussed below, include determining the following:
-
The unit of account.
-
Whether the contract is indexed to the combined company’s stock.
-
Whether the contract satisfies certain additional conditions for equity classification.
D.7.1 Unit of Account
The evaluation of whether an earn-out arrangement can be classified in equity
begins with a determination of 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. For more information about the unit of account, see
Section 3.2 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity.
D.7.2 Indexation
For each unit of account, the entity then evaluates the
indexation requirements in ASC 815-40-15 by using a two-step process for
determining whether a contract is considered to be indexed to the combined
company’s stock. If the entity determines that the contract is not considered
indexed to the combined company’s stock, the contract must be classified as a
liability (i.e., equity classification is never permitted). To determine that a
contract is considered to be indexed to the combined company’s stock, the entity
must evaluate conditions that affect either of the following steps:
-
Step 1 — The exercise or settlement of the contract (“contingent exercise provisions”).
-
Step 2 — The monetary value of the settlement amount (i.e., factors that affect the settlement amount, or “settlement provisions”).
All share-settleable earn-out arrangements contain contingent
exercise provisions, and most of them also contain settlement provisions. In
some cases, a provision reflects both a contingent exercise provision and a
settlement provision.14 The determination of whether the term of an earn-out arrangement is a
contingent exercise provision or a settlement provision can significantly affect
whether the contract is indexed to the combined company’s stock because the
guidance on contingent exercise provisions significantly differs from the
guidance on settlement conditions.
Example D-2
A share-settleable earn-out arrangement
specifies that the combined company will issue an
aggregate of 5 million shares of its common stock to the
target’s shareholders if either (1) the quoted price of
the stock exceeds $20 during a stated period or (2)
there is a change of control. In this example, the
combined company’s stock price and the occurrence of a
change of control affects only whether the holders will
receive the 5 million shares. Both variables represent
only contingent exercise provisions because the holders
will receive either no shares or 5 million shares.
This scenario differs from that in Example D-1. In that example, the holders
may receive no shares, 1 million shares, 2 million
shares, 3 million shares, or 4 million shares, depending
on the combined company’s stock price or the price paid
in a change of control. In both examples, the conditions
are contingent exercise provisions. However, unlike the
conditions in this example, the conditions in Example D-1 are also
settlement provisions.
For an exercise contingency not to prevent a contract from being indexed to the
combined company’s stock, it must meet the guidance in ASC 815-40-15-7A, which
states, in part:
An exercise contingency shall not preclude an instrument (or embedded
feature) from being considered indexed to an entity’s own stock provided
that it is not based on either of the following:
- An observable market, other than the market for the issuer’s stock (if applicable)
- An observable index, other than an index calculated or measured solely by reference to the issuer’s own operations (for example, sales revenue of the issuer; earnings before interest, taxes, depreciation, and amortization of the issuer; net income of the issuer; or total equity of the issuer).
The terms of share-settleable earn-out arrangements that reflect
contingent exercise provisions (e.g., the combined company’s stock price or a
change of control) generally do not prevent the contract from meeting the first
step in ASC 815-40-15 to be considered indexed to the combined company’s stock.
However, terms that affect the settlement value of the contract (i.e.,
settlement provisions) may prevent it from being indexed to the combined
company’s stock in the second step under ASC 815-40-15. For an instrument to
meet the conditions in the second step, any input that could affect the
settlement amount must meet the condition discussed in ASC 815-40-15-7D, which
states, in part:
[T]he instrument (or embedded feature) shall still be
considered indexed to an entity’s own stock if the only variables that
could affect the settlement amount would be inputs to the fair value of
a fixed-for-fixed forward or option on equity shares.
Common terms in these arrangements that affect the settlement amount, but that
generally do not prevent the contract from meeting the requirement in step 2
under ASC 815-40-15, include:
-
The combined company’s stock price (i.e., the quoted price or a reasonable average of quoted prices).
-
Standard antidilutive adjustments.
-
Adjustments for dividends on the combined company’s stock.
-
Adjustments for lost time value upon an early settlement (provided that those adjustments reflect only reasonable compensation for lost time value).
Common terms in these arrangements that affect the settlement
amount but that would generally prevent the contract from meeting the
requirement in step 2 of ASC 815-40-15 include:
-
All remaining shares would be issuable (or the forfeiture provisions would lapse) upon any change of control involving the combined company.
-
All remaining shares would be issuable (or the forfeiture provisions would lapse) upon a bankruptcy or insolvency of the combined company.
We have observed that, in current practice, earn-out arrangements can generally
be categorized into four different types, which are discussed in the table
below.
Type
|
Evaluation of Indexation Guidance
|
---|---|
A fixed number of shares will be issued if (1) the
combined company’s stock price meets or exceeds a stated
price or (2) there is a change of control of the
combined company.
See Example D-2.
|
If either of these two conditions is
met, the issuance of the earn-out shares is only
considered an exercise contingency because there is no
variability in the number of shares issuable. This
exercise contingency does not preclude the earn-out
share arrangement from being considered indexed to the
combined company’s stock.
|
A variable number of shares will be issued on the basis
of the combined company’s stated stock prices. If there
is a change of control, all the earn-out shares will be
issued.
Example
As additional consideration for a SPAC transaction, 1
million common shares of the combined company will be
issued to the target’s shareholders for each of the
following share price levels achieved over the next five years:
If Level 4 is achieved, an aggregate of
4 million common shares of the combined company (i.e., 1
million shares for each level) will be issued pro rata
to the target’s shareholders on the basis of their
pretransaction ownership interests. If, however, the
combined company is acquired in a change of control, all
previously unissued shares will be issued.
|
This arrangement contains a provision
that affects the settlement amount. The number of
earn-out shares issuable varies on the basis of whether
there is a change of control of the combined company.
That is, in the absence of a change of control, a
variable number of shares will be issued on the basis of
stock price. However, if a change of control occurs, all
of the earn-out shares will be issued (i.e., 4 million
shares will be issued regardless of the combined
company’s stock price). Because the arrangement contains
a settlement provision that precludes it from being
indexed to the combined company’s stock under step 2 in
ASC 815-40-15-7, liability classification is
required.
|
A variable number of shares will be issued on the basis
of the combined company’s stated stock prices. If there
is a change of control at a price per share that equals
or exceeds a stated amount that is less than the price
needed for all the earn-out shares to be issued, all of
the earn-out shares will nevertheless be issued.
Example
As additional consideration for a SPAC transaction, 1
million common shares of the combined company will be
issued to the target’s shareholders for each of the
following share price levels achieved over the next five years:
If Level 4 is achieved, an aggregate of 4 million common
shares of the combined company (i.e., 1 million shares
for each level) will be issued on a pro rata basis to
the target’s shareholders on the basis of their
pretransaction ownership interests. If, however, the
combined company is acquired in a change of control at a
price of $15 or more, all previously unissued shares
will be issued.
|
This arrangement contains a provision
that affects the settlement amount. The number of
earn-out shares issuable varies depending on whether
there is a change of control of the combined company at
a stated price. That is, in the absence of a change of
control at a stated price, a variable number of shares
will be issued on the basis of stock price. However, if
a change of control occurs at a price per share of $15
or more, all the earn-out shares will be issued (i.e., 4
million shares will be issued regardless of the combined
company’s stock price). Because the arrangement contains
a settlement provision that precludes it from being
indexed to the combined company’s stock in step 2 under
ASC 815-40-15-7, liability classification is
required.
|
A variable number of shares will be issued on the basis
of either (1) the combined company’s stated stock prices
or (2) the price per share in a change of control of the
combined company.
See Example D-1.
|
This arrangement contains a provision
that affects the settlement amount. The determination of
whether this arrangement is indexed to the combined
company’s stock in step 2 under ASC 815-40-15-7 depends
on (1) how the price per share is calculated in a change
of control of the combined company and (2) an entity’s
interpretation of the application of ASC 815-40-15 to
the potential settlement that would occur upon a change
of control.
Some entities have determined that the
settlement amount is affected by the occurrence or
nonoccurrence of a change of control, which is not an
input into the pricing of a fixed-for-fixed forward or
option on equity shares. These entities have therefore
concluded that the share-settleable earn-out arrangement
is not indexed to the combined company’s stock in step 2
under ASC 815-40-15-7. As a result, the earn-out
arrangement is classified as a liability. Note that
these entities reach this conclusion without evaluating
the calculation of the price per share in a change of
control of the combined company.
Other entities focus on the calculation of price per
share in the event of a change of control. On the basis
of a preclearance with the staff of the SEC’s Office of
the Chief Accountant, there are two possible outcomes:
A price-per-share calculation that
includes the number of shares issuable under the
earn-out arrangement and other potentially issuable
shares of the issuer can be described as “circular,”
“net,” or “as-diluted.” Although computable, it is not a
simple calculation. In addition, the terms of the
provision that apply in the event of a change of control
are often subject to interpretation (i.e., ambiguous).
In these situations, entities may wish to consult with
attorneys to obtain a legal interpretation that supports
equity classification of the instrument. However, if the
terms of the provision in the earn-out agreement do not
specifically indicate that a calculation method
consistent with the circular, net, or as-diluted
approach applies, the entity would not have sufficient
evidence to support a conclusion that the
share-settleable earn-out arrangement is indexed to the
entity’s stock under step 2 in ASC 815-40-15-7;
therefore, liability classification would be required.
That is, an entity cannot rely on an attorney’s
interpretation of an ambiguous provision and conclude
that the circular, net, or as-diluted calculation
applies, because it would not be able to support such a
conclusion with sufficient evidence.
|
In the table above, it is assumed that none of the earn-out
shares are within the scope of ASC 718. In practice, share-settleable earn-out
share arrangements may be issuable to employees of the target that hold vested
or unvested shares or options on the date on which the SPAC merges with a
target. In addition to considering the guidance in ASC 718, entities should
assess whether the potential shares issuable to common stockholders under ASC
815-40 could be affected by the number of shares issuable to recipients whose
earn-out shares are within the scope of ASC 718 (i.e., recipients that receive
those shares as a form of stock-based compensation). For example, assume that
earn-out shares will be issued to holders of unvested stock options on the
merger date provided that those holders are still employees on the date on which
the earn-out share target or targets are met. If an option holder is no longer
an employee as of that date, the earn-out shares otherwise receivable by the
holder will be reallocated to the pool of shares receivable by common
stockholders that did not receive such shares in return for services (i.e., that
were not within the scope of ASC 718). In this situation, as a result of the
guidance on the unit of account in ASC 815-40, the portion of the
share-settleable earn-out arrangement that is within the scope of ASC 815-40
would not be considered indexed to the combined company’s stock because the
number of shares varies on the basis of employee behavior. In a manner
consistent with Example 20 in ASC 815-40-55, the share-settleable earn-out
arrangement within the scope of ASC 815-40 must be classified as a liability in
its entirety.
For more information on the application of the indexation guidance, see Chapter 4 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity.
D.7.3 Equity Classification Conditions
Once a share-settleable earn-out arrangement is determined to be
indexed to the combined company’s stock under ASC 815-40, the entity must
evaluate whether it controls settlement of the contract in its shares. ASC
815-40-25 addresses the conditions that must be met. Only contracts for which
the entity controls settlement in shares (i.e., that meet the conditions in ASC
815-40-25) may be classified in equity. See Chapter 5 of Deloitte’s Roadmap Contracts on an Entity’s Own
Equity for more information about these classification
conditions.
D.7.4 Other Considerations
Regardless of the classification of a share-settled earn-out
arrangement, ASC 815-40 requires an entity to recognize the initial fair value
of the instrument. The offsetting entry will depend on the facts and
circumstances. We believe that for earn-out arrangements with target
shareholders, the offsetting entry should be reflected in the same manner as it
would if the entity declared a pro rata dividend to its common shareholders.
Entities should also consider the effect that share-settled
earn-out arrangements may have on their EPS calculations and disclosures.
Share-settled earn-out arrangements represent potential common shares;
therefore, in calculating diluted EPS, the combined company should consider the
guidance on contingently issuable shares. In addition, some share-settled
earn-out arrangements require that shares be issued or released from escrow if
the combined company’s common stock exceeds a certain price over a specified
period. For example, an arrangement may stipulate that 1 million shares must be
issued on the date the daily volume-weighted average share price is greater than
or equal to $13.00 for any 20 days within a 30-day trading period. For these
types of arrangements, we understand that there is diversity in practice
regarding how ASC 260 is applied. ASC 260-10-45-52 states:
The number of shares contingently issuable may depend on the market price
of the stock at a future date. In that case, computations of diluted EPS
shall reflect the number of shares that would be issued based on the current
market price at the end of the period being reported on if the effect is
dilutive. If the condition is based on an average of market prices over some
period of time, the average for that period shall be used. Because the
market price may change in a future period, basic EPS shall not include such
contingently issuable shares because all necessary conditions have not been
satisfied.
Some believe that the denominator of diluted EPS should not include any shares
that are issuable under the earn-out arrangement unless the triggering event
either (1) has been met as of the end of the reporting period or (2) would have
been met in the absence of a required waiting period (i.e., some arrangements do
not allow stock price conditions to be met until a specified period after the
SPAC merger has been consummated). This view is premised on a belief that the
guidance on shares that are contingently issuable on the basis of an average of
market prices applies and therefore no shares would be included in the
denominator of diluted EPS unless a triggering event has been met, or would have
been met, as of the reporting date. According to this view, if the triggering
event is met as of the end of the reporting period, the shares are included in
the denominator from the beginning of the reporting period (or issuance date of
the earn-out arrangement, if later).
Others believe that the denominator of diluted EPS should include shares that
would be issuable if the entity’s stock price as of the end of the reporting
period would not change in the future. This view is premised on the belief that
the guidance on shares that are contingently issuable on the basis of an average
of market prices only applies to the volume-weighted average price as of the end
of the reporting period. According to this view, the fact that shares are
issuable only if a volume-weighted average daily price is met for a certain
number of days within a defined period does not mean that the entity looks to
the trailing prices over that defined period as of the end of the reporting
period.
We believe that either of these two views is acceptable. Entities should disclose
the approach they use to calculate diluted EPS for such arrangements.
In addition, share-settled earn-out arrangements that give the
holders nonforfeitable rights to dividends represent participating securities
regardless of whether (1) the arrangements are classified as equities or
liability instruments or (2) the combined company actually declares or pays
dividends. See Deloitte’s Roadmap Earnings per Share for more
information about participating securities and the two-class method of
calculating EPS.
Footnotes
12
There may be other options or warrants on stock that were previously issued
by the SPAC or target that remain outstanding after the merger. While many
of the accounting considerations discussed in this section are relevant to
these instruments, this section focuses on earn-out arrangements.
13
Generally, an earn-out arrangement would be subject to ASC
718 if, in addition to meeting one or more share price levels or other
conditions, the holder must provide service to the combined company after
the merger date. Therefore, entities should consider whether the
counterparty to the arrangement must provide services to the combined
company to earn the award. For more information, see Section D.8.
14
Contracts containing only transfer restrictions that
lapse upon the passage of time are considered outstanding shares and are
not subject to this evaluation. As discussed above, those arrangements
are accounted for as outstanding shares rather than as equity-linked
instruments.