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 an earn-out arrangement such as that in the example above, the accounting for the shares awarded depends on the terms of the arrangement. When such an earn-out arrangement is entered into with the SPAC’s sponsor, the shares are generally issued before the transaction; however, at the time of the SPAC merger, 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 (e.g., they would be forfeited if one or more conditions are not met by a stated date), for accounting purposes, those arrangements are treated in the same manner as earn-out arrangements that involve the conditional issuance of shares (i.e., the shares are treated as equity-linked instruments rather than as 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, 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.

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 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, an 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 fully understand 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 regarding such definitions.

Several considerations are relevant to the application of ASC 815-40 to an equity-linked instrument such as an 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 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

An 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 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 one 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: Level 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. Level 2 — 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. Level 3 — 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. Level 4 — 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. 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, 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). This 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; therefore, 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: Level 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. Level 2 — 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. Level 3 — 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. Level 4 — 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. 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). This 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; therefore, 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 depends on how the price per share is calculated in a change of control of the combined company and 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 earn-out arrangement is not indexed to the combined company’s stock in step 2 under ASC 815-40-15. 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: If the price per share is calculated by dividing the transaction consideration by a number of outstanding shares that exclude the shares issuable under the earn-out share arrangement, the arrangement is not considered indexed to the combined company’s stock in step 2 under ASC 815-40-15 and must be classified as a liability. If the price per share is calculated by dividing the transaction consideration by a number of outstanding shares that include the shares issuable under the earn-out share arrangement, the arrangement is considered indexed to the combined company’s stock in step 2 under ASC 815-40-15 and may be classified as an equity instrument as long as no other condition in ASC 815-40 precludes such classification. A price-per-share calculation that includes the number of shares issuable under the earn-out arrangement can be described as “circular,” “net,” or “as-diluted.” This calculation is not simple, and because the terms of the provision that apply in the event of a change of control are often subject to interpretation (i.e., ambiguous), entities must consult with attorneys to reach the proper legal interpretation. If an entity cannot conclude that the calculation in the arrangement would be circular, net, or as-diluted, the earn-out arrangement cannot be classified in equity. We understand that many entities are modifying the terms of such provisions or taking other actions to eliminate the ambiguity in the contractual terms of the change-of-control provision.

In the table above, it is assumed that none of the earn-out shares are within the scope of ASC 718. We have seen instances in practice in which earn-out share arrangements with target shareholders may be issuable to employees that hold vested or unvested shares or options on the date on which the SPAC merges with a target. In addition to ASC 718 accounting considerations, entities should assess whether the potential shares issuable to common stockholders for which the accounting is in accordance with ASC 815-40 could be affected by the number of shares issuable to recipients for which the accounting is 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 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 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 an 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 an 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 earn-out arrangements may have on their EPS calculations and disclosures. 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 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, 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

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.

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.

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.