Contingent Consideration: Valuing & Reporting These Two-Way Hedges for Oil & Gas Acquisitions
Bid-ask spreads have recently been a sticking point in oil and gas deals. Sellers may feel optimistic on commodity prices or future asset performance, but buyers may be cautious, or even pessimistic, on these points. One popular alternative to bridge this gap between buyers and sellers is through incorporating contingent consideration into the deal terms. Contingent consideration can be set up as a portion of the total consideration transferred for the sale of an oil and gas asset, such as a business unit or acreage of an oilfield. These arrangements allow for some of the total consideration to be based on future outcomes. By making part of the consideration for an acquisition contingent upon specific future outcomes, a seller can achieve an earnout and participate in the upside if the asset performs well. Conversely, a buyer can be partially protected from downside consequences if the asset underperforms expectations.
Contingent consideration arrangements can be based on numerous metrics or event triggers. Often, a contingent consideration payment is earned based on a measure of profitability, such as a percentage of earnings before interest, tax, depreciation and amortization (“EBITDA”) being paid to the seller. A contingent consideration can also be based on the achievement of a specified share price or any number of other financial metrics. In other circumstances, a binary switch triggers payment when some milestone is reached, such as approval of a patent. In the commodity space, a contingent consideration payout might be based on the average market price of the commodity exceeding a certain level over a defined period. In any case, features of contingent consideration arrangements must be analyzed carefully to determine the implications on the accounting treatment and valuation techniques.
Oil & GAS Accounting Implications
The guidance in Accounting Standards Codification (“ASC”) 805 requires an acquirer to recognize contingent consideration obligations as of the acquisition date as part of the consideration transferred in exchange for the acquired business. There are many factors to consider when determining how to account for contingent consideration. First, it must be determined whether or not the arrangement meets the definition of contingent consideration. The terms of some post-closing employment agreements, deferred payments and consideration held in escrow can appear deceivingly similar to the terms of a contingent consideration. If delivery of the consideration is based upon existing circumstances as of the acquisition date rather than the occurrence of some future event (the contingency), it is not a contingent consideration.
Next, the unit of account must be determined. This entails defining the contingent consideration arrangement as a single arrangement or multiple arrangements. If there are multiple contingencies for which payment can be received that are unrelated, multiple units of account should be used. For example, a payment in the contract could be based on first-year revenue and another payment is based on second-year revenue. However, if the contingencies are interrelated, it makes sense to consider them as part of the same contingent consideration.
Contingent consideration requires initial recognition at fair value. Subsequent accounting is dependent on the classification of the contingent consideration. A contingent consideration arrangement can have either an equity or a liability classification as defined under ASC 480, ASC 805 and ASC 815. Equity classification does not require subsequent re-measurement, while liability classification requires the contingent consideration to be re-measured at fair value each reporting date. The criteria for selecting the correct classification are somewhat complex. Generally speaking, the criteria that must be met for equity classification are highly restrictive, which results in liability classification in most cases.
OIL & GAS Valuation Implications
There are two basic methods that can be employed in the valuation of contingent consideration arrangements: the Scenario-Based Method (“SBM”) and the Option Pricing Method (“OPM”). When determining which method to use, the type of risk associated with the chosen underlying metric, as well as the payoff structure, must be considered. The valuation input variables required and the calculation of the discount rate are affected by which method is chosen.
The SBM is best for valuing contingent considerations where the metrics have diversifiable underlying risk. The risk associated with financial metrics such as revenue and EBITDA cannot be isolated from market risk and, thus, contingent considerations with such metrics are not well-suited for the SBM. The SBM is most appropriate for firm-specific metrics that are narrowly defined, such as product development milestones. The SBM also works well for metrics that have a linear payout, such as a fixed percentage of EBITDA; otherwise, the SBM is not the best choice.
An SBM model defines a set of scenarios where various metric outcomes are weighted by their corresponding probabilities of occurrence to arrive at a probability-weighted mean outcome. Once the scenarios are defined accordingly, the only remaining variable needed is the discount rate. The discount rate used in the SBM requires various assumptions. These assumptions include a spread for the structure of the payoff, a possible size premium and any other risk spread inherent in the underlying metric or counterparty involved.
The SBM has some advantages. It is easy to understand, implement and present to others. Also, it is very flexible and can model any assumption made on the shape of a distribution, including asymmetric and other irregular distributions that are not normal or lognormal. The main disadvantages pertain to the fact that the assumptions for many inputs required in the SBM are qualitative and difficult to support, especially within the discount rate. It can be a burdensome process developing and supporting these assumptions.
The OPM is better-suited than the SBM for valuing contingent consideration arrangements where the underlying risk is non-diversifiable or the structure has nonlinearities, such as thresholds, caps and tiers. The purpose of the OPM is to create a risk-neutral framework for a metric that requires fewer assumptions to be made in the valuation process. Using the OPM, all of the risks are embedded in the metric itself except for time value and credit risk.
There are only two variables needed for the OPM: the expected value and the volatility of the metric. The expected value can be provided by management directly or derived from information provided by management, such as a reserve report delivered by an oil and gas company. It can also be derived from market data, such as the forward prices of a commodity over a given time period. The other variable that is needed for the OPM is the volatility of the metric expressed as the standard deviation. This can be calculated from historical stock prices, earnings reports, market prices, etc., depending on the metric chosen. This process can be data intensive. For instance, if the metric is the stock price of an acquired company that is not publicly traded or does not have adequate historical data, the historical stock prices of a set of comparable peer companies must be analyzed to make an assumption regarding the acquired company’s equity volatility.
When the structure of a contingent consideration arrangement is path-dependent, such as when different payments are achievable in multiple periods, or is based on multiple interdependent metrics, such as a threshold that must be achieved for both EBITDA and share price, Monte Carlo simulation is generally required. This applies more frequently to structures complex enough that they fit best into the OPM, but Monte Carlo simulation is sometimes necessary when valuing a contingent consideration using the SBM framework, also. Each iteration of a Monte Carlo simulation functions as one draw from each metric’s assumed distribution. With a large number of iterations, a reliable mean value for the contingent consideration can be ascertained, discounted to the present value using an appropriate discount rate.
There are many nuances and complexities involved in valuing and reporting the fair value of contingent consideration arrangements. These arrangements should be carefully analyzed so as to be valued and reported in a way that prevents auditor and investor scrutiny. Opportune is a trusted advisor that has a proven track record with these types of oil and gas valuations.
About the Authors:
Matt Smith is a Director in Opportune’s Derivative Valuation and Hedge Accounting practice. Matt assists companies with their derivative valuation, hedge accounting, documentation and disclosure requirements. His background includes extensive experience in technical accounting research, SEC financial reporting, derivative valuation and hedge accounting. He gained this experience from his various positions in the commodity space as a technical consultant and from his experience as an audit manager with EY. Matt has an undergraduate degree in accounting from Oral Roberts University. He is also a member of the American Institute of Certified Public Accountants.
Petar Tomov is a Manager in the Derivative Valuation practice of Opportune. Prior to joining Opportune, he worked as a valuation manager at a Big 4 accounting firm, where he spent nearly six years preparing valuation deliverables for stock-based compensation, complex securities and intangible assets. Petar holds a BS in Mathematics and an MBA from the University of Texas at Dallas.