The oil and gas industry experienced a significant downturn in early 2020, which was largely due to a combination of the coronavirus pandemic and actions taken by OPEC. This triggered bankruptcy and restructuring events throughout the oil and gas industry. Many oil and gas companies were forced to reduce capital expenditure budgets and cut operating costs. In addition, companies carefully reviewed assets and some made decisions to sell off assets to strengthen their balance sheets. A frequent theme in these purchase and sale agreements has been the inclusion of contingent consideration—otherwise referred to as earnouts.
Contingent consideration represents payments that buyers and sellers will pay or receive after the closing of a transaction based on future performance. While it’s possible to have contingently returnable consideration, where the seller could be required to pay a portion of the initial purchase consideration back to the buyer, it’s unusual in the oil and gas industry. The terms are intended to bridge gaps during contract negotiations when buyers and sellers cannot reach an agreement on the consideration to be exchanged. Sellers of assets largely include these contract terms in order to receive additional consideration in the event prices rebound. Buyers attempt to prevent paying for potential market upside that may never occur.
These contingent payments can sometimes be 25%-40% of the total consideration of the transaction, and companies should assess the credit risk of the arrangement. Generally, the terms are specific to the company and not the assets. Therefore, future payments are subject to the credit risk of a company and are also generally subordinate to any debt agreements.
The amount and timing of consideration can be tied to anything that the parties mutually agree to in the contract. While many oil and gas contingent consideration features are based on future commodity pricing thresholds, the terms of the agreement could also focus on future EBITDA, revenue, quantity, share price, cash flows achieved, or other factors. Contingent consideration payment terms may be short-term; however, some oil and gas contingent consideration features contain terms that are over five years after the closing date of the transaction.
The financial reporting and valuation for these features can be complex and must be reviewed as if the contingent consideration was its own freestanding instrument.
The first step in the analysis is to determine whether the features meet the accounting definition of 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’s not contingent consideration under that accounting guidance. If it’s determined that a company has an agreement that meets the accounting definition, the initial fair value of the contingent consideration must be recorded in the financial statements.
Subsequent reporting is determined based on either equity or liability classification. A contingent consideration arrangement can have either an equity or a liability classification and companies must carefully consider the guidelines as defined under ASC 480, ASC 805, and ASC 815. This guidance is complex and the process is often iterative to make the final determination.
“As the use of contingent consideration becomes more prevalent in oil and gas agreements, companies should carefully consider the terms during contract negotations.”
Equity classification doesn’t require subsequent re-measurement, while liability classification requires the contingent consideration to be re-measured at fair value on each reporting date. Making an equity classification determination is limited to very specific circumstances. Therefore, liability classification is generally the ultimate determination for contingent consideration.
Determining the fair value of contingent consideration is also often very complex. In the oil and gas industry, contingent consideration often includes multi-year payment terms, multiple commodities and provides limits on total payments in any particular year or cumulatively over a period of time. Very little specific guidance exists on how to determine the fair value of contingent consideration arrangements.
Two basic methods 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 SBM is best for valuing contingent considerations where the metrics have diversifiable underlying risk. 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.
The SBM has some advantages. It’s easy to understand and implement. Also, it’s very flexible and can model any assumption made on the shape of a distribution, including asymmetric and other irregular distributions that aren’t 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. It can be a burdensome process developing and supporting these assumptions.
The OPM is better-suited than the SBM for valuing contingent consideration arrangements that include 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. 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 the management directly or derived from information provided by management or derived from market data. This process can be data-intensive. For instance, if the metric is the stock price of an acquired company that’s not publicly traded or doesn’t have adequate historical data, the historical stock prices of a set of comparable peer companies must be analyzed to assume 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. Each iteration of a Monte Carlo simulation functions as one draw from each metric’s assumed distribution. With many iterations, a reliable mean value for the contingent consideration can be ascertained, discounted to the present value using an appropriate discount rate.
As the use of contingent consideration becomes more prevalent in oil and gas agreements, companies should carefully consider the terms during contract negotiations. The reporting and valuation requirements are complex and can have a lasting impact on financial results. Opportune LLP is the energy industry’s leading provider of valuation and financial reporting services for contingent consideration. Please contact one of the firm’s experts for additional information.
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