NaviNow Company agrees $20 million in cash to the four former owners of TrafficEye for all of its assets and liabilities. These four owners of TrafficEye developed and patented a technology for real-time monitoring of traffic patterns on the nations top 200 frequently congested highways. NaviNow plans to combine the new technology with its existing global positioning systems and projects a resulting substantial revenue increase.
As part of the acquisition contract, NaviNow also agrees to pay additional amounts to the former owners upon achievement of certain financial goals. NaviNow will pay $8 million to the four former owners of TrafficEye if revenues from the combined system exceed $100 million over the next three years. NaviNow estimates this contingent payment to have a probability adjusted present value of $4 million.
The four former owners have also been offered employment contracts with NaviNow to help with system integration and performance enhancement issues. The employment contracts are silent as to service periods, have nominal salaries similar to those of equivalent employees, and specify a profit-sharing component over the next three years (if the employees remain with the company) that NaviNow estimates to have a current fair value $2 million. The four former owners of TrafficEye say they will stay on as employees of NaviNow for at least three years to help achieve the desired financial goals.
Should NaviNow account for the contingent payments promised to the former owners of TrafficEye as consideration transferred in the acquisition or as compensation expense to employees?
CONSIDERATION OR COMPENSATION CASE (estimated time 40 minutes)
According to FASB ASC (805-10-55-25):
If it is not clear whether an arrangement for payments to employees or selling shareholders is part of the exchange for the acquiree or is a transaction separate from the business combination, the acquirer should consider the following indicators:
a. Continuing employment. The terms of continuing employment by the selling shareholders who become key employees may be an indicator of the substance of a contingent consideration arrangement. The relevant terms of continuing employment may be included in an employment agreement, acquisition agreement, or some other document. A contingent consideration arrangement in which the payments are automatically forfeited if employment terminates is compensation for post combination services. Arrangements in which the contingent payments are not affected by employment termination may indicate that the contingent payments are additional consideration rather than compensation.
b. Duration of continuing employment. If the period of required employment coincides with or is longer than the contingent payment period, that fact may indicate that the contingent payments are, in substance, compensation.
c. Level of compensation. Situations in which employee compensation other than the contingent payments is at a reasonable level in comparison to that of other key employees in the combined entity may indicate that the contingent payments are additional consideration rather than compensation.
d. Incremental payments to employees. If selling shareholders who do not become employees receive lower contingent payments on a per-share basis than the selling shareholders who become employees of the combined entity, that fact may indicate that the incremental amount of contingent payments to the selling shareholders who become employees is compensation.
e. Number of shares owned. The relative number of shares owned by the selling shareholders who remain as key employees may be an indicator of the substance of the contingent consideration arrangement. For example, if the selling shareholders who owned substantially all of the shares in the acquiree continue as key employees, that fact may indicate that the arrangement is, in substance, a profit-sharing arrangement intended to provide compensation for post combination services. Alternatively, if selling shareholders who continue as key employees owned only a small number of shares of the acquiree and all selling shareholders receive the same amount of contingent consideration on a per-share basis, that fact may indicate that the contingent payments are an additional consideration. The acquisition ownership interests held by parties related to selling shareholders who continue as key employees, such as family members, also should be considered.
f. Linkage to the valuation. If the initial consideration transferred at the acquisition date is based on the low end of a range established in the valuation of the
acquiree and the contingent formula relates to that valuation approach, that fact may suggest that the contingent payments are an additional consideration.
Alternatively, if the contingent payment formula is consistent with prior profit-sharing arrangements, that fact may suggest that the substance of the arrangement is to provide compensation.
g. Formula for determining consideration. The formula used to determine the contingent payment may be helpful in assessing the substance of the arrangement. For example, if a contingent payment is determined on the basis of a multiple of earnings, that might suggest that the obligation is contingent consideration in the business combination and that the formula is intended to establish or verify the fair value of the acquiree. In contrast, a contingent payment that is a specified percentage of earnings might suggest that the obligation to employees is a profit-sharing arrangement to compensate employees for services rendered.
Note: This case was designed to have conflicting indicators across the various criteria identified in the FASB ASC for determining the issue of compensation vs. consideration. Thus, the solution is subject to alternative explanations and student can be encouraged to use their own judgment and interpretations in supporting their answers.
In the author’s judgment, the $8 million contingent payment (fair value = $4 million) is contingent consideration to be included in the overall fair value NaviNow records for its acquisition of TrafficEye. This contingency is not dependent on continuing employment (criteria a.) and uses a formula based on a component of earnings (criteria g.).
Even though the four former owners of TrafficEye owned 100% of the shares (criteria e.), which suggests the $8 million is compensation, the overall fact pattern indicates consideration because no services are required for the payment.
The profit-sharing component of the employment contract appears to be compensation. Criteria g. specifically identifies profit-sharing arrangements as indicative of compensation for services rendered. Criteria a. also applies given that the employees would be unable to participate in profit-sharing if they terminate employment.
Although the employees receive non-profit sharing compensation similar to other employees (criteria c.), the overall pattern of evidence suggests that any payments made under the profit-sharing arrangement should be recognized as compensation expense when incurred and not contingent consideration for the acquisition.