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ARXIS - Litigation Consulting
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September 2020

 
Recent Case:

Valuation of an Earnout Provision in Acquisition

which way to go

Type of Matter:

Valuing a business certainly is not always straightforward. Sometimes it requires thinking outside the box to develop an approach that works for the particular situation. Such was the case when Arxis Financial was recently engaged in an acquisition that was about to get ugly with potential litigation.

A business owner sold their business and the negotiations involved how much would be paid after the close of the transaction and how much would be based on the future performance of the company. It is typical that such payments (earnout provisions) are put in contracts to incentivize the seller to work towards the buyer's success. It also allows for the possibility that the seller can make some extra money on the sale than they might otherwise be paid.

For tax and litigation reasons, Arxis Financial was contacted in this particular case to value the earnout provision. The seller needed to know the fair market value of the potential earnout cash flow as of the date of sale.

Arxis Work:

For the valuator, an earnout element adds to the complexity of determining and quantifying the differences between value, price, and proceeds. In this particular case, we knew the price but the actual value of the business and proceeds of the transaction were unknown. Potential earnout payments were based on future performance that may or may not materialize. Also, there were questions whether the company would actually be able to meet the required payments without permanently damaging the company.

Valuing a transaction as of the close date, when there are potential additional future payments, presents great difficulty in determining the Fair Market Value of the business as of that date. There is no real alternative to using the income approach since the cash flows are complex, uncertain, and maybe even speculative, depending on the negotiations and terms. Variations on the income approach range from a clear-cut discounted cash flow approach to complex Monte Carlo Simulation models addressing the probability that cash payments will be earned and paid out. It is also common to see probability-weighted return methodology applied within an income approach to valuing earnouts. The additional difficulty was that actual future performance could not be considered in valuing the earnouts. Only facts known or knowable as of the date of the sale could be considered in the valuation of the earnout.

In this case, the potential future benefit streams were probability weighted and then discounted using a discount rate that was derived from the actual transaction and then adjusted. The adjustments included consideration of additional risk factors such as transaction risk (the risk that the relationship between seller and buyer would deteriorate and/or that the additional compensation to the seller will actually be difficult for the company to honor) and performance risk (the risk that the business simply cannot achieve growth rates that exceed those contemplated in the original deal).

Result:

An opinion of value was determined and accepted. The case settled and expensive litigation was avoided.

 
Service Profile:

Forensic Accounting Services for Insurance Fraud

hurdles

Since insurance fraud investigations are initiated due to suspicions about a certain type of fraud or a suspected individual, it is helpful to engage the expertise of a trained fraud examination specialist. Arxis Financial employs trained professionals who specialize in the detection and prevention of fraud.

In insurance fraud matters, attorneys engage Arxis Financial to analyze, explain and present financially complex issues, typically relating to on-the-job injury and property-casualty fraud, as well as other insurance fraud schemes. The specialists in Arxis Financial's "Forensic Accounting" practice apply detailed investigation and analysis that is necessary to uncover essential facts and provide meaningful insights. Our fraud investigators assist in determining whether fraud occurred, and if so, to estimate the extent of monetary loss or damages and to determine who committed the fraud.

Arxis Financial utilizes various investigative and analytical procedures to support criminal or civil actions. Our services include analysis of personal and business transactions, document review and tracing, and expert witness testimony. Expert analysis and conclusions are presented in depositions and trial at local, state and federal court levels as well as mediation and arbitration. We assist attorneys in interpreting the data, and help counsel to understand and analyze events or issues. This level of support can be a key asset in determining a legal strategy as well as reaching a reasonable and efficient conclusion.

The Forensic Accounting practice is headed by partner Chris L. Hamilton, CPA, CFE, CVA. Mr. Hamilton is a Certified Public Accountant, Certified Fraud Examiner, and Certified Valuation Analyst. He is a licensed life and disability insurance agent and a General Securities Representative. Mr. Hamilton has published articles in several publications, and has made presentations at national conferences, training institutes and seminars on topics including forensic accounting, fraud and business appraisal.

 
 
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Chris Hamilton, CPA, CFE, CVA
 
 
Chris Hamilton, CPA, CFE, CVA
chamilton@arxisfinancial.com
(805) 342-0749
www.arxisfinancial.com
 
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