A professional valuation group is working on new guidance that would produce formal standards on how to value contingent consideration, a common provision in business combinations.

The Appraisal Foundation issued an exposure draft on how to value contingent consideration, also called an earnout, which is often used to bridge the price gap between what a seller wants to get and a buyer wants to pay in a merger or acquisition. Consideration, or payment, is contingent upon future performance, typically. Payment might be based on meeting any number of targets like revenue, margins, stock price, regulatory reviews, litigation outcomes, covenants, or product development.

The proposed guidance advocates a risk-neutral framework based on option pricing, says Travis Harms, head the financial reporting valuation group at Mercer Capital. “It means the best way to value an earnout is by analogizing to a call option or some combination of call options that do the same thing, and then using the valuation methods developed over the last 50 years to value the call option to in turn value earnouts,” he says.

Valuations have tripped a number of red flags in audit inspections conducted by the Public Company Accounting Oversight Board. PCAOB inspectors routinely find problems with various types of accounting estimates, including fair value measurements. The board 

Valuation standards are not as locked down as audit or accounting standards, but their importance to the financial reporting supply chain has grown over the past decade or more as an increasing number of accounting standards call for use of fair value to report more current values in financial statements. The revenue recognition standard that all public companies must implement by the start of 2018 raises the bar yet again on valuation and accounting estimates with even more new calls for judgments, some of which point toward current values.

The Appraisal Foundation proposal is geared toward trying to assure contingent consideration is valued consistently across transactions to improve consistency and comparability across capital markets. It seeks to steer valuations away from imprecise “scenarios-based approaches,” Harms said, which amount to educated guesswork. “The thought behind the new guidance is it will provide a more reliable, more consistent, more auditable measure of fair value,” he said.