Chapter 14: Non-compete agreements

A non-compete agreement, negotiated as part of a business combination, generally prohibits former owners or key employees from competing with the combined entity. The agreement covers a set period of time that typically commences after the acquisition date or termination of employment with the combined entity

Non-compete agreements

Non-compete agreements are accounted for separately from the business combination if they are entered into by or on behalf of the acquirer or primarily for the benefit of the acquirer. A non-compete agreement negotiated as part of a business combination will typically be initiated by the acquirer to protect the interests of the acquirer and the combined entity. A non-compete agreement might have been part of an employee contract that was in place before the business combination. In those cases, a non-compete agreement that is triggered by a change in control or by the employee’s departure would represent an asset of the acquired business.

Non-compete agreements often meet the criteria for separate recognition as an intangible asset, by satisfying the contractual or other legal right criterion. The combined entity should, however, consider whether any components of the payment relate to future services, which should be accounted for in accordance with IAS 19. A non-compete agreement will normally have a finite life, requiring amortisation of the asset.

The amortisation period should reflect the period over which the benefits from the non-compete agreement are derived, which is generally the contractual period.

Employee compensation arrangements

Selling shareholders might be key employees of the acquiree, particularly where smaller or unlisted entities are acquired. The selling shareholders might remain as employees of the acquired business after the business combination.

Arrangements that include contingent consideration need to be assessed, to determine if the amounts payable are consideration for the business or are for post-combination employee services, based on the nature of the arrangements. Payments that are consideration are part of the business combination. Payments that are for employee services are post-combination remuneration expenses that will be charged to the combined group’s income statement in accordance with IFRS 2 or IAS 19.

Assessment of payments to selling shareholders requires an understanding of why the contingent consideration is included in the agreement, which party (the acquiree or the acquirer) initiated the arrangement, and when the parties entered into the arrangement.

The nature of the arrangement dictates whether contingent payments to selling shareholders that become employees of the combined entity are contingent consideration in a business combination or separate transactions.

There are eight indicators that should be considered when analysing these payments (these criteria are applied to all arrangements for payments to selling shareholders who become employees of the combined entity, including cash compensation and share-based compensation):

1. Continuing employment: terms of employment might be in the sale and purchase agreement, an employment agreement or in some other document. In any case, an arrangement in which payments are automatically forfeited if employment ceases is remuneration for postcombination services. Conversely, if the payments are not affected by whether the person is employed or not, this might indicate that the arrangement is contingent consideration and not remuneration.
2. Duration of continuing employment: the contingent payment is more likely to be remuneration where the period of required employment is the same as or longer than the contingent payment period.
3. Level of remuneration: where the remuneration of the selling shareholders who are employees is reasonable compared to other key employees (when the contingent payment arrangement is excluded), this might indicate that the contingent payments are additional consideration for the business.
4. Incremental payments to employees: selling shareholders who do not become employees might receive lower contingent payments (on a pershare basis) than the selling shareholders who become employees of the combined entity. This indicates that the incremental amount of contingent payments to the selling shareholders who become employees is remuneration and not consideration.
5. Number of shares owned: the contingent payment arrangement is more likely to be a profit-sharing remuneration arrangement if the selling shareholders owned substantially all of the shares in the acquiree and became employees. Conversely, if the selling shareholders (who continue as key employees) owned a small part of the business and all shareholders receive the same contingent payments (on a per-share basis), this indicates that the payments are consideration and not remuneration. The acquirer should also consider ownership interests of parties related to selling shareholders who remain as key employees, such as members of their families.
6. Linkage to the valuation: the acquirer and acquiree will often negotiate within a range of valuations. A contingent payment arrangement is more likely to be consideration where the amount of consideration transferred at the acquisition date is at the low end of the valuation, with further contingent amounts payable. On the other hand, the contingent payment formula might be consistent with profit-sharing arrangements that existed with the key employees before the business combination. This indicates that the arrangement is remuneration and not consideration.
7. Formula for determining consideration: a formula that is based on an earnings multiple is more likely to be contingent consideration, because it is intended to establish the fair value of the acquired business. Alternatively, a formula based on a proportion of profit earned indicates that the arrangement is a profit-sharing agreement and is remuneration for post-combination services.
8. Other agreements: amounts payable to selling shareholders might be for something other than both consideration and employee remuneration. For example, there might be other arrangements such as non-compete agreements, executory contracts, consultancy contracts and asset lease agreements. A selling shareholder might own a property that is leased by the acquiree.

A new lease is entered into as part of the business combination. This new lease might indicate that a contingent payment arrangement is, in part, a payment for the lease and should be recognised separately in the acquirer’s post-combination financial statements, if that lease is at less than market rates.

Contingent consideration arrangement forfeited on termination of employment

All of the indicators listed in IFRS 3 should be considered when analysing payments to employees or selling shareholders. However, if the contingent payments are automatically forfeited on termination of employment, the standard requires them to be treated as remuneration for post-combination services, rather than as part of the consideration for the business combination.

Example Entity B (the acquiree) is owned by a sole shareholder, who is also the chief executive officer of entity B. Entity B is purchased by entity A (the acquirer) in a business combination. Entity B’s sole shareholder will receive additional consideration for the acquisition, based on entity A achieving specific earnings before interest, tax, depreciation and amortisation (EBITDA) levels over the two-year period following the acquisition. Entity A believes that retaining the services of the sole shareholder for at least two years is critical to transitioning entity B’s ongoing business.

The arrangement also stipulates that the sole shareholder will forfeit any rights to the additional consideration if the shareholder is not an employee of entity B at the end of the two-year period.

Is the arrangement remuneration for post-combination services or consideration for the acquisition of entity B?

The arrangement is remuneration for post-combination services, because the payments are automatically forfeited if employment terminates. Any payments made to the former shareholder of entity B, for achievement of the specific EBITDA levels, are accounted for as a compensation cost in entity A’s post-combination financial statements.

Contingent consideration arrangement with no link to continuing services

Entity D is acquired by entity C for cash consideration of C250 million. Entity C must make an additional payment to the selling shareholders (‘sellers’) if entity D achieves a pre-determined sales volume target in each of the three years following the acquisition.

Entity D has four shareholders, who were employees of entity D before the business combination and remain employees of the combined entity. Payment will only be made at the end of the three years if all targets are met. In addition to the background above, other facts are: the sellers maintain similar salaries to other employees at their level; the sellers are not required to remain employed during the three years in order to receive the additional payment; an independent valuation performed on entity D placed a value on the business of between C250 million and C300 million; and the sellers will receive payment in proportion to their prior interest owned. Is the additional payment consideration or remuneration? The payments are not forfeited if employment ceases, so additional indicators should be analysed.

The level of remuneration, without the additional payments, seems reasonable compared to the other employees. The contingent payment appears to compensate for the minimum up-front consideration, because the purchase price is at the low end of the independent valuation range. These factors indicate that the payment is consideration paid to the sellers in exchange for entity D, so it would be included as purchase consideration.

Cash distributed among multiple shareholders linked to employee retention

Entity D is acquired by entity C for cash consideration of C250 million. Entity C must make an additional payment to the selling shareholders (‘sellers’) if entity D achieves a pre-determined sales volume target in each of the three years following the acquisition.

Entity D has four shareholders, who were employees of entity D before the business combination and remain employees of the combined entity. Payment will only be made at the end of the three years if all targets are met. In addition to the background above, other facts are: In addition to the background in the first paragraph of example 2, the following facts apply: the sellers have low salary levels compared to other employees; the sellers can influence the sales revenue if they continue as employees; if a seller resigns, that employee forfeits their portion of the payment (which is shared among remaining sellers); if none of the sellers remains employed at the end of the three years but all sales targets are met, the additional payment is distributed to all sellers in proportion to their prior ownership interests; an independent valuation performed on entity D placed a value on the business of between C250 million and C300 million; and the sellers will receive payment in proportion to their prior interest owned.

Is the additional payment consideration or remuneration?

The contingent payments are not automatically forfeited if all of the sellers cease employment, but each individual seller controls their ability to earn their portion of the additional payment by continuing employment. The sellers receive low salary levels, compared to other employees at their level, and they have the ability to influence the sales targets if they continue as employees. The commercial substance of the agreement incentivises the seller to continue in employment. The scenario where all sellers cease employment is considered to lack substance, because the last seller employed is unlikely to forfeit the entire payment. These factors indicate that the additional payment would be accounted for as remuneration for the post-combination employee services of the sellers.

Golden parachute and stay bonus arrangements

Employment agreements with key employees often include arrangements whereby the key employee receives a bonus, either in cash or equity, when his or her employment is terminated. These arrangements are often triggered by a business combination (change of control) and are commonly referred to as ‘golden parachute’ arrangements.

Examples of liabilities that might crystallise as a result of an acquisition are those arising from pre-existing contractual arrangements, such as compensation clauses in directors’ service contracts that are triggered in the event of a change of ownership.

Once it becomes probable that the business combination will take place, these liabilities become pre-combination liabilities of the acquiree, and they are recorded in the acquiree’s books. To the extent that the liability has not been settled by the acquisition date, it becomes an assumed liability as part of the business combination.

These arrangements need to be assessed to determine if they represent payment for pre- or post-combination services. Generally, if the arrangement was included in the employment agreement before contemplation of the acquisition, and there is no post-combination service required, it is associated with a pre-combination arrangement. The expense is typically recognised in the financial statements of the acquiree at the acquisition date. The following examples illustrate golden parachute and stay bonus arrangements.

Example 1 – Golden parachute arrangement

The employment contract for the CEO of entity B provides that, if entity B is acquired and the CEO remains employed until the acquisition date, the CEO will receive a C5 million cash payment (a ‘golden parachute’ arrangement). Several years after the employment contract is signed, entity B is acquired by entity A.

The CEO is not obliged to remain employed after the acquisition date. How is the arrangement accounted for?

Entity A is required to assess whether the C5 million cash payment to the CEO is

(1) an assumed obligation that should be included in the business combination accounting, or

(2) a post-combination expense that should be accounted for separately from the business combination. The reasons for the transaction: The C5 million payment was originally included in the CEO’s employment contract by entity B to secure employment of the CEO, through to the acquisition date, in the event that entity B was acquired in the future.

Who initiated the transaction: The payment was arranged by entity B to benefit entity B, through to the acquisition date, in the event of an acquisition? The timing of the transaction: The employment contract was in existence before the business combination. The payment to the CEO is not primarily for the economic benefit of entity A. Additionally, the CEO is not required to provide continuing services to entity A to receive the payment. Therefore, the payment is recorded as compensation cost in entity B’s pre-combination financial statements. If it has not been paid at the date of the acquisition, the payment is recorded as a liability of the acquired business at the date of acquisition.

Example 2 – Stay bonus arrangement

Entity C acquires entity D, and entity C agrees to provide a cash payment of C1 million to each of entity D’s key employees if they remain employed with the combined entity for at least one year from the acquisition date. The cash payment of C1 million will be forfeited if the key employee resigns before the first anniversary of the acquisition date. A similar clause was not included in entity D’s key employees’ contracts before the acquisition.

Entity C assesses whether the C1 million cash payment to each of the key employees is

(1) consideration transferred for the acquiree, or

(2) a post combination expense that is accounted for outside the business combination.

The reasons for the transaction: The C1 million payment was offered to entity D’s key employees by entity C to facilitate the transition process following the acquisition.

Who initiated the transaction: The payment was arranged by entity C to benefit entity C for the first year following the acquisition.

The timing of the transaction: The arrangement was negotiated in conjunction with the business combination, and it was not included in the original employment agreements of the key employees. The payments to entity D’s key employees appear to be arranged primarily for the economic benefit of entity C. The key employees will forfeit the payment if they do not provide services to the combined entity for at least one year following the acquisition date. Therefore, the payments are not part of the consideration transferred for entity D, and they are recorded as remuneration cost in the post-combination financial statements of the combined group.

Example 3 – Dual trigger arrangement consisting of change in control and termination

Entity D acquires entity E in a business combination. Entity E has an existing employment agreement in place with one of its key employees that states that the employee will be paid C1 million on a change of control and termination of employment within 18 months following the acquisition date (sometimes referred to as a ‘dual trigger’). The employee receives the stated amount only if the employee is subsequently terminated without cause or leaves for good reason as defined in the employment agreement. As of the date of the business combination, entity D has determined that it would not offer employment to the key employee of entity E, effectively terminating employment on the acquisition date, and it would pay C1 million to the former employee of entity E at closing.

Entity D assesses whether the C1 million cash payment at closing to the key employee is:-

(1) consideration transferred for the acquisition of entity E, or

(2) a post-combination expense that is accounted for outside the business combination.

The termination payment to the employee is only incurred when both conditions outlined in the employment agreement are met (that is, a change of control and termination of employment). Since the decision to terminate the employee is out of entity E’s control, only one of the two conditions is met by entity E at the acquisition date.

Therefore, it would not be appropriate for entity E to record a liability in connection with the effective termination of the key employee. Entity D should recognise C1 million of expense in its post-combination period as a transaction separate from the business combination. As noted above, the payment to the employee is conditional on both a change in control of the acquiree and a termination of employment by the acquirer. The decision by entity D was made for its own benefit, and it should be recorded separately from the business combination in accordance with IFRS 3. Therefore, entity D would not record a liability in acquisition accounting, but it would instead record the expense in the period after the business combination when it terminated the employee.