Retention Clauses: How They Impact Goodwill in Mergers

The article is authored by Miguel Monteiro, project director at Brazilian consulting firm Apsis Consultoria Empresarial 

 In Purchase Price Allocation (PPA) reports, to comply with the accounting principles required by accounting standard CPC 15 (R1) – Business Combinations (“CPC 15”), equivalent to IFRS 3, and the tax aspects introduced by Law 12.973/14, which impact the goodwill generated in a merger, a topic that has generated considerable debate is the distinction between the concepts of consideration (“acquisition price”) and compensation to selling shareholders who will continue working in the business (“Compensation”). 

It is important to remember that the accounting term, goodwill,  is the difference between the acquisition price (consideration transferred and to be transferred for an equity interest in a company or business) and the book value of the acquired company’s or business’ net assets, adjusted by any identified fair-value adjustments (step-ups and step-downs) from the valuation report. As such, the acquisition price directly affects the goodwill because of the merger. This goodwill may be fiscally amortized over five years, at a rate of 1/60 per month, following certain corporate restructuring events such as mergers, spinoffs or incorporations, thereby generating a tax benefit for the acquiring company. 

It is important to emphasize that if part of the consideration transferred and to be transferred in the acquisition is identified as Compensation, this portion should not be included in the acquisition price, thus reducing the goodwill and the potential tax benefit associated with the transaction. Moreover, since it is classified as compensation, this amount may be subject to applicable labor and social charges, thereby increasing the acquirer’s cash outflow. The combination of these two factors can have a significant impact on acquiring companies. In this context, the key question arises: how can risk be reduced? 

CPC 15, item (a) of paragraph B55 clearly states that if an additional payment can be canceled in situations where the selling shareholders do not remain in the acquired company or business for a specific period defined in the contract/agreement, that portion should be considered compensation for post-combination services, and not part of the acquisition price. See below an excerpt from CPC 15: 

 B55: When it is unclear whether the payments provided for in the agreement to employees or selling shareholders are part of the exchange transaction to obtain control of the acquiree or constitute separate transactions from the combination, the acquirer must consider the following indicators: 

Condition of continued employment: The conditions regarding the continued employment of selling shareholders who become key employees in the combined entity may serve as an indicator of whether the arrangement constitutes contingent consideration. These employment conditions may be included in an employment agreement, in the acquisition contract, or in another document. Contingent consideration arrangements in which the payments are automatically forfeited upon the employee’s termination are considered compensation for post-combination services. Agreements where contingent payments are not affected by the employee’s departure may indicate that the contingent payment constitutes additional consideration in the exchange transaction to obtain control of the acquiree, rather than compensation for services rendered. 

 CPC 15, still in item B55, outlines other indicators for correctly distinguishing between purchase price and compensation, such as: 

- Duration of continued employment;   

- Level of compensation;   

- Incremental payments to employees;   

- Number of shares held;   

- Link to valuation;   

- Formula for determining consideration;   

- Other agreements and issues. 

 Although all subtopics in paragraph B55 of CPC 15 should be considered when analyzing the composition of the purchase price, it’s important to highlight that item (a) is the only one which ‒ if the condition of continued employment of the selling shareholders is met—categorically characterizes the payment as compensation, resulting in the exclusion of that amount from the purchase price. The remaining subtopics should be viewed as indicators within the broader context. 

Below is a hypothetical example, for illustrative purposes only: 

Purchase price paid upfront: R$ 1,000 thousand   

Book equity of the acquired company: R$ 100 thousand   

Fair value adjustments identified in the PPA report: R$ 100 thousand   

- Scenario I: The purchase price is not tied to the selling shareholder’s continued role as an executive in the acquired company or business.   

- Scenario II: 100% of the purchase price is tied to the selling shareholder’s continued role as an executive in the acquired company or business.   

In Scenario I, the goodwill from the transaction will amount to R$ 800 thousand. 

In Scenario II, the goodwill will be zero, and the acquiring company will have a bargain purchase gain of R$ 200 thousand. 

In Scenario II, assuming part of the price negotiated in the purchase and sale agreement is conditioned on the selling shareholder’s continued employment in the acquired company or business ‒ and that if the shareholder voluntarily leaves the company, they will forfeit the right to receive the full amount ‒ the purchase price (R$ 1,000 thousand) must be recognized as compensation over the required period of continued employment. Therefore, it should not be included in the consideration transferred for the business combination. 

In this case, not only will the company not have goodwill to amortize for tax purposes, but it will also register a bargain purchase gain, and it must also assess the applicability of labor charges on the R$ 1,000 thousand, which will be recognized as income in the acquired business over the executive’s required tenure, as contractually agreed. 

There is evident creativity in the drafting of certain contractual clauses. For example, it may be stated that the purchase price is not conditioned upon the seller’s continued employment with the acquired entity, yet a penalty ‒ equivalent in value to a portion of the purchase price ‒ is stipulated should the executive voluntarily leave the company or business within a specified period. In practice, this does not alter the substance of the continued employment condition mentioned in CPC 15. 

It is important to remember that CPC 15, like all international financial reporting standards (IFRS) and the generally accepted accounting practices in Brazil, emphasizes the substance over form principle. Therefore, the evaluator must always recognize the true substance of the transaction. 

During the drafting phases of purchase and sale agreements and negotiations with the selling shareholders, we recommend close attention to the topics discussed here. 

Creativity can be observed in the drafting of certain contractual clauses. For example, the contract may state that the purchase price is not conditioned on the seller’s continued employment with the acquired entity. However, it may also impose a penalty ‒ equivalent in value to part of the purchase price ‒ if the executive voluntarily leaves the company or the acquired business within a certain period. In practice, this does not change the substance of the continued employment condition described in CPC 15.