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March 2008
M&A: Valuing
Non-Compete Agreements
The value of a
non-compete agreement can be a major factor in arriving at a sales price
that is acceptable to both parties
If you are purchasing a successful business, a
major concern may be your ability to keep trade secrets and business
relationships under lock and key. After all, it is those very assets that
led to the company’s success, and you want to ensure that they won’t walk
out the door with the departing owner.
A non-compete agreement can regulate
competition between the buyer and the former owner, and provisions can
minimize competition through defined geographic and time boundaries. In
exchange for compliance, departing personnel generally receive financial
compensation.
Tax Treatment. In most cases, buyers
may take deductions for amortization expenses related to non-compete
agreements. In most cases, a non-compete agreement is amortized by the
buyer over a 15-year period, regardless of the agreement’s actual term or
payment conditions. The seller must recognize as ordinary income the
amounts received from the non-compete agreement, and tax treatment is
recognized as an intangible asset.
For tax purposes, the value assigned to the
non-compete agreement must be economically realistic, bargained for
separately, and agreed upon by both parties. Setting a realistic economic
value involves balancing the probable damages against the value of the
payments made through the agreement. The area affected most would be the
stream of sales.
A qualified independent business valuator can
help you determine how much of a threat would be posed by competition from
the former owner. He may also be able to help you properly structure the
contract to gain any available tax benefits and avoid potential post-sale
problems.
Estimating Probable Damages. Estimating
the probable damages that post-sale competition can create will require an
analysis of the business’s finances and operations. The research typically
includes:
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analyzing the competitive and financial
position of the company within its industry,
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determining the outlook for both the company
and its industry,
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analyzing the potential negative impact that
competition would have on the business, and
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determining the present value of profits
lost to competition.
Setting a Value. The following example
describes the process we may use to determine the value of a non-compete
agreement. (The names of the companies and individuals are fictitious.)
Example. Mr. Anderson is the owner of
Suit Up, a regional distributor of sporting goods. He is in negotiations
to sell his company to Sporting Life, a national competitor.
During the company’s history, Anderson
developed a strong and reliable client base. His relationship with his
customers seems to be so strong that Sporting Life asks him to sign a
three-year non-compete agreement, specifying geographic territories
where Anderson would be barred from doing business after the acquisition
is completed.
Anderson and Sporting Life hire a valuation
professional to determine the value of the non-compete agreement, based
on the parties’ common assumptions about Suit Up’s projected five-year
earnings if it remained under Anderson’s ownership. The valuator found
the projections to be reasonable based on a financial analysis of
historical results, forecasts and industry trends.
Next, the valuator interviewed key managers
at both companies and estimated that unrestricted competition by
Anderson would cause the earnings of Sporting Life’s new division to
decline by approximately 60% in the first year after the sale. He also
estimated that Sporting Life would gradually recover the earnings over a
three-year period.
Finally, the valuator talked to Anderson.
Noting his entrepreneurial bent, the valuator estimated that, if
Anderson did not commit to a non-compete agreement, there was an 80%
chance that he would compete with Sporting Life during the first year
after the purchase. The valuator further estimated that, if Anderson did
not compete in the first year, the likelihood that he would compete
would decrease to 40% by the third year.
The valuator considered the future
probability of competition and factored it into the valuation proposal.
He was then able to determine the yearly dollar value of the earnings
that Sporting Life would lose in unrestricted competition with Anderson,
and he was able to report to the parties the fair market value of the
non-compete agreement.
Retaining a valuation professional during
the sale negotiations allowed Sporting Life to determine the value of
the non-compete agreement before it finalized the sale. It also helped
Sporting Life make its overall acquisition decision.
In the event of a breach from the original
contract, Sporting Life is protected in two ways. If Anderson were to
violate the non-compete agreement, Sporting Life could stop paying
compensation to Anderson. The company could also take legal action
against Anderson to force him to honor his agreement.
As you are negotiating the price of the
company and developing your non-compete agreement, your Schmidt Westergard
business valuation professional can answer your questions and help you
establish an accurate value.
Based in Mesa, Arizona, and serving closely held businesses in the East Valley,
the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is
an independent full-service tax, audit, accounting and business advisory firm
focusing on the middle market.
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