My first in-depth experience in understanding non-compete agreements (many years ago) was in graduate school. At that time, the examples given only included transactions between large, publicly held companies. As a business valuation expert, I found that non-compete agreements involving closely-held businesses to be “standard fair” -particularly when the seller is not of retirement age.
Non-compete agreements can help businesses retain valuable employees, safeguard inside information and prevent unfair competition. But although they’re designed to protect companies, they can also put them at great risk if they’re not properly structured and maintained. It can be important to determine the value of a non-compete agreement, particularly in instances of a business’ sale, financial reporting requirement, or for tax purposes. As a valuation expert we use several methods to value these intangible assets; and attorneys should have a basic understanding of the issues related to same.
The basics
A non-compete agreement (or “covenant not to compete”) is a contract between an employee and an employer. The idea is that the employee agrees not to compete with the employer for a certain time period and within a specified geographic area.
When valuing a non-compete, one should consider several factors.
These include, but are not limited to:
1. The value of the overall business,
2. The probable damages a breach might cause,
3. The likelihood of competition, and
4. The enforceability of the noncompete agreement.
Different scenarios
Competition from a former employee or seller who didn’t sign a non-compete agreement could potentially prevent that business from achieving its expected earnings or even force a company out of business. So the value of the entire business represents the absolute ceiling for the non-compete’s value.
The next benchmark is estimating how much business the seller or a key employee could take during the term of the non-compete agreement. Often an appraiser runs two separate discounted cash flow scenarios. The difference between cash flows with and without a non-compete in place represents a second ceiling for the non-compete’s value.
Factors that are considered when preparing the different scenarios include:
1. The company’s competitive and financial position,
2. Business forecasts and trends, and
3. The individual’s skills and customer relationships.
Factors to consider
The valuation model should consider multiplies of each differential by the probability that the seller or key employee will subsequently compete with the business. If the party in question has no incentive, ability or reason to compete, the non-compete could be worthless.
Factors to consider when predicting the threat of competition from a seller or key employee include the person’s:
1. Age, health, job satisfaction and financial standing,
2. Postemployment (or postsale) relocation and employment plans,
3. Alternative business ventures, and
4. Previous competitive experience.
The sufficiency of sales proceeds will also be a meaningful measurement. In addition, one should consider whether the non-compete clause is legally enforceable. Generally, non-compete agreements can be enforced only if the restrictions are reasonable. As an attorney you are already aware that the courts have rejected non-competes that cover an unreasonably large territory or a long time period.
What’s “reasonable” varies from business to business, based on the characteristics of the business, state statutes and case law, and agreement terms. Employers must update agreements regularly and strictly enforce all breaches in accordance with the stated terms. If they don’t, their noncompetes may become unenforceable.
Noncompetes help smooth the way
Non compete agreements can help smooth transitions within companies. They can also help with transactions after a merger or acquisition closes — but only if buyers and sellers are equally satisfied with the financial results. An experienced valuation expert can provide reassurance that the non-compete agreement is valued appropriately.
For additional information on the valuation of non-compete agreements or any other issues related to business valuation, forensic accounting or litigation support please feel free to contact our office at the above phone numbers. You can also email our office at msgcpa@msgcpa.com for immediate assistance.