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Valuing Covenants Not to Compete

Posted in Business Valuation, on Feb 2016, By: Mark S. Gottlieb

The guest on Thursday’s episode of The Daily Show, Airbnb CEO Brian Chesky, explained that value in the American economy is becoming less associated with ownership and more associated with experience. Airbnb has revolutionized travel and hospitality by allowing users to pay to stay in the homes of other users, rather than in hotels. Trevor Noah, the host of The Daily Show, joked that Airbnb and other similar organizations are making ownership obsolete: people no longer need to purchase cars, homes, or, now, pay for hotels.

In a serious tone, Chesky explained that this decline in ownership came with an increase in the value of experience. He said that a person’s value is now shown through their Instagram feed rather than the size of their house or worth of their car. Though this shift in value may signify a change in economic ideology, intangible assets, such as experience, have long accounted for a surprisingly substantial amount of a company’s total value.
A company’s intangible assets bring value to the business without having a material presence. Essentially, intangibles come from employees’ experiences.

Types of Intangible Assets

Intangible assets fall under 5 major categories.
The following lists these categories and examples of each:

  1. Marketing-related intangible assets
    •    Trademarks,
    •    Logos, and
    •    Domain Names.
  2. Consumer-related intangible assets
    •    Customer information, and
    •    Customer relationships.
  3. Artistic-related intangible assets
    •    Literary/musical/visual art works, and
    •    Performance events.
  4. Contract-based intangible assets
    •    Use rights,
    •    Licensing agreements,
    •    Franchise agreements, and
    •    Employment contracts.
  5. Technology-based intangible assets
    •    Patented technology, and
    •    Trade-secrets.

Importance of Intangible Assets

Unlike tangible assets, intangibles are generally characterized by increasing returns of scale, which means they can be used repeatedly without losing value. These increasing returns come hand-in-hand with increasing risk as the abstract nature of these assets makes them very easy to lose. In order to avoid losing these assets, it has become common practice for business owners to issue restrictive covenants that inhibit an employee’s ability to compete with the employer. These agreements often take the form of “covenants not to compete,” which prevent the employee from working with a competitor of the employer for a certain amount of time after the termination of their employment.

Covenants Not to Compete

“Covenants not to compete” and other restrictive agreements have the potential to reduce the risk related to business acquisitions, encourage employees to stay with the employer, and minimize the impact of employee loses, but there are various factors that can hamper their value.
In order to ensure that a potential restrictive covenant is worth implementing or that an existing agreement is effective in retaining assets, an intensive valuation is essential. Due to the nature of intangible assets, this process incorporates many elements of business valuation and includes the following steps:

1. Intangible assets are valued, usually using the income approach, which compares future cash flow to the rate of return.

2. The value of a prospective or existing covenant is valued using the “with or without” method, which calls for the analysis of potential revenue with a covenant and of potential revenue without a covenant, taking into account a series of factors, such as:

  • Implications of taxes,
  • Impact of timing,
  • Issues with enforceability (i.e. Jurisdictional restrictions), and
  • Nature of the industry.

3. The positive value of the “covenant not to compete” or other restrictive covenant is calculated by:

  • Increase in revenue,
  • Decrease in expenses,
  • Acceleration of development, and
  • Increase in cash flow.

If there is a decrease in revenue, increase in expense, deceleration of development, or decrease in cash flow, the agreement is not valuable.

Once the valuation is complete, the employer is provided with a statement outlining the worth of the company’s intangible assets as well as a description of financial outcomes that would come from issuing a restrictive covenant. This information is essential to negotiate the terms of the agreement and finalize the most financially effective covenant.

In an economy that attributes such a large amount of worth to experience, it is essential to properly evaluate and protect intangible assets. These assets are often the foundation of a business’s value.

If your client requires a business valuation that may include or separately compute the value of a covenant not to compete, please feel free to contact our office at msgcpa@msgcpa.com or 646-661-3800.