Often business buyers and sellers include a seller non-compete agreement within the business purchase terms. Because a non- compete covenant can be considered an acquired
intangible asset from the seller and be amortized for cost recovery for federal tax purposes, a savvy business buyer needs to understand the importance of this business purchase agreement component.
What is a “Non-Compete Agreement”?
A business seller agrees to not participate or compete with the buyer of his business in the same market, industry, geography or product niche his business has historically participated for a stipulated period of time. When this agreement is included in the business purchase contract it is often called a “covenant not to compete” or a “non-compete” agreement. If this agreement meets certain conditions, it can be defined as an acquired amortizable intangible asset for the buyer. Consequently, it will be subject to specific cost recovery requirements from the U.S. Internal Revenue Service.
Allocation of Purchase Value of a Business
In many business purchase agreements, a portion of the lump sum purchase price is allocated to the covenant not to compete. An experienced business buyer, when ready to make a purchase offer, will be keenly aware of how best to allocate the purchase value of the business under consideration and what value portion goes to the non-compete covenant.
The purchase price of the business will be allocated among various asset classifications to be purchased. Typically, assets are divided between tangible or “hard assets” and intangible or “soft assets”. For illustration purposes, hard assets are items of physical presence and potential use in the operation of the business; equipment, furniture, inventory and vehicles. Soft assets often include goodwill, intellectual property and non-compete covenants.
It is also important for the business buyer to evaluate non-compete agreement values because the IRS has declared that intangible assets, with few exceptions, must be depreciated over a 15 year period, more than twice as long as most tangible business assets.
Changes in federal tax code have significantly reduced the adverse tax interests of business buyers and sellers, however more IRS scrutiny is put on business purchase price allocations to covenants not to compete because often the business buyer wants an unreasonably large value allocation put on the non- compete agreement to reduce his future tax burden made via higher amortization expenses in future business accounting periods.
How Do I Determine a Non-Compete Value?
A business buyer needs to define and attempt to quantify how much “damage” the business seller and his key associates, could realistically inflect on his new business if there is no non- compete agreement in the purchase transaction to determine a non-compete agreement value. Usually a thorough assessment of the seller’s CEO and senior management can lead to a reasonable sales revenue loss assessment.
A seasoned business valuation consultant can, “earn his keep” in this area. Converting potential revenue losses due to a lack of a non-compete agreement into potential earnings losses is not that clear cut when factoring in various fixed cost and variable expense ramifications and scenarios. Merely multiplying the projected profit margin by the potential projected sales reductions will not get you a valid “damage” assessment. A well-thought-out, comparative, discounted net cash flow analysis over the non-compete agreement time frame is fundamental to determining the fair market value of a given non-compete agreement.
Determining the fair market value of a non-compete agreement is a complex process and is determined by many diverse elements related to the business buyer’s perceived valuation of the business seller’s; financial and human resources, motivations to compete, relationships with key existing customers and ability to use or access critical innovative technology or information.
Obviously the term of the non-compete agreement is critical to the business buyer. Like a call option on a stock, the longer the term to contract expiration the more the business buyer will have to pay. Time frame determination variables to consider in establishing a non-compete agreement term are: seller reasons for sale, the span of key executives willing to sign non-competes, current positions of existing products in their typical life-cycles, expiration of key patents, the cost to effectively enter and compete in the targeted industries and the related term of seller financing in the deal.
Finally, if you are either a seasoned business buyer or someone with no business acquisition experience, it is most prudent to use professional assistance to define non-compete covenant structure, valuation and amortization processes. Having proven, certified experts who represent “3rd party”, objective opinions to the business seller will significantly enhance your ability to establish favorable purchase terms for the business you seek.