Valuing noncompetes in business combinations

Purchase price allocations are an important part of negotiating a successful M&A transaction. The value of most assets — such as receivables, inventory and equipment — may be fairly straightforward. But the value of noncompete agreements is often a sticking point.

To complicate matters, the buyer and seller may have conflicting tax objectives. This is because the buyer must amortize the amount allocated to noncompetes over 15 years, whereas the seller must recognize the allocation as ordinary income.

When the buyer and seller allocate different amounts to a noncompete agreement on their respective tax forms, they may trigger unwanted attention from the IRS. An objective business valuation professional can help the parties come to an agreement on the allocation amount before the deal closes.

Factors to consider

Under a noncompete agreement, the seller agrees not to compete with the buyer within a specified geographic area for a certain time period (usually five years or less). When valuing noncompetes, experts consider the:

• Value of the overall business,
• Probable damages a breach might cause,
• Likelihood of competition, and
• Enforceability of the noncompete agreement.

Generally, noncompete agreements can be enforced only if the restrictions are reasonable. For example, some courts may reject noncompetes that cover an unreasonably large territory or long period of time.

What’s “reasonable” varies from business to business, requiring specific consideration of the business, the terms of the agreement, state statutes and case law. For example, California and a handful of other states restrict the use of noncompete agreements in certain circumstances.

With-and-without approach

Without a noncompete agreement, the worst-case scenario is that competition from a seller will drive the company out of business. Therefore, the value of the entire business represents the absolute ceiling for the value of a noncompete.

Most likely, a seller couldn’t steal 100% of a business’s profits. Plus, tangible assets possess some value and could be liquidated if the business failed. So, when valuing noncompetes, experts typically run two discounted cash flow scenarios — one with the noncompete in place, and the other without.

The expert then computes the difference between the two expected cash flow streams. Factors to consider when preparing the different scenarios include the company’s competitive and financial position, business forecasts and trends, and the seller’s skills and customer relationships.

Likelihood of competition

Next, each differential must be multiplied by the probability that the seller will subsequently compete with the business. If the party in question has no incentive, ability or reason to compete, the noncompete can be worthless.

Factors to consider when predicting the threat of competition include the seller’s age, health, financial standing and previous competitive experience. The expert also will consider any post-sale relocation and employment plans.

Get it right

Noncompete agreements should be a forethought, not an afterthought, in M&As. Contact us to help negotiate a purchase price allocation that’s right for your situation.

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