Noncompete agreements can be valuable to a business. They help retain key employees, safeguard inside information, protect a company’s assets and prevent unfair competition. However, assigning value to these contractual arrangements can be complicated. Here’s the approach business valuation experts generally use for these intangible assets.
A noncompete agreement (or “covenant not to compete”) is a contract between an employee and an employer. The employee agrees not to compete with the employer for a certain time period and within a specified geographic area. Noncompete clauses also may be entered into by buyers and sellers as part of a merger or acquisition (M&A) transaction.
For example, Jan is the research and development manager of a chemical company. As a condition of her employment, she signs a contract, agreeing not to work for any competing business in the United States for a two-year period following any prospective departure.
The value of a noncompete also might be relevant in divorce cases. Some jurisdictions exclude goodwill (or, more often, the portion of goodwill that’s linked to individual owners) from an owner’s marital estate. The value of a noncompete agreement may be used to approximate the value of so-called “personal” goodwill.
When valuing noncompetes, financial experts consider the:
Without a noncompete agreement, the worst-case scenario is that competition from a former employee or 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 key employee or 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 individual’s skills and customer relationships.
Likelihood of competition
Next, each differential must be multiplied by the probability that the key employer (or seller in an M&A) 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 individual’s age, health, job satisfaction, financial standing and previous competitive experience. The expert also will consider any postemployment (or postsale) relocation and employment plans.
It’s also important to consider whether the noncompete clause is legally enforceable. 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, state statutes and case law, and agreement terms. For example, it may violate the law for an employer to ask an employee to sign an agreement before making a full-time job offer. Plus, California and a handful of other states restrict the use of noncompete agreements in certain circumstances.
In addition, 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.
Building a better deal
Noncompete agreements should be a forethought, not an afterthought, in M&As. Effective agreements can benefit sellers by making the business more attractive to potential buyers. They can also provide a buyer with assurance that it won’t spend millions of dollars on an acquisition, only to watch the management team leave and open a competing business shortly thereafter.
Contact a business valuation expert for more information. He or she can help value a noncompete for purposes of a divorce, M&A negotiations and postsale financial reporting.
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