BY: Jeffrey D. J ones, ASA, CBA, CBI
Most all transactions involing the sale of a business or a partial ownerwship therein require the selling entity to enter into a Covenant Not To Compete covering a defined territory for a specified length of time to protect the buying entity from potential loss of customers, employees, and future business. For tax purposes, both buyer and seller must agree upon how to value the Covenant Not To Compete so the purchase price can be properly allocated. In the event the seller violates the terms of the covenant, a monitary penalty and/or reduction in the price paid for the entity can be assessed by the courts.
The concept of Fair Market Value assumes a willing seller who will do all the things necessary to facilitate the sale of a business or partial ownership interest therein and a willing generic buyer who expects to be able to obtain and maintain the tangible and intangible assets being acquired.
If the terms of the covenant not to compete are reasonable, and if the seller is truly being compensated for giving up his/her right to forego opportunities that would place him/her in competition with the purchaser, then the payment allocable to the covenant constitutes ordinary income to the seller, and the buyer is entitled to amortize the cost of the covenant over a 15 year period.
The value allocated to the covenant must reflect economic reality. In making this determination, the courts have looked to the same factors as those listed in the IRS code specifying the “economic reality test.” The value of the covenant to the purchaser comes from the continued profitability and the likelihood of survival of the acquired business. The value to the seller, on the other hand, is measured by the opportunities foregone to reenter a particular market for a given period.
One method to value a covenant is the compensation-based approach. Under this method, the covenantor’s (seller’s) average compensation (including salary, bonuses, and benefits) is calculated. This amount is projected over the life of the covenant, and a discount rate is applied to adjust the figure to present value. This method measures the loss of earnings anticipated by the seller as a result of his forbearance from competing in the specified market.
In some complex buy-sell agreements, however, a court may find the compensation-based approach too simplistic. A second method calculates the present value of the economic loss to the buyer on the assumption that the seller reentered the market. Such an approach was sanctioned by the Tax Court in Ansan Tool and Manufacturing Co. v. Commissioner, T.C. Memo. 1992-121, where the compensation-based method was determined inadequate for the unique arrangement between the taxpayer and the seller in a stock buyout.
There are situations where the same parties execute both a covenant not to compete and an employment contract. Both agreements need to be evaluated carefully because their provisions may overlap, and thus, so may their values. An employment agreement may convey similar benefits and cover the same time period as a covenant not to compete, and arguably its value is not separate and distinct from the value of the covenant.
Any consideration paid for a bonafide covenant not to compete forms the cost basis of a fixed-life, depreciable intangible asset. However, a covenant not to compete is not amortizable unless the objective facts show that (1) the covenant is genuine, i.e., it has economic significance apart from the tax consequences, (2) the parties intended to attribute some value to the covenant at the time they executed their formal buy-sell agreement, and (3) the covenant has been properly valued.
The value of a covenant not to compete or the lack thereof can be determined by measuring the economic impact on the business during the period of the covenant. Texas courts have generally restricted covenants not to compete to no more than five years on the basis of not wanting to prevent a person from being able to earning a living at their chosen profession for long periods of time. Furthermore, covenants are limited to the market area in which the business is currently doing business and/or to those customers and clients being served by the subject business. The measure of impact on future earnings for the next five years can be determined as follows.
- Develop a Discount Rate for the lack of a covenant not to compete that reflects the risk factors
of a seller reentering the market place and competing with the subject Company resulting in
economic damages.
- Forecast future earnings for the specified period covered by the covenant not to compete.
- Determine the present value of future earnings for the subject Company for a period equal to
the term of the covenant not to compete.
- Apply the Discount Rate for Lack of A Covenant Not to Compete to the present value of the
forecasted earnings.
While the process seems straight forward, the actual analysis and development of the economic damages for a lack of a covenant not to compete should be conducted by an experienced business appraiser who is well versed in these methodologies and founded in the economic reality of the market place.
Jeff is President of Certified Appraisers, Inc. and Advanced Business Brokers, Inc. 10500 Northwest Frwy., Suite 200, Houston, TX 77092 713-680-3290, [email protected]
