The Value of a Covenant Not to Compete

By Tom Ochsenschlager

Inselling a family business, owners often overlook one of their most important assets.

A NON-COMPETE covenant is one of the most important intangible assets of a familyowned business. Yet in negotiations for the sale of some businesses, it is frequently overlooked byboth the buyer, who stands to benefit the most from the covenant, and the seller, who doesn'tappreciate what he too can gain.

The retiring owner, eager to be free of the business, often settles for an up-front payment for"good will" that is something less than he could rightfully demand. The buyer, on the other hand,believing the seller has no intention of going into business again, doesn't insist on a non-competeclause. Six months later, the old owner, tired of golf, is back from Florida and setting up shop inthe same business.

For buyers, the covenant represents protection from their potentially toughest competitor, theseller. The buyer also receives tax benefits-though these may now be in jeopardy, as we will see,because of legislation pending in Congress. For sellers, covenants can provide regular income and achance to start a new company.

When a family business is being sold, whether it be the stock of the company or its assets, thebuyer and seller are likely to focus on the value of tangible assets. If they do consider"intangibles," they talk mostly about the general category of good will, without breaking it down intoits components.

Buyers and sellers have no trouble assigning value to such capital assets as machinery. They mayalso appreciate that a patent for a unique product with strong sales is valuable and should beseparately appraised; a patent, after all, comes with ribbons and impressive legal papers and is oftenthe very foundation of a business. In many transactions, however, the parties do not attempt to assignvalues to other, less visible assets that contribute to the company's earning power.

In family owned companies the earning power of the good will often relates to the unique abilitiesof the family members who are active in the business. Perhaps the father is particularly skilled inthe manufacture of the product. The daughter may have crucial marketing contacts; the son may haveimportant relationships with vendors.

In sale agreements, buyers and sellers should negotiate the value of these skills and specialrelationships, and assign specific values to them that are separate from the catch-all category ofgood will.

The most common kinds of separate intangibles are continuing employment agreements and covenantsnot to compete. The continuing employment agreement is most appropriate when the buyer believes hecannot easily replace one of the owners and wants to hire that person for a time until a new personcan be found. For instance, if the daughter has close ties to important customers, the buyer mightwant to retain her to make a smooth transition.

More often, the buyer believes he can replace the seller's skills and is more worried that theseller will set up a company that will compete with his soon after the transaction is completed. Thusthe need for a non-compete covenant.

The value to be placed on an agreement not to compete for a specific period is negotiated as partof the sale. The negotiations should include a carefully drawn definition of the business; adescription of the geographic area in which the covenant will apply; the number of years in which theaccord will be enforceable. And obviously, the amount of payments and the schedule for payment shouldbe detailed.

The terms of the covenant will vary from business to business, and, of course, the covenant shouldbe drafted with the aid of an attorney experienced in such transactions. Generally, the covenantshould not be too broad or it will be difficult to enforce. For example, the courts would probablyrefuse to enforce an agreement that prohibits the seller from entering any business in the UnitedStates for a period of 10 years. The agreement should restrict the seller only from competing in thesame business, in the geographic area that the present company now serves or can be reasonablyexpected to serve. (The Standard Industry Classification Code is often used to define the business inthe sale agreement.) Typically, covenants apply for three to five years. Be aware, though, that theIRS could challenge a non-compete clause if the seller is not actually a competitive threat-forexample, if he is too old to start a new concern or is in poor health.

 

THE PRIMARY REASON for a covenant is to give the new owner a fighting chance tosucceed with his newly acquired company. There are also tax considerations, however.

For the seller, the income from the covenant payments will be taxed as ordinary income at the timeit is received. If the non-compete is lumped as part of good will and is not broken out as a separateitem, it will be taxed as a long-term capital gain. That should not make a difference to sellers now,while the top rates for income and capital gains taxes are nearly the same (unless the sellers havecapital-loss carry-forwards that would offset the capital gain). If capital gains tax rates are everreduced, as the Administration is proposing, the sellers may prefer not to negotiate a separatecovenant. But under current law, most sellers are likely to be indifferent to whether they receivepayments for good will or for a non-compete covenant.

For the buyer it is a different story. Under current law, payments for the non-compete covenants,if reasonable, can be amortized over the life of the contract. In most cases, that means the paymentscan be deducted over a three- to five-year period. This is in sharp contrast to the tax treatment ofgood will, which cannot be deducted at all. Good will becomes part of the cost of the business,recoverable only when the owner sells or liquidates the company. By allowing deductions of paymentsfor a non-compete covenant, the law thus enhances the after-tax cash flow of the new owners. So thereis a considerable advantage to breaking out from good will the amount attributable to a non-competecovenant.

The two advantages of such a covenant to the buyers-protection against competition and increasedafter-tax cash flow-should thus figure in the price the seller can ask for the business. To the extentthat sellers are aware of them, they constitute valuable assets.

However, the legislation now before Congress would change the rules. It would require buyers toamortize virtually all intangibles, including both non-compete covenants and good will, over a periodof 14 years. Although this improves considerably the tax treatment of good will (previously notdeductible), it makes non-compete covenants covering fewer than 14 years less attractive because itstretches out the deduction.

As now written, the legislation will provide a windfall for large companies, which normally assignmillions to good will on their balance sheets. But it will be less advantageous to small businessowners who are selling their companies and can get higher net proceeds if the buyer is able toamortize these intangibles over a shorter time span.

The bill has the support of Dan Rostenkowski, the chairman of the House Ways and Means Committee,as well as many other Congressmen, and is likely to pass in this session. Our firm believes that itwill be enacted sometime this summer.

Since the legislation would cover all transactions after the date of enactment, there is time tocomplete deals under the current law, while buyers-- and sellers-- can still benefit from the three-to five-year deduction. Because buyers save more if they complete the transaction sooner rather thanlater, sellers should consider trying to persuade them to share some of that savings in return for anearly closing on the deal.

Tom Ochsenschlager is a partner in the national tax office of Grant Thornton in Washington, D.C.The accounting and management consulting firm, which has 50 offices around the country, advises manyfamily owned companies.

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Spring 1992

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