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.
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.
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