Risk Criteria and Valuation Methods
Criteria and Valuation Methods
Not to Compete, Pt. 2
a covenant not to compete was agreed to between the parties, but no specific
amount of consideration has been allocated to the covenant, courts have looked
to the "mutual intent" test to determine whether some allocation is
mutual intent test looks at whether the parties to the buy-sell agreement
mutually agreed that some portion of the total consideration paid for the going
concern was intended for the covenant not to compete. This test is applied where
the agreement contains a covenant not to compete, but the purchase price is
stated as a lump sum for the entire transaction, i.e., there is no express
allocation of a specific amount to the covenant.
intent is usually found where the parties bargained over the inclusion of the
covenant not to compete, or where it was understood that the covenant was an
essential part of the agreement. The "economic reality test" plays a
role in this inquiry.
The covenant not to compete must also have some independent basis in fact
such that the parties might bargain for it.
the standpoint of valuing covenants not to compete, the basis is usually
economic damages which is a negative concept.
They represent payments for "negative" services.
It is a negative value deducted from the fair market value of the
business which assumes a complete covenant.
Often the courts and many appraisers have mischaracterized the value of
covenants as value separate and apart from the business.
If there had been no business there could not have been any value to a
it is possible to value covenants, they must be in conjunction with a business
that has confidential information to protect and/or business goodwill at
the value of the covenant, if any, is considered to be a deduction from the
price paid for the business.
value assigned to a covenant not to compete should be carefully scrutinized for
economic reality. Valuation becomes an issue when the allocation by one or both
parties appears to be excessive.
The taxpayer has the burden of proving that he is entitled to a
deduction. In Welch v. Helvering, a 1933 federal tax case, the
court determined that because the amount paid for a covenant not to compete
represents compensation to the covenantor, the taxpayer bears the burden of
proof for establishing the proper amount attributable to the covenant.
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 discussion of the economic reality test.
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