levitra"> levitra"> Risk Criteria and Valuation Methods for Valuing Covenants Not to Compete, Pt. 2

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Risk Criteria and Valuation Methods

Risk Criteria and Valuation Methods

for Valuing Covenants

Not to Compete, Pt. 2

By: Jeff Jones

Mutual Intent Test

Where 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 called for.

The 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.

Mutual 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.

Valuation Issues

From 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 covenant. While 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 jeopardy. Then the value of the covenant, if any, is considered to be a deduction from the price paid for the business.

The 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,[19] 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.

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 discussion of the economic reality test.

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