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.

The value of the covenant to the purchaser comes from the increased profitability and the likelihood of survival of the newly-acquired enterprise that the covenant affords. The value to the seller, on the other hand, is measured by the opportunities foregone to reenter a particular market for a given period.

Courts will also look to the value claimed for the covenant relative to the values of the other assets acquired. For example, in Dixie Finance Co. v. United States,^[20] a 1973 5th Circuit case, the amount that the taxpayer allocated to the stock purchase was less than its fair market value, the court refused to allocate any of the purchase price to a covenant not to compete. Other cases have found that the excess purchase price paid for the assets was allocable to a covenant where the buyer was not interested in acquiring the goodwill of the seller, and thus the goodwill had a zero value.

Finally, 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.

VALUATION METHODS

Any consideration paid for a bona fide 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.

One method of valuing 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 a court may find the compensation-based approach too simplistic. Another method is to value what the buyer acquired, protection of the continued profitability of the business from the seller’s hostile use of his or her contacts in the market. This 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.

A version of the above method of valuation, which I will call Present Value of Economic Damages, includes first determining the fair market value of the subject business based on the assumption that the seller is willing to sign a complete covenant not to compete. Then estimate the present value of the economic damages over the economic life of the covenant which forms the basis of the discount applied to the fair market value of the subject company assuming a complete covenant not to compete. This discount is called Discount for Lack of Covenant Not To Compete (DFLCNC). The size of the discount will depend upon the terms of the covenant, and the economic risks that the seller will compete, or is allowed to compete, in the same or similar business.

The terms of a covenant not to compete are often negotiated. Case law typically limits the term of covenants to five years and to geographical areas currently being served by the subject company. A complete restrictive covenant will typically restrict the seller from working for a competitor, opening a competitive business, or being a owner, partner, or shareholder in the same or similar business. Sellers and buyers can and often do negotiate the terms of covenants where the term is less than five years, the geographic area is narrowed, and the scope of work that the seller is allowed to do is broadened. The price is often negotiated downward to account for these narrowing factors. As an example, a non-piracy covenant would typically restrict the seller from hiring any employees of the subject business and prevent the seller from serving existing customers for the term of the covenant; however, the seller would be allowed to work in the same or similar business and in the same geographic market area. Under the limited covenant, the seller is allowed to continue to earn a living within his chosen profession while being adequately reimbursed for giving up the subject company and not being able to hire their employees or take their customers. The non-piracy covenant overcomes the marital case law issue of not allowing value of covenants to be a divisible asset where it would restrict the seller or hypothetical seller from earning a living within his chosen profession.

The procedures for conducting the Present Value of Economic Damages method include the following:

1. Review the provisions of the covenant not to compete.

2. Determine the stated term of the covenant and verify its reasonableness.

3. Determine whether the restrictions represent a complete or limited covenant.

4. Forecast earnings on either a pretax or after tax basis over the economic life of the covenant

assuming no discount for a restrictive covenant.

5. Determine the economic damages for each year of the forecast earnings based on a rigorous

analysis of the risks associated with the seller's ability to complete with the subject company.

The lost earnings, due to the lack of a complete covenant not to compete, represent the lost

earnings for each year of the forecast.

6. Determine the present value of each year’s economic damages using the company's cost of

capital adjusted for the same level of earnings used in the forecast.

7. Determine the value of the covenant not to compete, by deducting the present value of the

economic damages resulting from the lack of a compete covenant, from the fair market value

of the business, assuming a complete covenant not to compete.

Table One is an abbreviated summary of the factors that make up the risk analysis of the seller's ability to compete with a subject company. The chart reflects the rigorous risk analysis used to determine the economic damages..

Table Two reflects a worksheet used to forecast future earnings, develop the economic damages, and calculate the present value of the economic damages. Note that in the given example, earnings have been forecast on a pretax basis, and the cost of capital used to present value the earnings have also been adjusted to a pretax rate.

There is a growing need to value covenants not to compete. It is likely that more sophisticated methodologies will be developed in the near future; however, in the final analysis, any method used to value covenants must meet the criteria outlined in this presentation.

SUMMARY

Covenants not to compete must be carefully drafted to be legally enforceable and meet the IRS requirements for price allocation and permitted amortization. Covenants must meet the legislative and case law test of reasonableness to be enforceable. Furthermore, covenants must pass the U.S. Internal Revenue Code's test of economic reality and mutual intent for price allocation and amortization. When the covenant meets these tests, the analysis can then utilize valuation methodology to determine economic damages due to breaches of a covenant or allocation of purchase price to meet legal and/or tax allocation.

Determining the value of a covenant not to compete or the economic impact for the lack thereof can be determined using a present value concept for the loss of future earnings. The procedures of this method include determining the present value of the loss of future earnings during the forecast of future earnings. Such a method was sanctioned by the Tax Court in Ansan Tool and Manufacturing Co. v. Commissioner, T.C. Memo. 1992-121.

The factors needed to determine the present value of the economic loss due to the lack of a complete covenant not to compete include:

* A base value of the subject Company given the assumption that the seller is willing to sign a

covenant not to compete which would completely restrict the seller from reentering the market

* A measurement of the seller’s ability to reenter the market and effectively compete with the

subject Company

* A forecast of future earnings for the subject Company, given the level of competition expected

by a seller who has reentered the market during the restricted period

* A discount rate applicable to the level of earnings reflecting cost of capital

In the final analysis, any method used to value covenants must meet the criteria outlined in this presentation.

Notes:

1. Valiulis, Anthony C. Covenants Not To Compete, Forms, Tactics, And The Law. New York:

John Wiley & Sons, Inc., 1985.

2. Rogers v. Parrey, 2 Bulst. 136, 80 Eng. Rep. 1012 (K.B. 1613)

3. Seline v. Baker, 536 S.W. 2nd 631 (Tex. Civ. App. 1976); O'Sullivan v. Conrad, 44 Ill. App. 3rd 752, 358 N.E.2d 926 (1976); Flower Haven, Inc. v Palmer, 502 P.2d 424 )Colo. Ct. App. 1972)

4. 127 Ala. 110, 28 So 669 (1899)

5. 85 F. 271 (6th Cir. 1898), modified, 175 U.S. 211 (1899)

6. Thomas W. Briggs Co. v. Mason, 217 Ky. 269, 275-78, 289 S.W. 295, 297-98 (1026).

7. United Tool & Indus. Supply Co. v. Torrisi, 356 Mass. 103. 248 N.E.2nd 266 (1969).

8. Keller v. California Liquid Gas Corp., 363 F. Supp. 123 (D. Wyo. 1973).

9. Id.

10. Garcia, Ernest C. and Fred A. Helms. "Covenants Not To Compete & Not To Disclose." Texas Bar Journal, January 2001, pp. 32-43.

11. Light v. Central Cellular Co. of Texas, 883 S.W.2d 642 (Tex. 1994).

12. Zip Manufacturing co. v. Harthcock, 824 S.W.2d at 647 n. 14.

13. Rathmell v. Morrison, 732 S.W.2d 6 (Tex. Civ. App. Houston 14th Dist., 1987)

14. In re the Marriage of Mally. (2001 Iowa App. Lexis 338 (Iowa Ct. App., May 23, 2001)

15. Kriesfeld v. Kriesfeld. 588 N.W. 2nd 210, 8, Neb. App. 1, (Jan. 5, 1999)

16. In re Marriage of Monaghan. 78 Wn. App. 918, 899 P.2d 841, 1995 Wash. App.

17. Mart v. Severson. 2002 DJDAR817

18. Schulz v. Commissioner, 294 F.2d 52, 54 (9th Cir. 1961).

19. In Welch v. Helvering, 290 U.S. 111 (1933).

20. Dixie Finance Co. v. United States, 474 F.2d 501 (5th Cir. 1973),