Finding the Value of a Noncompete Agreement

Noncompete agreements help businesses retain valuable employees, safeguard inside information and prevent unfair competition. But although they’re designed to protect companies, they can also put them at great risk if they’re not properly structured and maintained.

It can be important to determine the value of a non-compete agreement in many situations, including in a business transaction or sale, or for financial reporting or tax purposes. Professional valuators may use several methods to value these intangible assets.

The basics

A non-compete agreement (or “covenant not to compete”) is a contract between an employee and an employer. The idea is that the employee agrees not to compete with the employer for a certain time period and within a specified geographic area.

When valuing a noncompete, an appraiser considers several factors. These include the value of the overall business, the probable damages a breach might cause, the likelihood of competition, and the enforceability of the non-compete agreement.

Different scenarios

Competition from a former employee or seller who didn’t sign a non-compete agreement could potentially force a company out of business. So the value of the entire business represents the absolute ceiling for the noncompete’s value. Most likely, a key employee or seller couldn’t steal 100% of a business’s profits. Plus, tangible assets possess some value and could be liquidated if the business failed.

Thus, the next benchmark is estimating how much business the seller or a key employee could take during the term of the non-compete agreement. Often an appraiser runs two separate discounted cash flow scenarios. The difference between cash flows with and without a noncompete in place represents a second ceiling for the noncompete’s value. Factors the valuator considers when preparing the different scenarios include the company’s competitive and financial position, business forecasts and trends, and the individual’s skills and customer relationships.

Factors to consider

Next, the appraiser multiplies each differential by the probability that the seller or key employee will subsequently compete with the business. If the party in question has no incentive, ability or reason to compete, the non-compete could be worthless. Factors to consider when predicting the threat of competition from a seller or key employee include the person’s:

• Age, health, job satisfaction and financial standing,
• Postemployment (or post sale) relocation and employment plans,
• Alternative business ventures, and
• Previous competitive experience.

The sufficiency of sales proceeds will also come into play. In addition, the appraiser should ask an attorney whether the noncompete clause is legally enforceable. Generally, non-compete agreements can be enforced only if the restrictions are reasonable. For instance, courts have rejected noncompetes that cover an unreasonably large territory or are for an unusually long time period.

“Reasonable” varies from business to business, based on the characteristics of the business, state statutes and case law, and agreement terms. Employers must update agreements regularly and strictly enforce all breaches in accordance with the stated terms. If they don’t, their noncompetes may become unenforceable.

Noncompetes help smooth the way

Noncompete agreements can help smooth transitions within companies. They can also help with transactions after a merger or acquisition closes — but only if buyers and sellers are equally satisfied with the financial results.