Purchase price allocations are an important part of negotiating a successful M&A transaction. The value of most assets — such as receivables, inventory, and equipment — may be fairly straightforward. But the value of noncompete agreements is often a sticking point.
To complicate matters, the buyer and seller may have conflicting tax objectives. This is because the buyer must amortize the amount allocated to noncompetes over 15 years, whereas the seller must recognize the allocation as ordinary income.
When the buyer and seller allocate different amounts to a noncompete agreement on their respective tax forms, they may trigger unwanted attention from the IRS. An objective business valuation professional can help the parties come to an agreement on the allocation amount before the deal closes.
Factors To Consider
Under a noncompete agreement, the seller agrees not to compete with the buyer within a specified geographic area for a certain time period (usually five years or less). When valuing noncompetes, experts consider the following:
Generally, noncompete agreements can be enforced only if the restrictions are reasonable. For example, some courts may reject noncompetes that cover an unreasonably large territory or long period of time.
What is reasonable varies from business to business, requiring specific consideration of the business, the terms of the agreement, state statutes, and case law. For example, California and a handful of other states restrict the use of noncompete agreements in certain circumstances.
With-and-Without Approach
Without a noncompete agreement, the worst-case scenario is that competition from a seller will drive the company out of business. Therefore, the value of the entire business represents the absolute ceiling for the value of a noncompete.
Most likely, a seller could not steal 100% of a business’s profits. Plus, tangible assets possess some value and could be liquidated if the business failed. So, when valuing noncompetes, experts typically run two discounted cash flow scenarios — one with the noncompete in place, and the other without.
The expert then computes the difference between the two expected cash flow streams. Factors to consider when preparing the different scenarios include the company’s competitive and financial position, business forecasts and trends, and the seller’s skills and customer relationships.
Likelihood of Competition
Next, each differential must be multiplied by the probability that the seller will subsequently compete with the business. If the party in question has no incentive, ability, or reason to compete, the noncompete can be worthless.
Factors to consider when predicting the threat of competition include the seller’s age, health, financial standing, and previous competitive experience. The expert also will consider any post-sale relocation and employment plans.
Get It Right
Noncompete agreements should be a forethought, not an afterthought, in M&As. Contact us to help negotiate a purchase price allocation that is right for your situation.
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Our firm provides the information in this article for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisors. Before making any decision or taking any action, you should consult a professional advisor who has been provided with all pertinent facts relevant to your particular situation. Tax articles in this blog are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided “as is,” with no assurance or guarantee of completeness, accuracy or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability and fitness for a particular purpose.
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