Covenants not to compete.

Before the Tax Reform Act of 1986, covenants not to compete were a critical part of the sale of many business. A buyer preferred to include such an agreement in the contract of sale, since the value could be amortized over the agreement's life. A seller preferred to allocate a portion of the purchase price to other assets, such as goodwill, which would be eligible for capital gain treatment on the business's sale.

Since the elimination of favorable tax rates for capital gains, covenants have had a much less controversial role in the sales of businesses. However, the recent regulations governing the allocations of purchase prices in asset acquisitions once again have highlighted the importance of properly valuing and substantiating such agreements. The Internal Revenue Service is again scrutinizing these agreements, to ensure both that they have economic substance and that these amounts should not be allocated instead to goodwill.

VALUATION

If a covenant not to compete is part of an asset acquisition, information on this agreement (such as the type of arrangement and the maximum consideration) must be disclosed.

The key element to this reporting requirement is obviously how to value the covenant (and how to substantiate this value). Ultimately, this involves identifying the elements that create value and determining the impact the seller would have on the value of the acquired business if he was free to compete against the business.

In general, there are three approaches to valuation: cost, market and income. The value of a covenant not to compete is most often determined under the income approach; the specific amount is based on the cash flow that would be lost if the covenant did not exist and the seller could compete with the buyer. This amount is computed on an aftertax basis and is adjusted to reflect the tax savings from amortizing the covenant over its contractual life.

NOTE: Appraisals should be independent and done by qualified valuation professionals.

It must be proven the covenant has value apart from the sale of the business and a determinable and limited life. Among the factors considered are

* The type of business.

* The seller's ability to compete.

* The seller's intention or willingness to compete, if the covenant did not exist (as evidenced by the negotiations between the buyer and seller).

* The ease of entry into the business or industry.

* Customer relationships with the seller.

* Form of payment.

* The enforceability of the covenant under state law.

These factors should be analyzed as of the acquisition date. It is possible to value them after the fact; however, the information on the business position, capabilities, competitive advantages and the buyer and seller's intentions must still relate to the date the business was transferred.

LENGTH OF THE COVENANT

One of the factors usually subject to negotiation is the length of the covenant. Generally, the only requirement that must be met is that this period of time be reasonable.

The seller must carefully analyze the economic impact of his competition on the business sold. Often, this impact is greatest in the early years following an acquisition. At the same time, the buyer may be able to realize significant tax benefits over the short term. In such situations, a covenant that lasts a short time may be beneficial to both buyer and seller.

OTHER ISSUES

Several issues should be taken into consideration to determine the terms and provisions of a covenant not to compete.

Allocations to covenant should not be proportionate to each selling shareholder's stock interest. Each shareholder should be dealth with separately, and the terms of each covenant should reflect this.

A separate value for the covenant not to compete should be negotiated. That is, the total purchase price should not be negotiated first and then split between the business and the covenant. The value of the business and the covenant should be substantially greater than the amount paid for the business without the covenant.

The value of a covenant not to compete should be distinct from value attributable to any other intangible assets.

Covenants not to compete are often negotiated in connection with consulting or employment agreements. When they are, the two agreements should be negotiated separately and the value of each separately determined.

For a discussion of these agreements and other recent developments, see the Tax Clinic, edited by Roy Harrill, in the November 1990 issue of The Tax Adviser.