How to value covenants not to compete; the appraiser must put a dollar figure on a series of qualitative assessments.

Valuation consultants often are called on by corporate buyers and sellers to appraise various intangible assets as part of an acquisition. Although an intangible asset appraisal may be necessary for a number of reasons, one of the most common reasons is to allocate the purchase price for tax reporting purposes.

One intangible asset that's appearing more frequently is the convenant not to compete. This is an agreement that precludes the seller from competing with the buyer for a specified time. From a tax perspective, valuing the covenant is particularly advantageous to a buyer because he or she can deduct annually, as an ordinary business expense, the amortized value of the covenant based on its legal life. According to Internal Revenue Code section 167, two conditions must be present for depreciation of an intangible asset to be allowed: The asset's useful life must be limited and it must be possible to estimate its value with reasonable accuracy.

The covenant not to compete presents some unique valuation problems. Its appraised value frequently is subject to detailed review by the Internal Revenue Service. This article discusses some of the reasons for the current increased interest in these valuation issues and provides an example of one method of valuing a typical covenant not to compete.

INCREASED USE OF COVENANTS

The slower pace of mergers and acquisitions in 1989 didn't dampen buyer willingness to pay premiums for companies they acquired. Often a portion of these premiums can be allocated to the covenant not to compete. Premiums are bolstered by buyers who are willing to pay, and even fight for, acquisitions that extend their product line or geographic reach and boost their ability to compete.

A typical covenant not to compete prevents the seller from competing with the buyer for a specified time. There are four elements that must be present to make the covenant a legal, valid and enforceable contract.

1. There must be an offer and an acceptance.

2. Both the buyer and seller must have the legal capacity to make a contract.

3. There must be no evidence of mistake, fraud, undue influence or duress.

4. Consideration, or the exchange of one item of value for another, must be present.

While covenants not to compete can be quite restrictive, they can't be so restrictive as to prevent the seller from earning a living. And the period of restriction must be reasonable; most covenants specify a term between 3 and 10 years.

WHY IS AN APPRAISAL NEEDED?

If consideration must be present to make the covenant a valid contract and if this consideration is specified in the covenant document itself, why is an appraisal advisable to value the covenant not to compete? The answer hinges on some important provisions of the Tax Reform Act of 1986 and on the definition of "value."

IRC section 1060 prescribes special allocation rules for "applicable asset acquisitions." To determine both the buyer's basis and the seller's gain or loss, the purchase price is to be allocated in the same manner as stock purchases treated as asset purchases under IRC section 338(b)(5) and temporary regulation 1.33(b)-2T. This regulation says the purchase price is allocable in the following order:

1. Assets consisting of cash, demand deposits and similar items.

2. Assets consisting of certificates of deposits, marketable securities and similar items.

3. All assets other than those listed in 1, 2 and 4--both tangible and intangible.

4. Assets in the nature of goodwill and going concern value.

A covenant not to compete must be shown to be separate from goodwill to qualify for category 3.

The term "fair market value" is used in both IRC section 338 and temporary regulation 1.338(b)-2T. In general, it's defined as the estimated amount at which the property might be exchanged between a willing buyer and a willing seller--neither being under compulsion and each having reasonable knowledge of all relevant facts. Implicit in this definition is the concept of arm's-length exchange--that is, both parties are well-informed or well-advised and each is acting in what he considers his own best interest.

TAX CONSIDERATIONS

In an acquisition, the fair market value of a covenant not to compete is taxed to the seller at ordinary income rates, while the sale of the rest of the business is taxed at capital gains rates. Before the TRA, sellers were hesitant to agree to a highly valued covenant because ordinary income tax rates were higher than capital gains rates. Buyers, of course, preferred a large value on the covenant because it's an amortizable asset that will yield future tax savings. These adversarial positions created an arm's-length exchange situation and the price specified in the contract therefore was considered to represent strong evidence of fair market value.

Because the TRA taxes all income--including capital gains--at the same rate as ordinary income, a seller now is indifferent about whether he sells the stock of a company or a covenant not to compete. Thus, a greater burden of proof now exists in demonstrating the agreed-on value represents an arm's-length agreement. A qualified appraisal can help.

Valuation consultants, the IRS and the Tax Court all have concentrated on economic substance and the intent of the parties as the controlling factors in determining whether to allocate a portion of the purchase price to a covenant not to compete. Economic substance exists if it can be shown the buyer would not have been willing to purchase the assets or stock without the covenant or would not have paid the price he did without the covenant. The intent of the parties generally can be shown by writing an allocated amount in the purchase agreement.

WHAT THE TAX COURTS SAYS

Several relevant court cases illustrate the important considerations--and the wide range of values--attached to a covenant not to compete.

* In R.A. Hammett, TCM1987-205, the court ruled the amount allocated to a covenant not to compete, although low, properly reflected the intent of the parties. This was a case arising from the purchase of an insurance agency in which $500 of a $200,000 purchase price was allocated to the covenant.

* In James A. Patterson (85-1904, 6th Cir., Feb. 2, 1987), the taxpayer had tried to make an after-the-fact allocation of $1 million of a $19 million purchase price to a covenant not to compete. The U.S. Court of Appeals affirmed a court ruling that when there's no agreement between a buyer and a seller to allocate any part of the purchase price to a covenant, the seller could treat all proceeds as capital gain.

* In an earlier case, Peterson Machine Tool, Inc., 79-TC no. 4, 1982, however, the court placed a value on a covenant not to compete despite the absence of a specific amount in the agreement. The sales contract, however, did state explicitly that covenants not to compete were essential to the consummation of the sale of the business. The court concluded this statement of materiality was sufficient to allocate one-quarter ($70,000) of the purchase price to the covenants.

* In Gene L. Kreider (Docket no. 4389-81, TC Mem 1984-68, Feb. 13, 1984), the court concluded that $454,255 of a purchase price of $1.2 million should be allocated to a covenant not to compete. In this case the court cited the seller's ability to be a formidable competitor if not restricted by the covenant.

These cases illustrate the wide range of values that can be assigned to covenants not to compete. In R.A. Hammett, the value was 0.25% of the purchase price. In James A. Patterson, the court denied an attempt to allocate 5.3% of the purchase price to a covenant. In Peterson Machine Tool, the court allocated 25% of the purchase price to the covenant and in Gene L. Kreider, the court allocated 37.9% of the purchase price.

VALUING A COVENANT NOT TO COMPETE

As with most intangible assets, there's no quick mathematical formula that can be applied to determine the value of a covenant not to compete. There are too many qualitative considerations to consider; the facts and circumstances of each case must be analyzed. Some of the more important questions a valuation consultant should investigate are:

* Will both an employment agreement and a covenant not to compete be included in the language of the contract?

* What's the contract term?

* Who are the parties to the covenant?

* How restrictive is the language?

* How old are the signers of the covenant?

* What technical or industry knowledge do the signers possess?

* How well known in the industry are the signers?

* Does the seller possess an "entrepreneurial" bent?

* How long has the business been in operation?

* How are the major competitors?

* Are there any barriers to entry into competition?

* What's the market share of the company?

* Are any trade secrets or unique service or manufacturing methods involved?

* How important are client relationships in the industry?

* What's the probability of the seller competing in each year of the covenant if he were free to do so?

* How much is the company earning? How much is it forecast to earn?

* What's the appropriate discount rate to use to determine the present value of future earnings or cash flow?

Obviously, it's important for the valuation consultant to read the contractual document and obtain a thorough understanding of its provisions. As a general rule, the more restrictive the language, the more valuable the covenant. But the language can't be so restrictive that it makes the covenant unenforceable.

The appraiser should interview the person subject to the covenant not to compete to determine the likelihood, absent the covenant, that he would leave and compete. Age can be a factor here, as can "entrepreneurial" bent--that is, the desire to run the show. The person's technical knowledge and industry reputation also should be assessed. Finally, the valuation consultant should analyze the industry carefully.

THREE VALUATION APPROACHES

There are three approaches to appraisals--the cost approach, the market approach and the income approach. All must be considered and the approach or approaches deemed most suitable for valuing each element of property should be selected.

The cost approach sets value according to the cost of reproducing or replacing the property. Deductions are made for physical deterioration and functional and economic obsolescence, if present and meansurable.

The market approach, on the other hand, estimates value by analyzing recent sales of comparable property.

The cost approach and the market approach generally apply in the valuation of tangible assets--such as machinery and equipment and real estate. In valuing a covenant not to compete, the income approach is used most often.

The term "income" in this approach connotes any future benefits that can be quantified in monetary terms. the approach involves two steps:

1. Project the total monetary benefits expected to accrue to an investor in te property.

2. Discount these to present worth using a discount rate that considers both the degree of risk involved and the layers of taxes included in the projection--precorporate tax, after-corporate tax and preindividual tax, or after both the corporate and the individual taxes.

Everything else being equal, the higher the risk, the higher the discount rate and the fewer layers of taxes included in the projection, the higher the discount rate.

[TABULAR DATA OMITTED]

The monetary benefits of a covenant not to compete include how much the buyer's earnings would be hurt if the seller entered into competition, tempered by the probability the seller actually would enter into competition at any point during the term of the covenant. Also included would be tax savings resulting from the covenant's amortization. All of the qualitative factors described above should be used to assess these benefits and to determine an appropriate discount rate.

SETTING A VALUE

Joe smith is the senior executive with Smithco, a management consulting firm, which is being acquired by the much larger Nationalco. He's 50 years old, in good health, has worked for Smithco for 15 years and has developed some strong relationships with many of Smithco's most important clients. Because of these facts, Nationalco requests he sign a 3-year agreement not to compete within a certain geographic territory or to attempt to solicit any clients of either Smithco or Nationalco.

The valuation consultant engaged by Smithco and Nationalco to determine the value of the covenant has obtained both optimistic and pessimistic 5-year earnings projections for Smithco. Based on his financial analysis of historical results and industry trends and forecasts, the consultant determines these projections are reasonable. Furthermore, he has interviewed key managers at both companies and estimates that, if Joe Smith did compete, earnings of Smithco would decline by approximately 50% in the initial year of competition but that it gradually would recover the earnings over a 3-year period.

Based on an interview with Smith, the appraiser recognizes Smith's entrepreneurial bent and estimates that, absent an agreement to prevent him from doing so, Smith would be at least 75% likely to compete in year 1 of the agreement. If he didn't compete in year 1, the likelihood of competing would fall to about 50% by year 3. The effective probability of Smith competing

[TABULAR DATA OMITTED]

in each year is shown in exhibit 1 on page 91.

The valuation consultant estimates the effective tax rate is 40% and determines the appropriate discount rate to be 15%. Since the covenant has a contractual life of 3 years, its value will be amortized over this period. Thus, the valuation model becomes one based on cash flow and must account for tax savings from amortization as an element of that cash flow. The valuation model is presented in exhibit 2 above.

A QUALITATIVE ASSESSMENT

Determining the value of a covenant not to compete, or testing the reasonableness of a value that has been assigned to such a covenant in a purchase agreement, is a process in wider use since the TRA. The appraisal process itself in volves a careful analysis of qualitative data supporting the economic reality of the covenant not to compete and the intent of the parties, as well as a detailed pro forma look at the effect of possible competition on the buyer.

LEE C. RUSSELL, CPA, CMA, is manager of professional services for American Appraisal Associates, Inc., Milwaukee, Wisconsin, an international valuation consulting firm. He is a senior member of the American Society of Appraisers.