Canada: The Valuation Of Non-Compete Agreements

A non-compete agreement is a covenant to the purchase and sale agreement that restricts the seller of a business from competing with that business in the future. Such covenants usually last for a specified period of time and may apply to a specific geographic area (generally the area currently being served by the subject company).

Non-compete agreements provide buyers with a measure of comfort in that the expected stream of earnings from the business being acquired will not be disrupted by competition from the former owner. The seller benefits because the buyer has confidence that the anticipated earnings will materialize and therefore the seller can maximize the purchase price.

In some cases, they receive an annual payment for a specified number of years. In others, the amount the seller receives is included as part of the total purchase price. In either case, the seller is granting a promise to the buyer that may have considerable value in terms of preserving the future earnings potential of the acquired business. Thus, a non-compete agreement represents an important (though intangible) asset for the buyer, quite apart from the operating assets.

Why put a value on non-compete agreements?

If the consideration paid to the seller for entering into a non-compete agreement is included as part of the total purchase price paid for the acquisition, there are three good reasons to assign a separate value to it.

Accounting Standards and Reporting Requirements

If the purchaser is a corporation, generally accepted accounting principles (GAAP)¹ require the parent company's financial statements to be consolidated with those of its subsidiary. Depending on the jurisdiction, these accounting rules have specific standards² that require a purchaser to allocate the total purchase price paid in a business combination to the fair market value of all the tangible and identifiable intangible assets acquired (which would include the non-compete agreement). This provides stakeholders with more information on the true nature and cost of the acquisition.

Compliance with Income Tax Rules

Proposed changes to the Income Tax Act mean that any amount the seller receives for granting a restrictive covenant will be treated as ordinary income for income tax purposes.³ The buyer will generally treat the expense as the seller treats the income; in this case, it would be a deductible business expense. There are some exceptions to this general income inclusion rule. One exception is where the grantor and grantee jointly elect, in prescribed form with their tax return for the year, that the amount is an eligible capital expenditure to the buyer and an eligible capital amount to the grantor. Therefore, it is necessary for the parties to determine the value of the non-compete to ensure there are no unintended tax consequences.

Possible Future Damage Claim

In the event the seller breaches the covenant not to compete, the purchaser may have a claim for economic damages. The fact that a valuation was prepared at the time of the transaction demonstrates that the parties contemplated that real damages would arise if the seller was allowed to compete. This helps support the purchaser's legal claim against the seller.

How should a non-compete agreement be valued?

There are two generally accepted approaches used to determine the value of a non-compete agreement:

Differential Valuation Approach

The differential approach involves valuing the business under two different scenarios. The first valuation assumes the non-compete agreement is in place and the second valuation assumes that it is not. The difference in the value of the business under each approach is attributed to the non-compete agreement. Because the differential approach involves a rigorous business valuation analysis under two scenarios, it allows for more flexibility in determining the net impact on future cash flows arising from potential competition from the seller. The downside is that this approach is more complex and time consuming.

Direct Valuation of Economic Damages Approach

The direct approach involves determining the present value of the potential future economic damages that would occur as a direct result of not implementing a non-compete agreement. The direct approach is somewhat simpler since it involves estimating the direct damages from competition, usually in the form of a percentage of income lost. This method is more widely used because of the need for only one estimate of future operating results, which makes the analysis less time consuming. Both methods, if properly applied, should arrive at a similar conclusion of value.

A Framework for Using the Direct Damages Approach

When using the direct damages approach, the first step involves a risk analysis to determine the maximum potential damages that could arise if the seller competes with the acquired business.

The second step is to determine the "expected value" of the losses based on a probability assessment that considers the likelihood that the seller would compete with the acquired business.

The third step involves determining the present value of the economic damages avoided over the term of the non-compete agreement.

Step 1: Estimate annual economic losses, assuming competition from the seller.

This step involves the following stages:

1. Estimate future earnings or cash flow, assuming a non-compete agreement is in place. This will generally incorporate the same set of assumptions that a hypothetical market participant would use in estimating future operating results for the purpose of pricing the acquisition.
2. Quantify the potential damages (in the form of reduced earnings or cash flow) if the vendor(s) were free to compete with the business post sale. This generally involves a two-step process:
   
   
   1. Perform a risk assessment that considers the key factors that could negatively influence the business projections determined in Stage 1. Depending on the nature of the business, the following questions should be asked:
      
      
      • Does the former owner have significant personal contact with customers?
      • If so, are these customers loyal to the former owner? How many customers could the former owner take to a new business and what is the profit related to these accounts?
      • Are the other employees loyal to this person and do those employees have strong relationships with customers?
      • Does the former owner have access to trade secrets that are critical to the company's success?

1. 
   
   
   1. • Lost sales to existing customers recruited by the former owner
      • Lost sales to new customers through the use of trade secrets taken by the former owner to provide a similar product or service
      • Lower gross profit margins due to reducing selling prices to compete with the former owner
      • Higher marketing expenses incurred in an attempt to mitigate damages (i.e., recoup the lost sales)
   2. Based on the above risk analysis, estimate the percentage of projected earnings or cash flow that would be lost due to seller competition. We have seen estimates ranging from 10% to 50%, depending on the nature of the business and the industry in which it operates.
   3. Apply this percentage to the annual projected cash flow determined in Stage 1. This represents your estimate of how much of the future earnings the former owner could take from the company if he or she decided to compete after the sale.

Step 2: Adjust the losses determined in Step 1 based on the probability that the seller would compete in the absence of a non-compete agreement.

This step involves performing a probability assessment to determine the likelihood that the former owner would compete in the absence of agreeing not to. It is likely to be the most difficult and subjective part of the analysis. Some of the factors that affect the probability of the former owner competing include:

• The age of the former owner. Is the individual near retirement age or is she too young to retire and physically able to compete?
• The former owner's employment status. Has he entered into a management contract to stay on with the existing business? If so, this reduces the likelihood of competing with the purchased business, particularly if a significant part of the purchase price is held back and paid out over time, or is contingent upon business performance. Does the individual have other skills in a different industry in which he could find work that is unrelated to the purchased company's industry?
• The former owner's financial resources. Is the individual wealthy or does she need to work?
• Competitive entry barriers. Are there significant barriers to entry in this industry? If the business is capital intensive, does the individual have access to sufficient capital resources? If not, is it likely that the individual would be hired by a competitor?
• The former owner's track record. Has the seller sold a business in the past and subsequently started up a similar competing business?
• The strength of legal agreements. Is the protection term and market area defined in the non-compete agreement reasonable and enforceable in a court of law? Are there other pre-existing legal obligations in place to help prevent the seller from competing?

Based on the above factors, estimate the probability that the former owner would compete with the purchased business if there were no restrictive covenants. The estimated probability factor is then applied to the losses calculated in Step 1(c) to determine the "expected value" of the losses.

Step 3: Determine the present value of the expected annual losses.

This step involves determining an appropriate discount rate with which to calculate the present value of the expected losses. Consider using, as a starting point, the weighted average cost of the capital (WACC) used to finance the acquisition. Generally speaking, the cash flows associated with intangible assets have greater risk than those associated with tangible assets. This additional risk would generally support a higher rate of return to compensate the investor. However, since much of the risk in the cash flows was already removed through the probability adjustment (in Step 2), a significant risk premium (applied to the WACC) would likely not be appropriate.

Once a discount rate is determined, apply the appropriate present value factors to the expected losses (determined in Step 2) to quantify the value of the non-compete agreement. For accounting purposes, the value of this intangible asset would be amortized over the term of the agreement.

A simplified example of the valuation analysis described above is provided in the following table:

Footnotes

1 This includes Canada's Private Enterprise GAAP, U.S. GAAP, and International Financial Reporting Standards (IFRS).

2 Accounting standards for business combinations include: (i) Canadian Institute of Chartered Accountants (CICA) Handbook Section No. 1582; (ii) in the U.S., Financial Accounting Standards Board (FASB) Accounting Standard Codification Topic 805; and (iii) International Accounting Standards Board (IASB) International Financial Reporting Standard No. 3.

3 The proposed new rules (i.e. Section 56.4 of the Income Tax Act) have been in draft form since 2003 (see http://www.cra-arc.gc.ca/tx/bsnss/tpcs/lf-vnts/sllng/rstrctv/menu-eng.html). Since then, they have gone through several variations but are still in draft form.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.