How to Value Covenants Not to Compete; the Appraiser Must Put a Dollar Figure on a Series of Qualitative Assessments (1990)

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 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 with reasonable accuracy. The covenant not to compete presents some unique valuation problems. Its appraised 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 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 the covenant not to compete? The answer hinges on some important provisions of the Tax Reform Act of 1986 and on the definition of 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. …