Appraising and amortizing noncompete covenants.by Reilly, Robert F.
Accordingly, the seller usually signs an agreement that he will not compete in the same industry for a specified period after the sale. Depending upon the facts and circumstances, the covenant may be global or it may be restricted to a specific territory. When the agreement is included as a term of the asset or stock sale agreement it is called a covenant not to compete. when it is created and bargained for as a separate asset sold by the seller to the buyer it is called a noncompete agreement. If it meets certain conditions, a noncompete covenant will be an acquired amortizable intangible asset to the buyer. It will be subject to cost recovery for federal income tax purposes.
REASONS TO APPRAISE NONCOMPETE COVENANTS
When a going-concern business enterprise is purchased, usually there is an allocation of a lump sum purchase price among the assets acquired. This allocation is performed for both financial accounting and income tax accounting purposes. Frequently, a portion of the lump sum purchase price is allocated to the covenant not to compete. The financial accounting requirements for the allocation of purchase price among the business assets acquired are provided by APBO 16. The income tax accounting requirements for this allocation are provided by Sec. 1060.
Before TRA 86, the seller would prefer to have as much of the purchase price allocated to goodwill (as opposed to the covenant) as possible, because the seller would be taxed on that portion of the sales proceeds at lower capital gains rates. The buyer, on the other hand, would prefer to have as much of the purchase price allocated to the covenant as possible. The buyer could amortize that allocated amount over the contractual term of the covenant. For federal income tax purposes, no amortization deduction is allowable for goodwill. Reg.1.167(a)(3).
After TRA 86, in most cases, the seller is indifferent to the allocation between goodwill and the covenant. The favorable rate difference between capital gains and ordinary income has been discontinued. Therefore, the business seller would be taxed on the gains on sale at ordinary income rates in any event.
The fact that the buyer and seller no longer have adverse tax interests will certainly mean that the IRS will more zealously challenge purchase price allocations to covenants not to compete. The IRS's argument will likely be that the seller has acquiesced, at no cost to the seller, to the buyer's unreasonably large allocation to the covenant so that the buyer can avoid taxes through higher amortization expenses in future periods.
As a result of TRA 86 and repeal of the so-called General Utilities doctrine, most acquirers, when the stock of a business entity is purchased, accept a carry-over tax basis for purchased assets. in other words, most acquirers no longer elect a deemed liquidation of the acquired company and allocate the total purchase price to the individual acquired assets. However, when a noncompete agreement is bargained for and acquired separately from, although clearly related to, the stock of the target company, then the total consideration paid can still be allocated between the purchased stock and the purchased noncompete agreement and the amount allocated to the noncompete agreement may be amortizable.
AUTHORITY FOR THE AMORTIZATION OF A NONCOMPETE COVENANT
There are substantial statutory authority, judicial precedent, and administrative rulings regarding amortization of acquired noncompete covenants. Generally, four tests have been applied by the courts in determining whether a covenant may be amortized for federal income tax purposes. These tests were articulated in Forward Communications Corp. v US., 78-2 USTC Para. 9542. A description of these tests follows.
* Whether the compensation paid for the covenant is severable from the price paid for the acquired goodwill;
* Whether either party to the contract is attempting to repudiate an amount knowingly fixed by both the buyer and seller as allocable to the covenant;
* Whether there is proof that both parties actually intended, when they signed the sale agreement, that some portion of the price be assigned to the covenant; and
* Whether the covenant is economically real and meaningful.
The covenant cannot merely be protective of the goodwill acquired. It should be established that the seller is able to compete against the buyer if not restrained by the covenant. The mere stated intention to compete, absent the covenant, will likely not be enough to satisfy the IRS, due to the lack of adverse tax interests. The buyer must demonstrate that the seller possesses a probable and viable means of competition. This requirement is articulated in General Insurance Agency Inc. v. Commissioner, 17 B.T.A. 1213 (1929). The mere potential of competition from the seller, due to his or her reputation with clients, will likely be construed to suggest that the covenant is merely to protect goodwill and thus is not severable from goodwill. This proscribed relationship of a covenant not to compete and goodwill is further explained in Visador Co. Comr., TC Memo 1973-173.
The real and likely threat of competition from the seller, due to the seller's product knowledge, technical skills, employee loyalty, customer loyalty, capital resources, expertise, and managerial skills, will likely be required to meet this first test. This requirement was articulated in Golden State Towel and Linen Service z,. US., 67-1 USTC Para. 9302, 179 Ct. Cl. 300, 373 F.2d 938 (1967), and in Michaels v. Commissioner, 12 T.C. 17, 19 (1949). An analysis of the seller's age, ability, health, financial condition, customer loyalty, employee loyalty, inclination, and other attributes would have to demonstrate that the seller would compete with the buyer, sans the noncompete agreement.
This test will likely be less meaningful now that the parties to a purchase do not have adverse tax interests. Accordingly, most purchase agreement allocations will not be repudiated since there is no incentive for the buyer and seller to disagree on the allocation. In fact, the regulations under Sec. 1060, and the corresponding regulations under Sec. 338, require that the buyer and the seller agree to the same allocations on their respective federal returns.
The third test can be met by documented negotiations between the parties as to the price to be paid. If possible, these negotiations should occur before the total purchase price is finalized. Inclusion of the agreed price of the covenant in the purchase agreement will provide stronger proof than a mere recitation of an intent in the agreement that some portion of the price will be allocated to the covenant. This contractual allocation is especially important now that the parties do not have adverse tax interests. A further explanation of the application of this test is presented in Annabelle Candy Co. v. Comr., 314 F.2d 1, 7-8 (9th Cir. 1962).
The fourth test can be met by a careful appraisal of the value of the covenant, preferably before the purchase agreement is signed. A reasonable value can be placed on a covenant by quantifying the value on the target's projected cash flow generation capacity, i.e., earnings before interest, depreciation, and taxes, over the term of the covenant on a comparative basis with the covenant in place as opposed to without the covenant in place. obviously, the difference in the two business enterprise values, i.e., with and without competition, is the fair market value of the covenant. A further explanation of determining the economic substance of a noncompete covenant is presented in Better Beverages, Inc. v. USA, 80-2 USTC Para. 9516 CCH.
The first question in the noncompete covenant valuation is: "If the seller of the covenant were to compete, how would it be done?" Frequently, the answer is that the seller either would start a new competing company, would buy a competing company, or would join a present competitor.
The second question is: "If the seller were to compete, what would be the most likely competition scenario?"
The third question is: "Under the most likely scenario of competition, which would be the decrement to the business enterprise value of the company being purchased over the term of the covenant?"
Once the most likely means of competition is established, the effect of the potential competition to the acquired company's net sales, net earnings, and net cash flow, over the term of the covenant, can be projected.
The potential loss of net sales from competition can usually be quantified only after: 1) comprehensive interviews with senior management of the acquired company; 2) rigorous analyses of historical results of operations of the acquired company within its competitive environment; and 3) exhaustive analyses of the macro and micro price elasticities and market dynamics of the subject industry. As stated earlier, the potential competition due solely to a transfer of goodwill should not be considered.
Usually, the input of the chief executive officer, the chief marketing officer, and the chief financial officer are all essential to the development of the projections associated with the impact of competition. Substantial professional judgement and expertise are required when the potential loss of sales is converted into the potential loss of earnings, as fixed costs and variable expenses must be carefully considered in the analysis. Merely multiplying the projected profit margins by the potential projected sales decrements will not be adequate to substantiate the valuation conclusion. Rather, a rigorous comparative discounted net cash flow analysis over the term of the covenant is required to quantify the fair market value of the noncompete agreement.
TEN STEPS IN APPRAISING NONCOMPETE COVENANTS
The typical ten steps in the appraisal process are presented herein as an illustrative example. In this example, Buyer, Inc., is about to purchase the Profitable Subsidiary, Inc., business unit for Seller, inc. Seller has agreed to grant to Buyer a global noncompete agreement related to the business of Profitable Subsidiary for five years.
In this example, assume that Seller will retain significant expertise and proprietary knowledge in the industry in which Profitable Subsidiary operates. in fact, Seller will continue to sell unrelated products to the customers of Profitable Subsidiary. Many of the Profitable Subsidiary executives still feel some loyalty to their long-time corporate parent, Seller. The management of Buyer believes that, absent the legally binding noncompete agreement, Seller would and could successfully compete in the industry served by Profitable Subsidiary.
The appraisal problem is: what is the fair market value of the noncompete agreement granted by Seller to Buyer?
Projecting the Most Likely Decrement in Revenues
The first step in the appraisal of the noncompete covenant is to project the most likely decrement in the acquired company's net revenues due to the seller's hypothetical competition over the contractual term of the agreement. This projection contemplates two factors: 1) the competing seller will attract current customers away from the acquired company; and 2) the competing seller will attract potential new customers and therefore reduce the prospective sales growth of the acquired company. The seller's hypothetical competition will affect the acquired company's revenue projections in the following two ways: 1) unit sales volume will decrease, or increase at a lower rate than otherwise; and 2) unit average selling price will decrease or increase at a lower rate than otherwise.
The revenue projection section of Exbibit 1 presents the comparative revenue variables for Profitable Subsidiary with and without the noncompete covenant. As indicated previously, the data results from significant and rigorous research.
Projecting the Increment in Operating Expenses
The second step is to project the increment in operating expenses due to the seller's hypothetical competition over the contractual term. This projection of incremental operating expenses contemplates the following factors: 1) the increased salary expense that the buyer will have to pay to employees-to keep them from "defecting" to the competing seller, i.e., their previous boss; 2) the cost to recruit, hire, and train new employees to replace those who defected;" 3) the increased marketing expense associated with retaining old customers, who are now being called on by the competing seller; 4) the increased marketing expense associated with prospecting new customers due to the competition caused by the seller; 5) the increased research and development costs associated with keeping the product or service competitive to the hypothetical new competition; and 6) the decreased overhead absorption associated with diminished production volume caused by the competition.
The expense projection section presents the operating expense and other expense variables for Profitable Subsidiary with and without the noncompete agreement.
Projecting the Increment in Capital Investment
The third step is to project the increment in capital (and other) investments, due to the seller's hypothetical competition over the contractual term. The incremental investments usually take the form of increased investments in accounts receivable, inventory, and plant and equipment. The increased receivables relate to the relaxed credit terms that must be granted to prevent current customers from "defecting." The increased inventory is to ensure customers selection and satisfaction, thereby militating against the customers' need to contact the hypothetical competitor. The increased level of capital expenditures is due to the investments in plant, property, and technology required to dissuade current and potential customers from "defecting." The investment projection section presents the capital and other investment variables for Profitable Subsidiary with and without the noncompete agreement.
Selecting the Appropriate Discount Rule
The fourth step is quantifying the appropriate present value discount rate. This discount rate should reflect the summation of the current risk-free rate of return, the time value of money over the term of the covenant, and the non-systematic risk associated with the business operations subject to the covenant. Depending upon how the discounted net cash flow model is constructed, several methods may be appropriate to calculate the discount rate. if a typical before-debt-service but after-tax-expense model is used, then a weighted average after-tax cost of capital would be the appropriate discount rate. The cost of capital projection section presents the discount rate variables related to Profitable Subsidiary with and without the noncompete agreements.
Determining the Residual Value
The fifth step is the determination of the appropriate business residual value, i.e., the value of the business enterprise at the termination of the covenant. This residual value is often determined by capitalizing the final year's cash flow projection during the discrete forecast period. This residual value in the with-competition scenario may be different from the without-competition scenario. First, the acquired company with competition will likely generate leis net cash flow than it would without competition in the final year of the covenant. Therefore, there will be a lower amount of net cash flow to capitalize. Second, the capitalization rates used in the two scenarios- i.e., with and without competition-will likely be different because the capitalization rate, like the present value discount rate, should reflect the risk of the economic income being capitalized. And the acquired company with competition enjoys lower risk, although it also enjoys a potentially lower earnings growth rate than it would without competition. The acquired company with competition has already identified and adjusted to all of its competitors. The acquired company without competition is now facing termination of the covenant and the first potential competition from the seller. The residual value projection section presents the residual value variables related to Profitable Subsidiary with and without the noncompete agreement.
Quantify Comparative Business Valuation Net Cash Flow
The sixth step is to quantify the comparative business valuation net cash flow analysis associated with competition, versus without competition. The comparative net cash flow analysis is-revenues minus expenses minus investments without competition-versus revenues minus expenses minus investments with competition. The incremental difference in the two projections represents the most likely "damage" that the seller would create if allowed to compete against the buyer,
The discounted net cash flow projection for Profitable Subsidiary with the noncompete agreement. Presents the discounted net cash flow projection for Profitable Subsidiary without the noncompete agreement.
Determining the Business Equity Value
The seventh step is to determine the business equity value of the acquired company without competition, and its business equity value with competition. The difference between these valuations represents a first iteration, or tentative estimate of the value of the noncompete agreement. This difference is only tentative because it ignores the fact that an amortizable intangible asset has been created. in other words, the acquired company with the noncompete agreement will enjoy the federal income tax benefits associated with amortizing this intangible.
Presents the comparison of the first iteration business equity values for Profitable Subsidiary with and without the noncompete agreement.
Quantifying the Impact of Amortization
The eighth step is to quantify the impact of amortizing this intangible on the discounted net cash flow analysis associated with the without-competition company. In this scenario, the projected federal income tax expense will be reduced by the annual amortization deductions multiplied by the effective income tax rate. This deduction is equal to the first iteration estimate of the noncompete agreement value divided by the term of the agreement, i.e., the amortization period for the intangible. Presents the impact on the net cash flow of Profitable Subsidiary associated with the amortization of the noncompete agreement.
Performing A Second Iteration
The ninth step is to perform a second iteration discounted net cash flow analysis of the company without competition. This analysis will be identical to the first except for the reduced income tax expense associated with amortizing the intangible; this will result in increased after-tax net cash flow and an increased second iteration business equity value for the without competition company. The results of this second iteration business valuation with the noncompete agreement.
Comparing the With and Without
The tenth step is to compare the business equity value of the acquired company with competition to its second iteration business equity value without competition. The differences between these two business equity value conclusions represents the fair market value of the non-compete covenant.
The difference between the value of the business equity without competition (i.e., $12,803,000 ) and its value with competition (i.e., $3,381,000) represents the fair market value of the noncompete agreement. In this example, the fair market value of noncompete agreement purchased by Buyer from Seller is $9,422,000.
CPAs have important roles to play in the noncompete covenant valuation and amortization process. First, CPAs are often involved early in the business acquisition process. Accordingly, they can recommend the creation of a noncompete agreement and help negotiate and structure its provisions.
Second, CPAs can identify noncompete covenant valuation opportunities for clients. And they can quantify the federal income tax any other associated benefits.
Third, CPAs can assist clients in selecting and hiring a professional appraiser. Experienced in relying upon the opinions of experts, CPAs should participate in the assessment of the appraiser's credentials, experience, and expertise. The valuation of noncompete covenants is a complex assignment; the appraiser selected should be able to demonstrate an impressive track record of substantiating such valuations before administrative or judicial review. As the CPA should be professionally qualified in accountancy, the appraiser should be professionally certified in the discipline of intangible asset and intellectual property appraisal. A directory of such certified appraisers maN, be obtained from the American Society of Appraisers, Washington, DC.
Fourth, accountants can assemble the historical financial and operational data used in the appraisal. Also, accountants can assist clients in preparing prospective financial and operational data; these data provide input to the appraiser's valuation model.
Finally, accountants should assist clients and the expert appraiser by assessing the reasonableness of the valuation conclusion. In respect of the accountant's familiarity with the client's business operations, most expert appraisers welcome the accountant's input.
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