Written by Christopher Denney, MPA, MST, CPA, CGMA, CVA, ABV
Intangible assets often account for a substantial portion of a company’s value. For example, on February 21, 2014 the market capitalization of Google was $404.64 billion, yet its net tangible assets were only $__ billion. Companies spend substantial sums to develop proprietary intangible assets, and have an increased need to protect the value of these assets.
When an economy goes from recession to growth, it’s not uncommon for employees to switch jobs, taking with them valuable intangible assets in the form of knowledge and relationships. To mitigate the risk of losing these assets, it has become a customary practice for business owners to require that key personnel execute non-compete and other forms of restrictive agreements to protect the value of their intangible assets.2 Such agreements are referred to herein as Restrictive Covenant Agreements. Accordingly, understanding the value of these agreements becomes critically important.
Valuing Restricting Covenants
James Hitchner wrote in his book Financial Valuation that an Enterprise’s Intangible Assets are valued based on returns. In fact, some intangibles have multiple uses, therefore generating multiple returns, and broadly, some of these include customer base, in-process research and development, and technology, as well as intellectual property such as patents, copyrights, trademarks, trade secrets, and know how. 3
There are different methods used to determine the value of the multiple returns from these intangible assets. Customer relationships and trade secrets are often valued using an excess earnings method. Know-how is often valued with the relief from royalty method. In-place workforce is valued with the cost method. Restrictive covenants, grouped in with marketing-related intangible assets under FAS141, obtained to protect the value of the previously mentioned assets, are valued using the “with or without” method. These methods are identified per ASC 805 for business combinations where an allocation of the purchase price for tangible and intangible assets is to be allocated based on fair value. The value of these items, especially restrictive covenants, is also considered in certain litigation scenarios.
The “with and without” model compares the profitability of the organization with a restrictive covenant, such as a non-compete agreement, with a formula derived using lost profits as a result of losing customers “without” a restrictive covenant in place.
Other Valuation Facts to Consider
The “with and without model” in the previous segment is a typical calculation of a covenant’s value. What if the covenant does not protect the asset completely or there is another negative consequence? There are other factors to consider, such as:
- Type and length of terms
- Jurisdictional issues
- Tax and M&A implications
- Human capital impact
- Business owner’s marital estate value
Impact of Type and Length
Restrictive covenants include, but are not limited to: protection of employee’s specialized technical skills; protection of the Company’s trade secrets, client files or client base; and non-solicitation of employees. The risk of loss for each of these items could be very different, and the “with or without model” may be appropriate to value such restrictive covenant violations.
Typically, the most restrictive employment or key owner covenant prohibits an individual from competing with an employer within a geographic area for a period of usually one to two years. Covenants in excess of two years are less likely to be upheld, due to hardship, and covenants less than one year are more likely to be upheld.
Therefore, it may be prudent to consider the length of time that the covenant will be in place and the type of assets that the covenant protects.
State precedence varies with regards to restrictive covenants. For example, in Indiana an employee trying to maintain a living may not be required to heed to the covenant. In New Jersey, state lawmakers have proposed a bill that would make non-compete agreements unenforceable to anyone that qualifies for unemployment. An Illinois court of appeals ruled recently that an employee must work for an organization for two years before a non-compete can be enforceable. The State of California ruled under Cal B&P Code, sec.16600 that “every contract that by which anyone is restrained from engaging in a lawful profession, trade, or business, of any kind is to that extent void”. Several states such as Massachusetts, Minnesota, and Virginia have introduced legislation that limits non-compete agreements. Some states require exact scope regarding limitations in order for the covenant to be upheld.
In a global economy, the enforcement of non-compete agreements across national borders has become increasingly difficult. In Canada, the non-compete is enforceable only if it does not preclude the public’s interest of free trade, and Canada also requires that the receipt of a non-compete intangible is ordinary income. In France, a non-compete is normally valid under the condition that it (i) does not unduly restrict the ability of the employee to work in his or her field of expertise, and (ii) provides for the payment of financial compensation to the employee. In Japan, the covenant is only enforceable, in addition to other conditions, if there is compensation given to the employee in return for restraint. In fact, most European Union countries require compensation throughout the term of constraint. This can be a costly provision, especially if the violation must be remanded back to the local jurisdiction.
The standard “with and without” model only takes into consideration the difference in the revenue streams between having and not having the covenant in place. It does not take into consideration the amount of legal costs to be used to enforce such covenants, and most often does not include an analysis as to whether the state or domain, in which it would be enforced, would actually enforce the agreement.
Tax and Merger & Acquisition Implications
According to the Internal Revenue Code, a fair value calculation under a business combination includes an added value to the buyer for the present value of the tax benefit for amortization of the covenant not to compete (or other arrangement to the extent such arrangement has substantially the same effect as a covenant not to compete) entered into in connection with an acquisition (directly or indirectly) of an interest in a trade or business or substantial portion 5 .
Not only is there a tax benefit to the buyer for a potential buyer in a business combination, but assigning a value to a non-compete to the seller would likely support consideration for personal goodwill and an allocation of the proceeds from the buyer to the directly to the owner/seller outside of the corporation. This direct payment would avoid double taxation.
Example: If the sales price of a C corporation is $100 million and its tangible assets are valued at $90 million, the $10 million difference could be allocated amongst intangibles including goodwill. If all $10 million is allocated to personal goodwill, the seller could receive ordinary income in the form of a consulting fee, subject to a non-compete, and the portion of the proceeds subject to goodwill would be taxed one time subject to the seller’s personal tax rate. The remaining proceeds would first be taxed at the corporate capital gain level, and then any proceeds left after the corporate capital gains would be taxed again as a dividend to the seller. Different rules would apply to the sale of a pass-through entity.
Human Capital Impact
One factor that may not be considered when requiring employees to submit to restrictive covenants is the cost of acquiring and maintaining a talented workforce as a result of the restriction. Many organizations try to protect their in-place workforce by requiring their service providers and employees to sign agreements not to solicit employees for employment. By keeping key members of management and employees in place with an agreement, the company expects less employee turnover, and the value of the organization’s intangibles is maintained. However, employees may be less likely to work for an organization knowing that their business network is reduced by signing such agreement. They may also be concerned about added risk of breach and request additional compensation if asked to sign an agreement after employment.
Most “with and without” models don’t factor in the potential increase in employee turnover for requiring employees to sign the agreements. They may consider only the value of retaining the employees themselves.
Impact of Business Owner’s Marital Estate
For states for which the value of personal goodwill is not included in the marital estate, the business owner with personal goodwill will have a reduced value of the business to be divided with his/her spouse. The fact that a restrictive covenant exists, may support the argument that personal goodwill exists. What the business owner may not foresee, is that by executing a non-compete agreement as in the Ohio Court of Appeals ruled in Case Banchefsky v. Banchefsky6, any value given to personal goodwill outside of the value of the non-compete, may be ignored all together. The business owner’s valuation analyst in Banchefsky provided a calculation of personal goodwill substantially greater than the value of the non-compete, but the court cited that the analyst’s calculation was not necessary given that there was an arm’s length transaction in the form of a non-compete to determine the owner’s personal goodwill. In this circumstance the business owner would have been better off not entering into the non-compete agreement. Careful consideration should be given not to frivolously sign such agreement.
To Restrict or Not to Restrict
While requiring employees and business owners to sign restrictive agreements may seem like a fail safe way of protecting the value of an organization’s intangible assets, careful consideration should be made as to the reasonableness of the requirement, and the potential for negative outcomes. The determination of value for restrictive covenants is based on a present value of the lost profits had the covenant not been in place. In weighing in the positive benefits of applying a restrictive covenant, the model should also consider negative outcomes of applying a restrictive covenant. These considerations would be whether the type of covenant is: reasonable within the person’s position and their time of service, the length of the restriction is reasonable, the geographic area is enforceable, the tax benefits and the M&A impact, and any negative impact on human capital. Excluding these attributes from the value could overstate or understate the value of these increasingly important assets.
1www.Morningstar.com(from February 21, 2014) 2More Firms Requiring Non-Compete Agreements, The Wall Street Journal Market Watch, July 8th, 2013. 3Financial Valuation, Third Edition, James R. Hitchner, Pages 897-898. 5 Internal Revenue Code Section 197(d) (1) (E) 6Banchefsky v. Banchefsky, 2010-Ohio-4267