By Michael French, CPA, ABV, CFE, Managing Director
Non-compete and non-solicitation agreements have long been standard features of business combination negotiations. However, their value as negotiating tools is often underestimated. A carefully crafted non-compete agreement can help a buyer negotiate a better deal, depending on factors such as timeframe and geographic limits, the competitive profile of the company’s industry, and the ability and likelihood that the seller would want to compete.
Important Bargaining Chip
In the context of business combinations, non-compete and non-solicitation agreements can become a bargaining chip that moves the dial on the deal’s price and/or terms. Although they typically are written to protect the interests of the buyer, both buyer and seller have a role in crafting a reasonable agreement that works for both sides.
Restrictive covenants in an M&A transaction typically serve the purpose of safeguarding the buyer’s value in the purchased business. By restricting the seller’s ability to compete with the purchased business for a certain period of time following the transaction, the buyer is looking to ensure that the acquired business does not lose value due to post-closing competition from the seller.
Negotiating the Non-compete
A typical negotiation starts with the understanding that the terms and provisional byproducts of restrictive covenants are just as negotiable as any other part of the transaction. But structuring a non-compete that serves the purposes of both sides can be a challenge, in part, because the two sides have different tax objectives that hinge on the allocation of the value of the non-compete. The buyer must amortize the amount allocated to a non-compete over 15 years while the seller recognizes the allocation as ordinary income.
Since the main features of a non-compete agreement typically are 1) the length of time the agreement covers and 2) the geographic area or industry it covers, these factors provide opportunities to negotiate in ways that impact the price and terms of the deal.
For example, a seller who is retiring or unable to continue working due to illness presents little likelihood of competition, and the buyer may be willing to agree to a less restrictive non-compete agreement in exchange for consideration on price. Conversely, a seller looking to continue working or owning another business in the same industry presents a high likelihood of competition. In this case, the buyer would be advised to negotiate a highly restrictive non-compete, among other protective terms.
Unlike non-compete agreements that apply to employees when they leave a competitive industry, state governments and courts rarely restrict covenants used in business combinations. Generally, court rulings have revolved around the principle that non-competes must be reasonably necessary to protect legitimate business interests.
For more information about the role of non-compete and non-solicitation agreements in a transaction you may be contemplating, contact your PKF Advisory team member or:
Michael French, CPA, ABV, CFE