What is a 'Covenant Not To Compete' when buying or selling a business
In most business transactions it is
standard to include a Covenant Not To Compete.
The logic is simple. The current
owner of the business decides they want to sell and a buyer wishes to buy the
business. As one of the conditions of
buying the business, the buyer stipulates that the seller cannot open the same
type of business that the seller currently operates as the buyer is concerned
the existing customers will want to do business with the seller rather than
transfer their loyalty to the buyer.
When used as a part of a change of ownership on a business between a buyer and a seller, the seller agrees not to engage in the same business or a similar business in a particular area for a period of time. Both these items form part of the negotiations. Generally the buyer wants the geographic area to be as large as possible while the seller as small as possible. Additionally, the buyer wants the time period to be as long as possible while the seller wants it to be as short as possible. Obviously, if the seller is retiring and no longer wishes to be active in a business, the time and geographic area may be of little concern and so they are willing to accept whatever the buyer wants.
What happens if the business being acquired has an online presence and gets business from the internet? This can be difficult for the seller as the buyer can rightly argue that they are not interested in buying the business unless the seller does not operate or be involved with a business in the same or similar industry that has an online or internet presence.
How do you decide the allocation or what part of the purchase price should be made to the Covenant Not To Compete? In the US, the IRS has a two pronged requirement. First, the amount must rest on economic realities and second, it must have independent economic significance. In other words, the value allocated to the Covenant Not To Compete must be realistic when taking into account the full purchase price and it must be able to be shown that restricting the ability of the seller to earn a future income by operating the same type of business must be real.
Some of the factors used to evaluate a Covenant Not To Compete include:
· The seller’s ability to compete and the seller’s intent to compete
· The seller’s economic resources
· The potential damage to the buyer posed by the seller’s competition
· The seller’s expertise in the industry and contacts as well as their relationships with key groups, for example, with customers and suppliers
· The buyers interest in eliminating a competition
· The duration and geographic scope of the Covenant Not To Compete, and finally,
· The seller’s intention to remain in the same geographic area.
A Covenant Not To Compete is a normal part of a business transaction negotiation. It can create tension in the negotiations, especially if both parties want diverse outcomes. That is, if the seller wants the geographic area to be within 3 miles of the current location of the business and the buyer wants 25 miles, that’s a big difference. It’s also not unusual for the buyer to test the seller to make sure the reason they are giving to sell the business matches their actions. For example, if the seller says they intend retiring after they sell the business or intend to move interstate after the business is sold and then says they want the Covenant Not To Compete to be a small geographic area for a short period of time, then it can raise a red flag.