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What is a 'Covenant Not To Compete' when buying or selling a business
| Guest post by: Andrew Rogerson |
Article Overview: A Covenant Not To Compete is useful when a seller has found a buyer for their current business. This ensures that the new buyer does not open the same type of business as the seller for risk that existing customers will want to do business with the seller and not the new buyer. There are many factors involved to evaluate a Covenant Not To Compete and they are outlined in this article.
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Free Download - How to sell a business By Andrew Rogerson |
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.
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About the Author: Andrew Rogerson RSS for Andrew's articles - Visit Andrew's website Andrew Rogerson is a 5-time business owner that loves helping entrepreneurs sell or buy a business. Andrew currently holds the Certified Business Intermediary (CBI) designation from the International Business Brokers Association (IBBA), the highest designation awarded by the IBBA. Andrew has also earned the Certified Business Broker (CBB) designation from the California Association of Business Brokers (CABB.) He holds a Certified Machinery and Equipment designation (CMEA) from the NEBB Institute and is a Certified Senior Business Analyst (CSBA) with the Society of Business Analysts. Andrew is a member of the Sacramento Metro Chamber of Commerce and past Chair of the Sacramento Chapter of the California Association of Business Brokers. Andrew is also the author on a series of four books: Successfully Sell Your Business, Successfully Buy Your Business, Successfully Buy Your Franchise and Successfully Start Your Business. For more information go to http://www.businesstransactionbooks.com Click here to visit Andrew's website   Successfully buy a business |
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