The value of a non-compete agreement
Non-compete agreements happen quite often as part of a business sale. As a result, you should have a decent idea of the agreement’s value in order to allocate part of the business purchase price to it. Usually you would have a written contract obligating the business seller to refrain from setting up a competitive business across the street for some time after selling the original firm to the buyer.
The terms of such a non-compete covenant are negotiated carefully as the tax implications differ between the seller and the buyer. Moreover, you should make sure you have a well defined agreement as to the time duration and area.
Why is this important? Imagine that a seller takes the buyer’s money, then moves across the street right after the business sale and starts a company that directly competes with the buyer’s business. Clearly, such a new company can draw business away from the old firm.
Indeed, in the absence of a non-compete covenant the original company may not sell at all. So to close a sale, the seller and the buyer need to agree on the terms of competitive exclusion, most importantly the length of time the agreement lasts.
Difference in financial performance is the basis of the non-compete agreement value
Once you have the agreement hammered out, you need to determine its value in present day dollars. To do this, ask this question, “What kind of harm would the original business suffer if the seller set up a competitive firm nearby right after the sale?”
To work this out, you should go back to your original financial forecast. Next, make an alternative forecast of sales, operating expenses, and investments needed in case the competition from the seller is present. Clearly, this would have an effect on sales and add costs for the old firm.
The difference between the two forecasts, especially the effect on business cash flow is what you need in order to figure out the value of the non-compete. To do so, you can discount the cash flow difference to the present value using an appropriate discount rate. This represents the value of the non-compete agreement at the time of business sale.