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 a similar type of business to the one the seller currently operates. This is because the buyer has the concern that existing customers will prefer to do business with the seller rather than transfer their loyalty to the buyer.
When used as part of a change of ownership of 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 specified period. Both these items form part of the negotiations. Generally, the buyer wants the geographic area to be as large as possible, while the seller wants it to be as small as possible. Additionally, the buyer wants the period of time to be as long as possible, while the seller wants it to be as short as possible. If the seller is retiring and no longer wishes to be active in business, the time and geographic area may be of little concern, and so they are willing to accept whatever the buyer wants.
What about an online business?
What happens if the business for sale 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 is not operating or is not 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 two requirements. First, the amount must rest on economic realities. Second, it must have independent economic significance. In other words, the value allocated to the Covenant Not to Compete must be realistic when considering the full purchase price. Additionally, it’s necessary to show that restricting the seller’s ability to earn future income by operating the same type of business is genuine.
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 from 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 buyer’s interest in eliminating a competitor.
- The duration and geographic scope of the Covenant Not To Compete.
- The seller intends to remain in the same geographic area.
A Covenant Not To Compete is a standard part of business transaction negotiations. 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 it to be 25 miles, that’s a significant difference.
It’s also not unusual for the buyer to test the seller to ensure the reason given for selling the business aligns with their actions. For example, if the seller states they intend to retire after selling the business or relocate interstate after the sale, and then requests a Covenant Not To Compete with a small geographic area for a short period, it can raise a red flag.
If you’d like more information on how to transition out of your business, please don’t hesitate to contact me for a brief consultation. We’ll discuss your specific business needs, what’s important to you, and create a plan for those first few steps.