Understanding Non-Compete Agreements in Business Sales
Discussing non-compete agreements may be uncomfortable, but they’re an important and essential component of business transactions. These agreements create restrictions for sellers and former owners to protect a business after it is sold. Non-compete agreements safeguard the buyer's goodwill, customer base, and proprietary information to assure the continuity and profitability of the business after the transition of ownership.
What Is a Non-Compete in Business Sales?
A non-compete agreement in the sale of a business is a contractual clause where the seller agrees to avoid engagement if it could harm the business's new owner. The restrictive covenant can prevent the seller or senior executives from starting a similar business, working for a competitor, or soliciting the business's customers for a specified period and within a defined geographic area.
The legal enforceability of non-competes helps protect the buyer's investment, secure sensitive information and intellectual property, and reduce the likelihood of legal challenges post-sale.
The Federal Trade Commission (FTC) plays a significant role in regulating non-compete agreements. Its involvement includes:
- Enforcement of antitrust laws that prevent unfair business practices and promote competition
- Investigation around companies that enforce non-compete agreements in ways that may violate antitrust laws
- Creation of proposed rules and policies to support competitive labor markets and protect legitimate business interests
- Authority regarding the use of non-compete agreements, non-disclosure agreements, and employment contracts. For example, the FTC recently worked to ban non-compete clauses between employers and their workers, citing that a former employer can penalize or prevent former employees or independent contractors from seeking or accepting a new job.
- Providing guidance on employment law and highlighting the potential harms of overly broad or abusive non-competes.
From a tax perspective, negotiating employment agreements can impact the allocation of purchase price between tangible assets (such as equipment and real estate) and intangible assets (like goodwill and non-compete agreements). The portion of the purchase price allocated to a non-compete agreement is generally treated as compensation to the seller and subject to ordinary income tax rates. Properly structuring these agreements can help optimize tax implications for both parties of the transaction.
Non-compete agreements also influence the purchase price allocation for accounting purposes. The IRS requires that the purchase price of a business be allocated based on the fair market value of its assets. The value assigned to the non-compete agreement affects how the purchase price is distributed among tangible and intangible assets, impacting depreciation schedules and amortization deductions for the buyer over time.
Elements of Non-Compete Agreements
Non-compete clauses include several elements to protect the buyer's interests, while outlining the seller's post-sale limitations. These details are crafted to balance the buyer's need to protect their investment and the seller's right to pursue future opportunities within reasonable limits.
Non-compete agreements are legally binding contracts, and a new business should always seek legal advice when creating a new non-compete to be certain that the business entity complies with local laws. Clear definitions of duration, geographic scope, and prohibited activities can safeguard the buyer's business interests post-sale. Elements include:
● Duration
Specifies the period during which the seller is prohibited from engaging in competitive activities. The duration may range from one to five years, depending on the industry and the nature of the business.
● Geographic Limitations
Defines the geographical area within which the seller is restricted from competing. This can be local, regional, national, or even international depending on the scope of the business and its market reach.
● Specific Prohibited Activities
Details the specific actions the seller cannot undertake as of a specific effective date. This often includes starting or joining a competing business, soliciting clients or employees for new employment, and using confidential information or trade secrets acquired during their tenure to advance their new business or career.
Impact on Business Valuation and Operations
Non-compete clauses impact business sales by assuring buyers that critical assets will remain protected post-acquisition. These clauses enhance the business's attractiveness by reducing risks and preserving its competitive edge. For buyers, this assurance backed by state law can justify a higher purchase price and broaden the pool of potential investors interested in acquiring the business.
That said, non-compete agreements also pose operational challenges. They may restrict the seller's involvement in the business post-sale, which may affect continuity, especially if the seller plays a key operational or strategic role. A new buyer must strategize for a seamless transition, including knowledge transfer and talent retention strategies, to mitigate disruptions. Effective enforcement of these agreements requires ongoing monitoring and in some instances, legal action, in order to prevent breaches.
Learn More With BizBuySell
Learn more about selling your business with BizBuySell's comprehensive How to Sell a Business Guide and Digital Toolkit. Whether you're navigating non-compete agreements, valuing your business for sale, or managing operational transitions, our resources provide expert guidance to help you achieve a successful sale. Visit BizBuySell today for tools and insights to streamline the selling process and maximize the value of your business.