Noncompete agreements can be valuable to a business, especially after a merger or acquisition. Estimating the value of these agreements has become more complicated in light of a controversial new final rule issued by the Federal Trade Commission (FTC) that will ban noncompetes for most employees and independent contractors, starting in September 2024.

Types of noncompetes

Noncompete agreements have been a standard business practice for decades. Some are required as a condition of employment or upon termination of employment. Here, the employer requires an employee to sign a noncompete agreement to protect the employer’s business interests, guard against disclosure of trade secrets, and prevent the employee from poaching customers or clients. These agreements generally limit employment activities in the same field for a specified period.

Noncompetes also may come into play in business combinations. These agreements typically prevent the seller from competing with the buyer within a specified geographic area for a certain time period (usually five years or less).

Valuing noncompetes

The value of a noncompete agreement with an employee or former owner may be estimated in various contexts, including legal disputes, mergers, financial reporting and tax matters. The most common approach to valuing a noncompete agreement is the with-and-without method. Without a noncompete agreement, the worst-case scenario is that competition from the individual (the employee or seller) will drive the company out of business. Therefore, the value of the entire business represents the absolute ceiling for the value of a noncompete.

Most likely, the individual couldn’t steal 100% of a business’s profits. Plus, tangible assets possess some value and could be liquidated if the business failed. So, when valuing noncompetes, experts typically run two discounted cash flow scenarios — one with the noncompete in place, and the other without.

The expert then computes the difference between the two expected cash flow streams. Factors to consider when preparing the different scenarios include:

• The company’s competitive and financial position,
• Business forecasts and trends, and
• The employee’s or seller’s skills and customer relationships.

Next, each differential must be multiplied by the probability that the individual will subsequently compete with the business. If the party in question has no incentive, ability or reason to compete, the noncompete can be worthless. Factors to consider when predicting the threat of competition include the individual’s age, health, financial standing and previous competitive experience. When valuing noncompetes related to mergers and acquisitions, the expert also will consider any post-sale relocation and employment plans.

Enforceability

A critical factor to consider when valuing noncompetes is whether the agreement would be legally enforceable. Generally, the restrictions in the agreement must be reasonable. For example, some courts may reject noncompetes that cover an unreasonably large territory or long period of time. What’s “reasonable” varies from business to business, requiring specific consideration of the business, the terms of the agreement, state statutes and case law. For example, California and a handful of other states restrict the use of noncompete agreements in certain circumstances.

In April 2024, the FTC imposed a nationwide ban on most noncompetes with workers that’s currently scheduled to go into effect in September 2024. However, the U.S. Chamber of Commerce and several business groups have filed federal lawsuits challenging the final rule and asking courts to block it. If the rule survives these challenges, it could have a major impact on the value of certain noncompetes going forward.

Note: There are several exceptions to the FTC’s ban. For example, existing agreements signed by “senior” executives — who earn more than $151,164 annually and are in policymaking positions — would still be enforceable. The rule also excludes nonprofit organizations and industries that aren’t covered by the Federal Trade Commission Act. And it doesn’t apply to owners who sell their business interests and won’t remain with the business.

Stay tuned

Business valuation professionals are eagerly awaiting court rulings on the legal challenges to the FTC’s ban. It’s possible that implementation of the final rule could be delayed — or the rule could be overturned altogether.

(This is Blog Post #1593)