If you enter into a transaction to sell your business, you will inevitably be asked to enter into a covenant not to compete. This post is not intended to comment on the legality or enforceability of non-competes (although this raises the critical point that having legal counsel and an investment banker with deep experience in transactions is a must), instead, it will comment on a number of economic issues surrounding non-competes.
1. Not All Dollars Are Equal
This is especially true when it comes to payments under non-competes. In many cases, specific payments are not made under a non-compete clause. If they are, a buyer will often try to “shift” purchase price into a non-compete payment. This is beneficial to a buyer – those payments are deductible for tax purposes, and costly to the seller – those payments are taxed as ordinary income, not capital gains. If a buyer approaches you with this idea, be wary, or read on to the next bullet and use it to your advantage.
2. Non-Compete Payments Can Be Used to Stretch Purchase Price
In a situation where there are multiple owners of a business, but only one or a few are active in the day-to-day management, a non-compete might be carefully crafted to extract extra dollars from a buyer. This is a very complicated strategy, but if addressed properly, can allow sellers to capture more value in a transaction. I will describe one scenario, although I strongly caution that each strategy is highly dependent on the facts of a particular deal. After a purchase price is agreed to, if the seller has deal leverage, key members of management who are also owners can, at times, carefully negotiate an additional payment(s) under his or her non-compete. This can be justified because the non-compete will be a heavier burden for the managing owner vs. the non-managing owner. This maneuver should not be attempted by anyone without significant experience in this area as it can lead to conflict and jeopardize the transaction if poorly played.
3. Take the Terms of the Non-Compete Seriously
Even if you have no intention of competing following a transaction and plan to ride off into the sunset following a deal, make sure you have your legal counsel carefully (and aggressively if needed) negotiate the terms of your non-compete. Countless times I have been contacted by former sellers who didn’t pay attention to their non-compete because they thought it would never come into play given their plans. A few years down the line, the seller wants to do some consulting or sit on a board and it turns out he is prohibited from doing so by his non-compete. While it might be simply fixed by asking the buyer for permission, many times it turns into a dispute – a dispute that could have been avoided at the time of the deal.
4. You ARE Going to Sign One
Don’t kid yourself, no one is going to buy your business and not ask, no, demand, that you sign a non-compete. This is a critical element to the buyer because he doesn’t want to see you out competing with him shortly after buying your business. Part of what the buyer is buying is that you will not be out there competing against the business he just bought. Keep this in mind and be careful. By following some of the tips outlined here, you might even use it to your advantage.
A non-compete is a complex legal contract and should be treated as such. However, it also needs to be included in your overall negotiation of a transaction. If discussed properly, it can even drive additional value to sellers. It is important to have experienced legal counsel on your deal team as well as a good investment banker who can communicate these strategies effectively.