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 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 priceIn 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 crafted properly, can allow buyers 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 management/owner vs. the non-management/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 a former seller who didn’t pay attention to the non-compete he signed years ago, thinking it would never come into play given his plans. A few years go by and 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 a simple fix 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.