The Non-Compete Agreement – A Negotiated Contract in a Business Sale Transaction
Non-compete agreements are typically included as part of the terms of a business sale transaction to protect the buyer from direct or indirect competition from the seller. A buyer would not want to purchase a business if the seller could relocate down the street. For this reason, buyers usually require that this threat be eliminated.
There are two main issues about which buyers and sellers should be aware. First, a non-compete agreement has limitations on time, industry, and geographic range of competition if it is to be enforceable, and, second, there are tax implications for both the buyer and the seller.
Limitations of Non-Compete Agreements
The terms of the non-compete should not be too broad or overly burdensome on the seller. Restrictions such as scope, time, and range of competition are generally only enforceable to the extent that they are reasonable.
Among the issues usually outlined in a non-compete agreement between buyer and seller are:
- specific payment being made for a seller’s agreement not to compete
- specific time period of non-compete (3 to 5 years)
- specific geographic area
- specific industry sector
A non-compete agreement will typically state that for a specified payment, which could be part of the sale price, the seller will promise not to go into a similar type of business, within a certain geographic area for a specified period of time. The agreement may also prohibit the seller from using confidential trade secrets or business processes that are being transferred to the buyer.
Again, keep in mind that a non-compete agreement will typically only be enforceable if it is reasonable in scope and duration. Therefore, a non-compete should only restrict the seller from working or being affiliated with a business that is similar or in the same industry as the one being sold. The restriction is usually limited to the same geographic area from which the customers of the business are sourced and apply for a reasonable period of time. What is reasonable will depend on the specifics of the industry, the business, and region. Standards for evaluating the reasonableness of a non-compete agreement may differ by State.
In an asset sale transaction, assets treated as capital gains are taxed at a significantly lower rate than those treated as ordinary income. However, gains on certain intangible assets, such as a non-compete agreement, are not generally eligible for capital gains treatment. Therefore, when allocating the purchase price to the various assets of the business, the parties should keep in mind that the allocation of the purchase price attributed to the covenant not to compete could significantly lower the after-tax amount that the seller will make from the sale.
It is prudent and recommended that both parties consult a tax professional and/or an attorney to assist in defining the terms of the purchase. However, it is important that those professionals be familiar with business transfer transactions.