Valuation of non-compete agreements

This article narrates the Types of non-compete agreements, Factors that influence the valuation of non-compete agreements.

A contract between an employer and an employee or between businesses protects the interests of all parties involved. It helps safeguard valuable proprietary information, client relationships, and trade secrets. Understanding the value of these non-competition agreements is essential for businesses to protect their interests during transactions and legal proceedings.

Non-compete agreements can represent between 0.3% to 7.0% of the value of an acquired business enterprise, depending on the industry segment. 

The upcoming FTC rule to ban most of these agreements starting in September 2024 could significantly alter the market dynamics and perceived value of these agreements. This regulatory change may lead to reevaluating their necessity and value in business transactions.

If you’re a founder, this article is a must-read to learn about NCA’s valuation and its benefits to company founders, particularly in terms of protecting their business interests and ensuring long-term stability.

Valuation of Non-Compete Agreement

Non-compete agreement valuation techniques include qualitative and quantitative techniques. These legal terms are frequently used in commercial activities like mergers and acquisitions, fundraising, selling, and financial reporting.

The valuation is complex due to legal reforms, changing markets , and evolving business practices. The important method for valuing NCAs is the with-and-without approach. This involves estimating the cash flows of a business both with the non-compete in place and without it. Factors influencing this valuation include:

  • Business Value – The total value of business impacts the ceiling for NCA valuation.
  • Potential Damages – The damages from a breach of the agreement.
  • Competitive Landscape – The chance of competition from the seller or employee is taking into account their financial condition and motivations.

How does non compete agreement work?

A non-compete agreement (NCA) is an enforceable contract that forbids the signee from using any competitive advantages acquired as a result of their affiliation with another party. Usually, it specifies the duration and area of the NCA’s application.

The goal is to safeguard the employer’s commercially valuable assets, including trade secrets, intellectual property, and private data such as customer information and marketing strategies.

Types of Non-Compete Agreement

Various non-compete agreements can be employed, based on the particular circumstances and legal system. Here are a few prevalent varieties.

Types of Non-Compete Agreement
  • Employee Non-Compete Agreement – This is a comprehensive clause that forbids the employee from taking any competitive actions against the employer’s business, usually within a certain geographic area and for a specific amount of time.
  • Non-Compete Agreement in Business Acquisitions – The major goal of this sort of agreement is to safeguard the acquiring company’s goodwill, trade secrets, customer base, and other intellectual information that is vital to the operation of the acquired business.
  • Non-Compete Agreement in Partnership Dissolution – Clause may be a part of a partnership separation agreement to safeguard the interests of the surviving members of the partnership itself. When a partnership dissolves, the partners may decide to insert a non-compete clause to ban one or more partners from directly competing with the partnership or taking part in similar commercial operations for a predetermined amount of time and within a predetermined geographic area.
  • Vendor/Supplier Non-Compete Agreement – The Parties acknowledge that the Vendor/Supplier and the Company have a business relationship whereby the Vendor/Supplier offers products or services to the Company. Both Parties agree to the terms and conditions set out in this Agreement in order to safeguard the Company’s confidential information, customer relationships, and competitive advantage.
  • Franchise Non-Compete Agreement – This is a written agreement between a franchisor and a franchisee that forbids the franchisee from operating a business that is comparable to but competes with the franchisor while the franchise agreement is in effect or later.
  • Independent Contractor Non-Compete Agreement – Agreement is a legal contract between an independent contractor and a hiring party that tries to safeguard the hiring party’s economic interests. This agreement prohibits the independent contractor from engaging in activities that directly compete with the hiring party during or after the length of their contract.

Valuation for Non Compete Agreement

There are two questions that must be answered when valuing a non-compete agreement.

  • How much of the company’s future earnings could the previous owner take if he or she opted to compete with the new company?
  • What is the possibility that the previous owner would participate?

The subjective process of valuing a non-compete agreement necessitates a careful evaluation of these variables in light of the unique situation.

Importance of valuing Non Compete Agreement

Understanding the value of a non-compete agreement is essential for various reasons. Here are some crucial considerations emphasizing the need of appreciating such agreements.

  • The intellectual property, trade secrets, and confidential data of a corporation are protected by a non-compete clause.
  • It aids in maintaining a business’s edge in the marketplace.
  • Customers frequently form close bonds with particular staff or business associates.
  • Important non-compete clauses can raise a company’s overall value.
  • This agreement must be valued in order to be enforceable in court. A well-structured and valuable agreement raises the likelihood of effective enforcement if a corporation needs to take legal action against a former employee or partner who violates the agreement.

Professionals in business valuations must stay informed about these trends to accurately assess the value of NCAs within M&A transactions and other contexts. As regulatory challenges continue to unfold, the future landscape for agreements will likely require ongoing adaptation by both employers and valuation experts.

Factors that influence valuation of Non Compete Agreement

A non-compete agreement’s value can be affected by a number of variables. Here are some crucial considerations.

Factors that influence valuation of Non Compete Agreement
  • Geographic scope – The non-compete agreement’s geographic scope is a key consideration. A restriction with a greater geographical extent, such as a countrywide restriction, may be valued more highly than a restriction with a regional or local reach.
  • Industry norms – The value of agreement might be affected by the unique industry and market conditions. The perceived worth of the agreement may vary depending on elements including industry competitiveness, market demand, and growth possibilities.
  • The expertise of the party involved – The valuation may be impacted by the parties’ ability to negotiate and by the legal experts’ knowledge. A greater price for the non-compete agreement might be possible with the help of savvy negotiators and legal counsel.

Methods of valuing Non Compete Agreement

Valuing a non-compete agreement can be a difficult undertaking because it requires considering the prospective impact on the parties involved as well as the specific circumstances surrounding the agreement. The following strategies are frequently employed:

Income Approach

It entails calculating the predicted future revenues or profits that the party subject to the agreement could achieve if they were not constrained by the non-compete clause.

In order to understand this clearly we quoted an example the example of the Income approach, Potential Revenue Without Non-Compete is considered and discounted to the Present Value:

YearPotential Revenue Without Non-CompeteGrowth RateProjected EarningsDiscount RatePresent Value of Earnings
1$400,0005%$400,00010% (0.909)$363,600
2$400,0005%$420,00010%
(0.826)
$346,920
3$420,0005%$441,00010%
(0.751)
$331,191
Total Present Value$1,041,711

Cost Approach

Evaluates the non-compete agreement’s worth by estimating the costs of enforcing the agreement or the prospective expenses of a breach. The example below considers the cost of replacing the individual’s contribution or enforcing the agreement legally.

Cost ItemAmount
Recruiting and Hiring Costs$70,000
Training Cost for Replacement$40,000
Legal Fees for Enforcement$30,000
Potential Revenue Lost During Transition$100,000
Total Value$240,000

Excess Earning Method

Estimates the value of a non-compete agreement by evaluating the additional earnings that can be created as a result of the agreement above and beyond what would be expected without it.

This will be clearly understood in the example below. We will discount the value of excess earnings to Present Value to obtain the value of non-compete as shown below:

YearRevenue generated due to Non-CompeteExcess Retained Earnings (%)Annual Excess EarningsDiscount RatePresent Value of Excess Earnings
1$500,00010%$50,0008% (0.926)$46,300
2$500,00010%$50,0008% (0.857)$42,850
3$500,00010%$50,0008% (0.794)$39,700
4$500,00010%$50,0008% (0.735)$36,750
5$500,00010%$50,0008% (0.681)$34,050
Total Present Value$199,650

Probability Weighted Approach

It entails determining the expected value based on the probability that is assigned to distinct circumstances. Probability is multiplied by the number of possible outcomes and discounted to present value; this returns the Value of a Non-Compete agreement.

ScenarioProbabilityExpected (Loss)/Profit per YearYear 1 PV at 10% discount rate (0.909)Year 2 PV at 10% discount rate
(0.826)
Year 3 PV at 10% discount rate
(0.751)
Total Expected Value
Scenario 1 (Breached)30%-$200,000-$54,540-$49,560-$45,060-$149,160
Scenario 2 (Compliant)70%$400,000$254,520$231,280$210,280$696,080
Total Value of Non-Compete$546,920

Challenges in valuing Non Compete Agreement

It might be difficult to value non-compete agreements because of a number of issues. Here are some major issues to take into account.

  • Subjectivity and Uncertainty – A non-compete agreement relies on elements like the industry, region, length, and nature of the agreement. It can be difficult to pinpoint a precise impact on a company’s profitability or competitive advantage.
  • Intangible Nature – It forbids a person from working in competition with a previous employer for a predetermined amount of time and within a predetermined geographic area after leaving their position. It can be more difficult to restrict intangible factors, like general knowledge and abilities gained through a job.
  • Geographic and Temporal Considerations – Employees frequently operate remotely or across multiple geographic regions in the modern, international business. Determining the proper geographic scope of a non-compete agreement presents a hurdle. The contract may be deemed irrational and unenforceable if it covers a huge geographic area and is too broad in scope.
  • Enforcement and Compliance – The enforceability of non-compete agreements varies by jurisdiction. Some regions have tight restrictions that limit their legitimacy, while others uphold them more freely. The legal environment makes the valuation process more challenging because an agreement’s enforceability has a huge impact on how much it is worth.
  • Confidentiality and Information Asymmetry – Employers and workers must share confidential information in order to uphold legitimate business interests under non-compete agreements. Employees might violate the agreement by using or disclosing this information in a new job.
  • Changes in Circumstances – Given the employee’s new responsibility, courts may assess the agreement’s scope and reasonableness. Non-compete agreements’ enforceability may be impacted by market changes and economic conditions, which may limit employees’ options for new employment.

Eqvista’s Non-Compete Agreement Valuation with Expert Assistance

It is crucial to note that the valuation of non-compete agreements is frequently subjective and may require negotiation between the parties concerned. Additionally, non-compete agreements’ enforcement and validity can differ between jurisdictions, so it’s important to consult with legal and financial experts who are knowledgeable about the pertinent rules and legislation.

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