ALLOCATION OF FAIR MARKET VALUE TO NON-COMPETE
AGREEMENTS IN VALUATION OF PERSONAL SERVICE BUSINESSES
Accountant from Massachusetts
Personal service businesses include accounting (CPA), law, medical and other practices where the clientele strongly identifies with an individual running the practice, be that person a sole proprietor, major stockholder, significant practitioner, etc. Commonly, such practices are sold on an earnout over a period of, usually, five years and require a non-compete agreement from the sole proprietor or other major players in the practice. The requirement of a non-compete agreement is key because it binds the Seller into assuring the continuing loyalty of the clientele and, commonly, the payments over time to the Seller are pegged to and contingent on retention of clientele existing at date of closing.
It is common in divorce and other matters for the opposing party (the Buyer) to value personal service businesses as if the Seller is compelled to consent to such a non-compete arrangement and payment over time. This flies in the face of the concept of Fair Market Value because:
The Seller is entitled to cash at closing
AND
The Seller is under no compunction to enter into a non-compete agreement. This event is separate and distinct from the Fair Market Value of the personal service business.
As a practical matter, particularly in divorce matters, one can often agree with the value assigned by the opposing party, i.e.: that party’s opinion of what a Buyer would pay, said value being predicated on time payment of the purchase price and noncompete agreements. Such an agreed value is not Fair Market Value and needs to be adjusted for the following discounts:
AN ILLUSTRATION
Agreed Value
$700,000
A. Discount for risk of accepting payment over time 30%
– $210,000
B. Discount for value of non-compete agreement
– $250,000
Fair Market Value
$240,000
Discounts, of course, vary with specific situations. In the above illustration:
A. Who would not accept a 30% discount for payment today, which is implicit in Fair Market Value, as opposed to payment over five years?
B. Assuming a practitioner with average earnings of $250,000 / year, who would argue that the non-compete was not worth$50,000 / year or ($50,000 x5) = $250,000?
The foregoing deals with the “sleight of hand” where the opposing Party / Buyer presents a valuation without discounting same to Fair Market Value.
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