If you are selling your business and the buyer wants you to sign a non-compete, you are probably thinking one of two things:
“I am selling my business, I am not going to set up an identical business the next day.”
“What if this non-compete binds me to unreasonable terms that impact my financial future.”
At MidStreet, we work with business owners to make sure they do not agree to terms that do not align with their future goals. If you are passionate about the industry of the business you are selling, it is not realistic to say you’d never work in the industry ever again.
This article will cover what a non-compete is, what agreements will it be included in, the purpose of it, what guidelines can and cannot be set, and how it factors into purchase price allocation.
Let’s hop in.
Disclaimer: Although effort has been made in providing accurate information, MidStreet does not warrant that accuracy and is not liable for any errors or omissions. MidStreet, nor its employees, are licensed tax professionals or attorneys. Readers are strongly encouraged to confirm tax and legal issues with accountants and attorneys in your respective state or province. The article is based on information as of summer 2021.
The Definition and Purpose of a Non-Compete
A non-compete is a clause that will be included in the letter of intent (LOI) or the asset purchase agreement for the sale of your business. It will be an agreement that binds you to not compete with the buyer of your business.
This agreement will require you to agree to not perform a certain type of work in a specified radius around the business. The sole purpose of this agreement is to ensure that the new owner has the opportunity to grow the business without large disruption (like you setting up shop right next door and competing with them).
For example, if you are selling an HVAC company in Wilmington, NC, the non-compete might specify:
James Joe (seller) is to not perform HVAC work within the Wilmington, NC area and surrounding areas within a 100-mile radius for 5 years after the official closing of the sale.
What Type of Guidelines Can be Set on a Non-Compete?
The non-compete will usually include the following guidelines:
- The area or radius in which you are to not compete
- The length of time you are to not compete in that area
- The degree to with which you are to not-compete
In some cases, non-competes may be more or less restrictive than others. For instance, one might state that you are to not perform any work within the industry and others may specify that you are to not start a new business in the same industry (but may allow you to still perform an entry-level role in the field).
The agreement will need to be reasonable and detailed in its scope. This will ensure that it does not impact the seller’s ability to maintain a livelihood after the sale if they decide to stay in the workforce.
That brings us to the next point - what can’t be in the non-compete.
What Types of Guidelines Cannot be Set in a Non-Compete?
The exact restrictions that are unenforceable in a non-compete will vary by state. However, in general, the agreement must:
- Be reasonable in scope
- Be necessary to protect the new owner
- Be reasonable within the context of the business
A niche company will require a stricter non-compete than a more generalized business in a highly saturated market.
How a Non-Compete Factors Into Purchase Price Allocation
In order for the non-compete to be enforceable, it will need a value assigned to it. That is where purchase price allocation comes in. There are five main categories of purchase price allocation when you sell your business:
Each of these categories will be taxed at ordinary income tax rates or long-term capital gains tax rates. The portion of the purchase price allocated to the non-compete will be taxed at an ordinary income tax rate.
Just like any other category, you and the buyer will need to come to an agreement on the allocation of each category. To read more about purchase price allocation, check out “What is Purchase Price Allocation in a Business Sale?”
Understand How a Non-Compete Factors Into Your Sale
Knowing what a non-compete is and how it can impact you before you accept an offer from a buyer is important. Depending on the terms of the non-compete, you may not be able to perform the work you have been performing for years for a specified period of time.
Just like you should be considering the terms of your sale and how they will impact you, you should also consider the emotions that will come with selling. Learn about the emotions by reading “The Emotions of Selling a Business.”
Do you have more questions about the process of selling your business? Give us a call today to discuss what is involved in selling your company.
