Valuing Covenants Not to Compete in a Professional Practice

Valuing Covenants Not to Compete in a Professional Practice

Author’s Note: The second edition of The Medical Practice Valuation Guidebook, NOW AVAILABLE, includes a detailed mathematical example and Author’s Insight and Analysis section, as well as the spreadsheet for performing the computations.

Valuators are often confronted with the need to allocate the results of a business enterprise valuation to individual assets. The need may arise for tax or financial reporting purposes, or perhaps as a useful cross check or reality check to the results of an income or market approach. Another example is in a jurisdiction that does not recognize personal goodwill as an asset for distribution in divorce. One of the more common and difficult intangibles to value is the noncompetition agreement executed in connection with the sale of a professional practice. A covenant not to compete is, in part, the measure of the value of key management (workforce in place) included in the valuation. The value of the covenant is NOT in addition to the value of the business, but is rather part of it.

Overview of “With and Without” Income Method

In order to value the covenant, a valuation of the entire business must first be completed in the customary fashion. Next, the valuator must forecast the income lost to the business in the event the seller competes by preparing an Alternate Valuation. This requires measuring those profits attributable solely to the seller or (alternatively stated) those that would be lost if the seller did compete, in each year of the forecast. It should be noted that the period of time for which the alternate forecast must be evaluated should also be consistent with the length of the covenant. Next, the valuator must estimate the probability of competition in each year of the forecast and apply that probability to the lost profits attributable to the seller. The present value is then computed, and the result summed to determine the value of the covenant in the event of competition.

Steps in valuing the covenant

1. Complete Valuation of Business

2. Estimate Probability of Competition in Each year of Forecast

3. Prepare Alternate Valuation Assuming Seller Competes, Estimate Profits Attributable to Seller

4. Compute Present Value

5. Present Value of Probability-adjusted Difference is Value of Covenant

Estimating the probability of competition in each year of Forecast

The typical practice valuation engagement may not generate all of the information desirable in assessing the probability of competition. Certain information may not be relevant to the actual transaction or may involve data the seller is unwilling to supply for perfectly valid reasons. On the other hand, there are some cases where the likelihood of competition may be quite readily apparent. Valuators should be certain to be familiar with applicable state law as to the enforceability of noncompetes, or nonsolicitation agreements. A nonsolicitation agreement would bar the seller from soliciting the services of the entity’s employees for a new enterprise, for example, or soliciting former patients or clients. Other analogous provisions typical of purchase and sale agreements include prohibitions against 1) defamatory statements, 2) disclosure of trade secrets, and 3) use of “intellectual property” of the practice.

Another area of inquiry into the law that may be relevant in some circumstances, particularly litigation, is the fiduciary duty owed a corporate entity by a shareholder-officer, or that owed a partner to a partnership, or LLC member to the LLC. For example, in some states a shareholder may be barred from attempting to usurp for him- or herself corporate opportunities. This could extend to patients, employees, and other valuable intangible corporate assets. In medical practices, there may be a strong counter-weight to such prohibitions, however due to the requirement for continuity of medical care, and the patient’s ownership of the information contained in the medical record. The threat of litigation may be a significant factor for the valuator to consider when assigning a probability to competition.

Specific factors to consider

The factors enumerated below are probably not exhaustive of the universe of potential relevant considerations. The order of assessment is relevant however, and the factors are detailed in the sequence recommended. Once a factor has made the probability of competition zero, consideration of other factors is (of course) unnecessary.

Age and health of the seller

This is commonly cited as the first and foremost factor in measuring probability. A 65-year-old physician selling his practice is unlikely to start up a new practice, even if in good health. If the seller is in poor health, the probability may decline to near zero.

Seller’s plans post-sale to re-locate

If a seller intends to re-locate beyond the area serviced by the existing practice, the probability of competition may be near zero. If the seller has already moved, is advertising the current residence for sale, or has already purchased a new residence, the probability of competition is likely to be so low as to be nonexistent or irrelevant.

Other business interests pursued by the seller, either locally or elsewhere

It is not uncommon for physicians to have business interests outside their practices, whether related to medicine or not. The valuator may wish to casually inquire as to the plans of the seller in this respect, and pursue any relevant response.

Prior evidence of sale and competition

It is conceivable one might encounter a situation involving a physician who has started and sold several practices in a given geographic area which would cause the valuator to assess the probability of competition at a higher level.

State law regarding enforceability of noncompetes

This factor could be listed earlier, but valuator’s are generally not qualified to make legal determinations and therefore should look to other factors first. Due to the threat and cost of litigation, a buyer’s counsel will often insist on a covenant, even if it is likely to be unenforceable.

Presence of pre-existing noncompete agreements between the selling entity and its owner-employees or partners

It is conceivable that a selling practice may already have in place a noncompetition agreement between its owners and the entity. A smart buyer will likely look to acquire these agreements. The presence of such agreements can influence the determination of who “owns” the intangible assets of the practice and in some jurisdictions may influence the enforceability of a noncompete.

Adequacy of sale proceeds to enable seller to retire

It would be unusual for a sale of a small medical practice to generate sufficient assets for retirement. However, the valuator may become aware of other retirement assets through the review of historical data, the contributions to pension or profit-sharing plans, or annual retirement plan filings.

Other assets of seller (if known, or obtainable)

Aside from the sales proceeds and retirement plan assets, other information about the seller’s overall net worth may be very difficult to obtain, but the valuator should be certain to look for evidence of same.

The assessment of the probability of a seller competing is the most critical and difficult task confronting the valuator. There is no “rule of thumb” that can be employed, rather the valuator must carefully consider the particulars of the situation.

After assessing the factors listed above and any others the valuator finds relevant, a Table such as that shown below is prepared summarizing the likelihood of competition in each year covered by the covenant.

Probability of Competition Table-From Year of Transaction

*Actual*		*Effective*
Probability	1-Probability	Probability
50.00%	50.00%	50.00%
60.00%	40.00%	30.00%
50.00%	50.00%	10.00%

The valuator determines the Actual probability for each year; the Effective probability in year 2 and 3 must account for the probability in year 1 in “decision tree” fashion. For example, the probability in year 3 must be multiplied by the probability of no competition in year 1 (100%-50%=50%) and year 2 (100%-60%=40%). The calculations of Effective probability are shown below:

Year 2 - 60% *50%=30%

Year 3 - 50%*40%*50%=10%

Prepare alternate valuation assuming seller competes, estimating profits attributable to the seller

In a small medical practice, it is safe to assume that a substantial portion of the revenues and profits are attributable to the seller. In such a case, if the seller opened a competing practice the day after the sale, the buyer would likely obtain little of what was bargained for, aside from hard assets and the practice location. As a practical matter, however, in the absence of misrepresentation, the seller is unlikely to compete the very next day. Even if the seller decided the day after the sale to open a competing practice, a site would have to be identified and acquired, equipment and furnishings would have to be purchased, a billing system acquired and made operational, old employees rehired or new ones hired and a host of other tasks accomplished. (Author’s Note: See a detailed discussion of this process at http://www.cpa.net/Enterprise.html ).

As a practical matter, some amount of time is likely to transpire between the sale and the commencement of competition. The longer this period of time, the greater the probability that the buyer will retain some of the practice (or the profits attributable to the seller) that has been purchased. In addition, the buyer is unlikely to sit idly by if the seller opens a competing practice and will take actions to attempt to preserve the investment that has been made. The valuator therefore needs to consider both the elapsed time before competition commences as well as the buyer’s response, when attributing profits to the seller in the forecast period of the Alternate Valuation.

Example

In the following example, the valuator has attributed 75% of all profits to the seller as of the valuation date. The valuator also concludes that the risk of loss of profits to the seller’s competition would decline from that 75% over time, and establishes 75% of the total profits attributable to the seller as the baseline loss in year 1. In addition, the buyer’s response actions would take several years to recapture the remaining lost profits. For example, in the first year, the 75% of the profits attributable to the seller are deemed to be lost (75% of 75%). In the second year the buyer is estimated to recover 25% of that 75%, leaving 56.25% unrecovered. Finally, in the third year, 50% of the 75% is recovered, leaving 37.50% unrecovered. To keep the example relatively simple, we assume that the effect of the seller’s competing is limited to a three-year period, regardless of whether the seller commences competing in year 1, 2 or 3, and that the profits lost will not vary with the year competition commences. (As a practical matter, the profits actually lost would be less the longer the seller waited to compete.)

Lost Profits Table in the Year Competition Begins

*Year*	*% Lost*	*% Recovered*	*Net Lost*
1	75.00%	0.00%	75.00%
2	75.00%	25.00%	56.25%
3	75.00%	50.00%	37.50%
4	75.00%	100.00%	0.00%
5	75.00%	100.00%	0.00%

The following Chart contains the Base or original valuation along with the Alternate Valuation. Note that as of the valuation date, 75% of that year’s profits are attributable to the seller.

		1	2	3	4	5	*Terminal*

*Base Valuation*
Free Cashflow	30,600	51,504	42,125	47,134	49,229	48,670	355,534
Present Value (PV)	317,326	47,034	32,852	31,390	27,998	23,638	154,413

Alternate Valuation

% Profits Attributed To Seller		75.00%	75.00%	75.00%	75.00%	75.00%	75.00%
PV Profits Attributed To Seller	237,994	35,276	24,639	23,543	20,998	17,728	115,810

Probability Of Competing		50.00%	50.00%	50.00%	50.00%	50.00%	50.00%
Present Value	118,997	17,638	12,319	11,771	10,499	8,864	57,905

The present value of the Alternate Valuation is NOT the value of covenant. It is simply an interim step in computing the covenant’s value, which computes the value of the business, or practice attributed to the seller assuming the seller is present in the business ($237,994) and the value attributed to the seller ($118,997) ignoring the multiplicative effect of probability. The presentation also indicates two common errors in use of this method: Failure to account for the buyer’s response to the seller’s competing, and failure to adjust years after year 1 for the multiplicative effect of probability.

The next Chart starts with the present value of all profits attributed to the seller as of the valuation date ($35,276) and in year 1, multiplies that by the 75% that are estimated to be actually lost (taken from the Lost Profits Table above). The same pattern is followed for years 2 and 3. Note that this measures only the lost profits if the seller competes commencing in year 1. The seller is then assumed to continue to compete through the remainder of the three-year term of the covenant.

The second half of the Chart computes the value of the lost profits if the seller commences competition in year 2. No lost profits are included from year 1 since the seller did not compete in that year.

		1	2	3	4	5	*Terminal*
Year 1
PV Net Profits		35,276	24,639	23,543	20,998	17,728	115,810
Net % Attributed To Seller		75.00%	56.25%	37.50%	0.00%	0.00%	0.00%
Net $Profit Attributed To Seller		26,457	13,859	8,829	0	0	0
Probability Of Competing		50.00%	50.00%	50.00%	0.00%	0.00%	0.00%
PV Of Lost Profits	24,572	13,228	6,930	4,414	0	0	0

Year 2
PV Net Profits			24,639	23,543	20,998	17,728	115,810
Net % Attributed To Seller			75.00%	56.25%	37.50%	0.00%	0.00%
Net $Profit Attributed To Seller			18,479	13,243	7,874	0	0
Probability Of Competing			30.00%	30.00%	30.00%	0.00%	0.00%
PV Of Lost Profits	11,879		5,544	3,973	2,362	0	0

The final Chart computes the value of the lost profits if the seller commences competition in year 3, and than totals the probability-adjusted present values for each year of the three-year covenant (24,572+11,879+3,612=40,063).

		1	2	3	4	5
Year 3
PV Net Profits				23,543	20,998	17,728
% Profits Attributed To Seller				75.00%	56.25%	37.50%
Net $Profit Attributed To Seller				17,657	11,812	6,648
Probability Of Competing				10.00%	10.00%	10.00%
Pv Of Lost Profits	3,612			1,766	1,181	665


Total Value Of Covenant	40,063

Recap

Complete a Valuation of the business

It is not possible to value a covenant without knowing the underlying value of the business, unless the valuator has some other source for estimating the profits of the business attributable to the seller. It should also be noted that the value of the business represents an absolute ceiling on the value of the covenant, and therefore should be determined in order to avoid overstating the covenant’s value.

Estimate the probability that the seller will compete in each year of the forecast covered by a noncompete

The most common source of errors in valuing covenants is to ignore the impact of probability. It is rare for there to be a 100% likelihood that the seller will compete, and almost equally as rare for 100% of the profits in a business to be attributable to the seller. If all of the profits in a business were attributable solely to the seller, it follows that all of the intangible value is in the nature of personal goodwill, and none is business “goodwill” or intangible value. A business consisting solely of personal goodwill would much more difficult to transfer and warrant a higher discount rate and a lower value, all other things being equal.

Complete an Alternate Valuation of the business assuming the seller competes and probability adjust each year’s cashflows

A valuation of the entire business establishes one ceiling on the potential value of the covenant. The Alternate value establishes a second ceiling since it is designed to identify all of the profits attributable to the seller, if the seller were to remain in the business, without considering the responses of the buyer to retain the business if the seller were to decide to compete. A second step in the Alternate value is probability weighting the profits attributable to the seller, without considering the multiplicative effect of probability from year to year.

After the above steps have been completed, the net profits expected to be lost to the seller’s competition must be determined, considering (again) the responses of the buyer. This requires the Alternate value profits attributable to the seller to be multiplied by the percentage representing the actual profits expected to be lost. Finally, the probabilities for each year, including the multiplicative effect described earlier, are applied to the actual profits expected to be lost and the present values summed.

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