29 Jun 2015
DISSECTING NON-COMPETE AGREEMENTS

by veristrat

Mergers & Acquisitions have become a common business strategy to consolidate businesses whereby an increase in market share is one of the plausible benefits of the transaction. However, the purpose of the transaction gets defeated if the seller starts a competing venture which can significantly reduce the benefits of the transaction. Therefore, Non- Compete Agreements play a key role in such transactions and are generally signed to ensure the attainment of the desired results from the transaction.

Simply put, a Non- Compete Agreement is an arrangement to the purchase and sale agreement that restricts the seller of a business from competing with that business in the future. Therefore, non-compete clauses help a company safeguard its trade secrets which are highly valuable in establishing competitive advantage. As per one of the CPA publications, a “Non-Compete Agreement” is created for a separate asset sold by the seller to the buyer and when the agreement is included as a term of the asset or stock sale agreement it is called a “Covenant Not to compete.”

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Usually, when a company is purchased, the purchase price paid is allocated among the acquired assets where a portion is allocated to the non-compete agreement. This is mainly done due to financial and tax reporting purposes whereby the buyer would prefer that a larger portion of the purchase price is allocated to the covenant as this could be amortized over the contractual term accruing substantial tax benefits. This exercise also assumes importance where the seller breaches the covenant and the purchaser may have a claim for economic damages which support the purchaser’s legal claim against the seller.

Most common method utilized for valuation of Non-Compete Agreements is the Differential Value Method. Under this the business is valued under two different scenarios, in which one assumes the agreement is in place and in other it is not. The difference in the value of the business under each approach is attributed to the agreement. However, as per the Indian Contract Act, every agreement by which anyone is restrained from practicing a lawful trade or business, is up to that extent is considered illegal. Hence, the reason arises to understand the components of such agreements which make them legally enforceable.

COMPONENTS OF NCA’S

Reasonable Period- Generally, non-compete agreements that do not exceed three years in duration are termed as reasonable. Nevertheless, it may be possible to accept a non-compete bond with a term longer than three years where a customer contract is of longer duration or due to the specific requirement of the nature of the know-how transferred.

Reasonability- NCA’s should be recognized as reasonable with respect to their scope in terms of subject, geographic area and person i.e. they should only focus on the areas which would have a direct operational impact as a consequence of the merger operation. Non-compete bonds must be limited geographically to the area of operation of the seller before the transaction. However, in exceptional circumstances, such as when the seller has borne expenditure to enter into new markets, restrictions concerning these markets may also be termed reasonable.

Anti – Competitive – NCA’s should not promote the spirit of non-competition whereby the merged entity assumes a dominant position and are able to exploit’s the customers, which is detrimental to the larger interests of society.

For Example – In 2013, during the acquisition of Strides Arcolab subsidiary by Mylan Inc., the Competition Commission of India raised concerns about the ‘Restrictive Covenant Agreement’ between the entities whereby the effective time period was six years from the date of completion of the acquisition. CCI observed that Agila (a wholly owned subsidiary of Strides Arcolab) had insignificant presence in the domestic pharmaceutical market in India and Mylan’s presence was also limited. As per the agreement, Strides Arcolab and its promoters were not to engage in “the business of developing, manufacturing, distributing, marketing or selling any injectable or oncology pharmaceutical products for human use, anywhere in the world”. CCI observed that the “non-compete agreement” should have covered only those products which are either being made or sold or are under development by Agila. The firms reduced the duration of the non-compete obligation to four years besides reworking the scope of the agreement to the products manufactured by Agila.(Source: Economics Times)

Hence, the need arises to conduct detailed study of the Non-compete agreements and understands its nature which can vary considerably with respect to its industry, business size etc. before a value is assigned by the evaluator.

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