A covenant not to compete on the part of the seller is similar to title insurance to the buyer of the business. It prevents the seller from competing in the same industry for a specified time period and within a specified geographic range. In this sense, it protects the buyer from the loss of value tied to the previous owners — often in the form of personal goodwill. It probably doesn't reflect the value of all an individual's personal goodwill, because some personal goodwill cannot be transferred to a new owner, no matter how hard you try.
Goodwill can be separated into two components:
Personal goodwill can be sub-divided into "pure" personal goodwill and "transferable" personal goodwill. Pure personal goodwill cannot be transferred to the enterprise or anyone else under any circumstance. These are usually personal relationships or specialized skills that cannot be passed on, such as a world-renowned surgeon who introduced a revolutionary new surgical technique.
Transferable personal goodwill can include personal relationships or specialized skills that can be conveyed to others through systematic training or development. This could also include items such as customer relationships or contact lists developed over a period of time.
The existence of a covenant not to compete provides evidence of transferrable goodwill that can be shifted to the buyer of the business. In assessing a business under the fair market value standard, there is an assumption of a hypothetical purchase and sale of the business.
Typically, a sale of the business assumes the purchaser wouldn't buy the business without obtaining a covenant from the sellers that insures the buyer receives the transferrable goodwill. If that's true, the fair market value determination already includes the value of transferrable personal goodwill. Theoretically, it does not include the "pure" (or nontransferable) personal goodwill.
This dynamic can result in some interesting situations when valuing a business for divorce purposes. Many states exclude personal goodwill from the marital estate. However, Wisconsin specifically excludes only the pure personal goodwill and specifically includes transferrable personal goodwill. It did so in its Supreme Court finding in McReath v. McReath (No.2009AP639, L.C. No. 2007FA208, July 12, 2011).
Most of the other states that exclude personal goodwill from a marital estate have not addressed the issue of pure versus transferable personal goodwill. The default assumption in most of those states is the exclusion of all personal goodwill, whether transferrable or not. That interpretation could change as courts in other states consider the Wisconsin Supreme Court ruling. Stay tuned.
In Thompson v. Commissioner (T.C. Memo 1996-468), the U.S. Tax Court provided a list of factors to determine the economic reality of covenants not to compete. Here's a list of questions — based on the factors listed in Thompson — that can be used to determine the extent to which a company's value includes elements of personal goodwill:
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