Non-Compete Valuation explained: this guide covers what it means, who it applies to, the step-by-step process, documents required, fees, due dates and penalties in India — so you can stay compliant with confidence and avoid costly mistakes.
A covenant is worth what its absence would cost — multiplied by the chance the seller would actually have competed.
The concept
The fundamental concept underlying this method is that the value of the subject intangible asset is the difference between an established, ongoing business and one where the subject intangible asset does not exist.
Key inputs of this method are the assumptions to what extent and how long the cash flows of the business get affected (adversely) in absence of the subject intangible asset. The method is typically used in order to value intangibles such as covenant not to compete agreements.
The two scenarios a non-compete valuation compares
- Value of the business with all assets in place as of the valuation date, i.e. the business utilises the intangible asset to be valued ('With' scenario);
- Value of the business with all assets in place except the subject intangible asset at the valuation date, i.e. it does not utilise the intangible asset to be valued ('Without' scenario).
It should be noted that all other factors relating to valuation should remain constant.
The four steps of a non-compete valuation
- Obtain the projections comprising revenue, expenses, working capital and capital expenditure under the with scenario and the without scenario.
- Discount the projections obtained under two scenarios to present value using an appropriate discount rate.
- Difference between present value of cash flows under two scenarios is considered to be the value of the intangible asset. The difference so computed can also be probability-weighted depending on the likelihood of competition expected / likelihood of without scenario to affect the cash flows.
- Tax amortisation benefit (TAB) can be appropriately built and added to the overall value of the intangible asset.
The differential cash flows answer one question: what would happen if the seller competed. That is not the same as what the covenant is worth.
A covenant taken from someone who was never going to compete — an owner retiring abroad, a seller with no capital and no team — prevents nothing. The differential is a hypothetical harm that would never have occurred.
Hence the probability of competing factor. In Illustration 10 it is 50%, halving 45.21 to 22.61. The seller was as likely as not to have re-entered the market, so the covenant is worth half the damage it averts.
Assessing that probability is a matter of evidence about the counterparty: their age, their resources, their industry knowledge, whether they retained a customer following, whether they have done it before.
Note also that the two methods must agree. The value of the intangible asset under both approaches, i.e., using difference in cash flows or business values, should be similar. Further, the discount rate used in both approaches shall be same. Using different rates for the with and without scenarios would manufacture a difference that has nothing to do with the covenant.
Illustration 10 — five-year non-compete
| Rs. in million | 2018 | 2019 | 2020 | 2021 | 2022 |
|---|---|---|---|---|---|
| Cash flows (with non-compete) | 20 | 25 | 35 | 40 | 40 |
| Cash flows (without non-compete) | 5 | 10 | 20 | 25 | 30 |
| Difference in cash flows | 15 | 15 | 15 | 15 | 10 |
| Discount factor @ 17.50% | 0.85 | 0.72 | 0.62 | 0.52 | 0.45 |
| PV of differential cash flows | 12.77 | 10.86 | 9.25 | 7.87 | 4.46 |
Sum of PV of differential cash flows 45.21; probability of competing 50%; fair value of non-compete 22.61.
Observe the shape of the differential: constant at 15 for four years, then falling to 10 in the fifth. The harm from competition tapers as the acquirer establishes its own position — which is the how long half of the key input.
Where a non-compete valuation needs judgement
Professional judgement would be required in scenarios where only one of the many intangibles are valued or not all intangibles are valued, as the value of the business attributable except to the intangible asset being valued is required.
And the method's honest limitation: while this method is intuitive and transparent in its approach to isolate the cash flows associated with the subject intangible, key inputs are often challenging to estimate.
Common mistakes in a non-compete valuation
- Omitting the probability of competing and taking the full differential.
- Using different discount rates for the with and without scenarios.
- Varying other assumptions between the two scenarios.
- Holding the differential constant for the whole covenant period without testing the taper.