Most business sale transactions in New Zealand come with a restraint of trade.

In principle this is an undertaking by the seller, the seller’s owners and sometimes its key personnel, not to compete with the business after the sale. It is designed to protect the existing and potential client relationships of the acquired business, and therefore its established goodwill, from competition by the seller.

But how do you assess the value of an offered restraint? If there is a breach, how do you assess any resultant loss? And how are restraints generally reflected in business valuations?

This article explores the value issues surrounding restraints of trade.

How valuable are restraints of trade?

Although their precise terms vary, restraints generally define conduct, duration and geographical area. For example, the vendor of a Hamilton legal practice may agree not to provide legal services (conduct) for 12 months (duration) in the Waikato (geography).

The widespread use of restraints of trade shows that both buyers and sellers of businesses consider them to have value.

From the seller’s perspective, a restraint helps to maximise the price they might receive, by effectively removing them as a competitor of the business.

For the buyer, the restraint is an important step in making sure that they get what they paid for – they are paying full price for the acquisition including its goodwill, and this goodwill will only be effectively transferred if the seller is unable to compete with the business after the sale.

The economic value of a restraint of trade will depend on the circumstances. In some cases its existence may preserve the entire business value, in other situations it may have limited or no value. In Thompson,¹ the restraint was determined to have a value equivalent to 10% of overall business value. In Z v Z,² it was assessed to be 69% of total business value.

How are restraints of trade valued in dollar terms?

Restraint of trade value assessments are typically required when there is a need to:

• assess financial loss suffered under a breach;
• consider the value of restraints offered as part of a business transaction;
• make business acquisition purchase price allocations under financial reporting standards; or
• as in Thompson, for relationship property purposes.

In principle, the financial value of a restraint of trade equals the present value of its future cash flows. Those cash flows are not of the restraint itself, but of the business it is designed to protect. In that sense, their valuation is similar to valuing certain intellectual property such as patents.

The cash flows considered in the valuation process can include both revenues and costs. A loss of customers from the breach of a restraint would be likely to result in reduced sales, and this could have a flow-on effect on costs, especially if the impact is so great that a business restructuring is required. The impact on cash flow can extend well beyond the actual term of the restraint.

It is difficult to obtain comparable information, which makes it rare to see restraints valued using evidence of prices paid for other restraints. This difficulty is compounded as the price paid for a restraint may not reflect its actual economic value, but may simply be a notional amount, for example to “seal the deal” or to reflect specific buyer and seller considerations such as tax.

For that reason, most restraints tend to be valued using an income-based approach, with two approaches commonly applied. In theory, both should result in a similar value:

• the ‘with and without’ method – the value is assessed as being the difference in the value of the business assuming the restraint of trade is, and is not, in place; and
• direct valuation – the value is assessed as the present value of the revenues that would be lost and additional costs incurred if a restraint of trade agreement was not implemented.

The existence of a restraint of trade covenant does not necessarily mean that it has value. A range of factors are considered in assessing value, which extend well beyond the agreed terms. These include:

• the seller’s ability and willingness to compete;
• the potential damage to the buyer posed by the seller’s competition; and
• the actual extent of the seller’s relationships with customers.

The restraint’s legal enforceability is also a key consideration, and in this the valuer will be likely to need guidance from their instructing counsel. Two American tax decisions provide a helpful more complete list of the key value considerations.³

In business sale negotiations an offer of a restraint of trade by the seller should be carefully evaluated, particularly if the seller is seeking a premium for the restraint. The reality might be that the restraint is either unenforceable to the level offered or, due to the factors described above, not as valuable as the seller believes.

How are restraints treated for business valuation purposes?

A large proportion of business valuations are performed on a notional basis, when no actual transaction is contemplated. Since restraints are typically contained in the business sale agreement, there will often not be a restraint of trade clause in place when the valuation is performed.

The extent to which a restraint of trade should be assumed will therefore depend on the specific circumstances and purpose of the valuation. However, if the valuation is being prepared on a “willing buyer and willing seller” basis, both valuation precedent and case law support the assumption of a reasonable restraint of trade being in place. This approach is aligned to the commercial reality where most business transactions include a restraint of trade. For that reason, it is also likely to be consistent with any comparable transactions used to price the assumed sale.

The assumption of a reasonable restraint of trade in the business valuation also appears consistent with the law, which I understand is that restraints must be shown to be reasonable to be enforceable.

Summary

Restraints of trade are often viewed as a key part of business sale agreements. While in some cases these may be worth the money, at other times their economic value may be relatively low, for example where it is highly unlikely that the vendor will compete.

Whether a valuation is being conducted for a business negotiation, loss assessment, or other purpose, the assessment of whether a restraint of trade has any economic value requires significant professional judgement, and every case is unique.

Jay Shaw is partner at Grant Thornton New Zealand, and specialises in business valuation and forensic accounting. You can contact him on 09 300 5804 or jay.shaw@nz.gt.com.

1. Thomson v Thompson SC 50/2014; [2015] NZSC 26
2. Z v Z [1989] 3 NZLR 413 (CA)
3. Beaver Bolt v Commissioner (TCM 1995-549); Thompson v Commissioner (TCM 1997-287)