Did the FTC Just Mess with Your Business Valuation?
Many family law practitioners and not a few business owners probably never heard of the Federal Trade Commission (FTC). A once active part of the business regulatory environment, the agency was placed on sedatives during the Reagan administration and didn’t have much to contribute during the Clinton and Obama years.
Under Biden, the meds were taken away and the gloves came off. Both the FTC and the Justice Department have become aggressive in challenging what they deem mergers inimical to market competition. Then, in late April they took a new approach, issuing what are supposed to be final guidelines putting an end to the proliferating business of non competition agreements.
A textbook example of the non-compete comes from the world of medicine. You complete your residency in your chosen specialty and look to put down roots in a medical community of your choice. You interview with a bunch of practices in your field. They come back with an agreement that you will be paid so much as a base and so much for your Relative Value Units (RVUs or how productive you are). Tucked into the agreement is a provision specifying that for so many years you will not take a job with any other practice within so many miles, In other words; “If it doesn’t work out in our practice, we don’t risk finding you working for the bad boys down the road who also do orthopedics or ophthalmology.”
There was a time when these were relatively rare contract provisions confined to highly skilled people like physicians. But over time, non competes became far more widely accepted and adopted. We live in an age when many businesses are created with an eye cast toward selling the business to an outsider in 5-10 years. So, you start a software company in 2015 and assemble a lot of talented people who help you grow the business. One day “big software” comes by and says “We will acquire you for 3x revenue but how are we assured that all of your engineers won’t form their own company or go hop on the Apple or Metawagon?” This is the moment when you pop open your file cabinet (remember those?) and show your suitor that you have agreements with every employee from the Chief of Software Engineering down to the lunchroom staff stating that they can’t write a program or make a sandwich anywhere in the Milky Way for six years from the date they depart Little Software.
These agreements got to be so popular that the General Accounting office claims 18% of US employees are subject to one today and 38% of employees have been subject to one at some point in their careers.
That’s pretty stunning when you think that only about 25% of the US workforce has an undergrad degree yet 38% has been asked to sign a non-compete. So, the FTC decided to get involved.
And the involved part is big. On April 23, they adopted a final rule outlawing most non-competes effective September 4. So why does this matter in a business valuation setting?
Let’s review. In 2018 if you were in the hunt to acquire what we will just labeled “Little Software, LLC” you saw they had a talent pool and a customer bases that would fit nicely with your business model. You could borrow your acquisition money at 4-4.5% and on the day of closing the sellers would deliver that file cabinet filled with non-competition agreements. Those employees were now yours and you had that on paper.
If you are buying the same business today, you are going to pay twice as much in interest to get the business and your labor lawyer is telling you she doesn’t really know whether those non competes are going to stand up. The employees need to make more than $150,000 and have a “policy making” position for the agreements to stand up. And if the non-competes don’t stand up, the law allows penalties of up to $50,000 per violation. Oh yes, and the agreement can’t be enforced.
So, the fertile ground once occupied by low interest and enforceable non-competition agreements may start to look more like a lunar landscape as we proceed into 2024. The business world is lobbying and litigating to stop these new regulations but if you are in an acquiring mood you will want more assurance about those non-compete agreements than “Maybe.”
As we wrote back in March 2023, a business valuation based on a direct market sale effected before Fall, 2022 may be based on interest rates that are no longer available in today’s market. That affects value. And a valuation based on a direct market approach done before this year may have to be adjusted because that cabinet full of non-competition agreements is experiencing a kind of dumpster fire until the courts or Congress successfully challenge the FTC’s rule-making powers in this realm.
Obviously, some of these non-competes are not really material. The lady in the lunchroom makes a unique crab bisque but if she leaves to work at a competitor, Little Software will be sad but economically unaffected. But if the programmer who helped develop the current incarnation of Funko Fusion for Universal Studios aspires to work elsewhere you need a non-compete that is going to stick. And anyone buying Little Software is going to be more than a “little” interested in whether it can stop employee migration before their checkbook comes out. Old sales transactions based on a world where non-competes were universally accepted will seem to have some dinosaur problems when your business appraiser is cross examined about the business valuation today.
We should note that if have the filing cabinet of non-competition agreements, it may be provident to have those reviewed by your attorney based on the FTC regulations. Our presentation of the new FTC policy does not encapsulate all of the regulations and definitions adopted.
