A covenant not to compete prevents the seller from competing in the same industry for a specified time period and within a specified geographic range, and on the part of the seller, is similar to title insurance to the buyer of the business. In this sense, it protects the buyer from the loss of value tied to the previous owners, often in the form of personal goodwill. Because some personal goodwill cannot be transferred to a new owner, no matter how hard you try, it probably doesn’t reflect the value of all an individual’s personal goodwill.
Goodwill can be separated into two components:
- Business (or enterprise) goodwill is tied to the business as an operating entity. It can include the company’s name, phone number, location, employees and special attributes, such as unusual menu items or recipes.
- Personal (or professional) goodwill is the intangible value of the business that’s directly attributable to an individual owner. Personal goodwill includes customer contacts, vendor relationships, specialized skills, etc.
Personal goodwill can be sub-divided into “transferable” personal goodwill and “pure” personal goodwill. 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.
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.
The Meaning of the Covenant
The existence of a covenant not to compete provides evidence of transferable goodwill that can be shifted to the buyer of the business. There is an assumption of a hypothetical purchase and sale of the business in assessing a business under the fair market value standard.
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 transferable goodwill. If that’s true, the fair market value determination already includes the value of transferable personal goodwill. Theoretically, it does not include the “pure” (or nontransferable) personal goodwill.
Some interesting situations can result from this dynamic, 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 transferable 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 transferable versus pure personal goodwill. The default assumption in most of those states is the exclusion of all personal goodwill, whether transferable or not. That interpretation could change as courts in other states consider the Wisconsin Supreme Court ruling, so stay tuned.