The Economics of Valuing Covenants Not to Compete Under the Fair Market Value Standard

Abstract

Inaccurate damage awards for contract breach, due to inaccurate valuations, create incentives for inefficient contracting going forward, which inhibits trade and economic welfare. This paper’s purpose is to help the Court evaluate the merits of covenant not to compete (CNC) appraisals under the Fair Market Value Standard (FMVS) by understanding the underlying economics. The economic implications of the FMVS’s required assumptions form a basis for several well-founded challenges to generally-accepted business valuation practice. Substantive details, in addition to overview, make this paper an important reference for the practicing appraiser. A general mathematical CNC valuation model, including baseline assumptions for the typical CNC, is provided. A substantive, complete, and compelling analysis should accompany each departure from the baseline assumptions. While some view mathematical precision in a subjective analysis as conveying a false appearance of accuracy, disclosed input values guard against undue reliance on appraiser judgment, facilitates effective peer scrutiny, and promotes consistent value conclusions across appraisals of a given CNC.

Keywords: covenant not to compete, fair market value, efficient breach, contract law, economics of the law, law and economics, valuation, competitive market, conjunctive fallacy

JEL Classification: D4, G12, J24, J41, K12, K31