To Compete or Not to Compete?

Our country was founded on a sense of adventure and competition. In fact, competition is one of the cornerstones of our free market economy. Many of our country’s most successful business and government leaders have been noted for their fierce competitive spirit. In today’s business environment, more and more employees are being required, as a condition of employment, to sign legal documents which limit their ability to compete with the employer should they decide to change jobs.

This article explores the common forms of restrictive covenants and the far-reaching implications they can have on the operations, financial performance and value of a business.

Forms of Restrictive Covenants

There are two predominant forms of restrictive covenants, which are generally referred to as non-competition agreements and non-solicitation agreements. Non-competition agreements generally attempt to restrict several types of activities, such as performing the same job responsibilities for another existing competitor; starting up a new business that would be competitive to the employee’s current employer; and attracting clients or patients away from the employee’s current employer. Non-solicitation agreements, on the other hand, attempt to prevent current or former employees from soliciting other key personnel away from their employer, thereby depriving the business of a valuable asset.

Goals of Restrictive Covenants

Generally speaking, restrictive covenant agreements are used to protect the company’s future cash flows and value. This is accomplished in two ways. First, covenants protect the company’s current client/patient base from being eroded by defecting employees. Since future revenues are critical to any business, protecting this valuable asset is critically important. It is generally much more expensive to develop new client relationships than it is to continue providing good service to existing ones.

The second way that restrictive covenants help protect the value of an organization is by protecting the significant investments that have been made in human capital. Retention of a well qualified and trained staff is critical to the success of any organization. This is especially true for service providers such as healthcare organizations. By prohibiting the solicitation of key employees, restrictive covenant agreements protect this valuable asset, which generally takes significant time and resources to develop.

Because of the financial significance of the above two items, restrictive covenant agreements generally include monetary penalty provisions in addition to requiring the individual to cease the offending activity. The financial penalty provisions are usually significant and can sometimes exceed the revenues lost or expenses incurred as a result of the violation.

Basis for Value

Due to the Stark laws and antikickback regulatory requirements, consideration paid by certain healthcare organizations, such as hospitals, to individuals with the ability to refer business, must generally be reflective of fair market value (FMV). Therefore, the amount paid as compensation for entering into a non-competition agreement where these rules apply should be based on the FMV of the covenant.

Individuals involved with structuring non-competition agreements for healthcare providers should have a firm understanding of the regulatory requirements and ensure the consideration paid for such agreement is its FMV, which is defined as: “The price at which the property or service would change hands between a hypothetical willing buyer and a hypothetical willing seller, neither being under a compulsion to buy or sell and both having reasonable knowledge of the relevant facts.”1

The above definition is consistent with the Stark Law definitions of FMV and general market value which are defined as:

• Fair Market Value:
  The value in arm’s-length transactions, consistent with the general market value.
• General Market Value:
  The price that an asset would bring as the result of bona fide bargaining between wellinformed buyers and sellers who are not otherwise in a position to generate business for the other party, or the compensation that would be included in a service agreement as the result of bona fide bargaining between well-informed parties to the agreement who are not otherwise in a position to generate business for the other party, on the date of acquisition of the asset or at the time of the service agreement2

Key Distinguishing TermsThere are three key features to most restrictive covenant agreements, which are: geographic breadth; length of term; and a description of the restricted services.

The geographic breadth restriction should be reasonable and reflective of the organization’s current primary service area. This restriction is intended to protect the organization’s investment in building its current market share while allowing the departing employee to continue earning a living, although it may be from several miles away. Geographic restrictions that are too broad, such as ones that attempt to cover areas that are much greater than the employer’s current market area, may be considered overreaching and difficult to enforce.

The term of the restriction should also be reasonable and reflective of the time that it should take for the employer to recover from the services of the departing employee. For example, the recovery period could be defined as the length of time needed to fully transition a departing physician’s patient load to a new equally qualified physician, including the time necessary to recruit and relocate the new employee. Again, this time period should be reasonable and not overly broad. There are numerous court cases where restrictive covenants have been deemed unenforceable because either the geographic breadth or term was determined to be punitive to the employee rather than protective of the employer. Some states, such as Louisiana, South Dakota and Texas, have statutes that specify the breadth or term of a covenant in order for it to be enforceable. As a general rule, if the term of the restrictive covenant is longer than two years, enforceability may be an issue.

Finally, the specific services covered by the covenant should be clearly defined in the agreement. The breadth of services restriction should mimic those currently being provided by the employee to the business, which may be narrower than all the services currently being offered by the employer. For example, if the business offers many services to its clients/patients, but the employee subject to the restriction is only qualified and involved in one or a few of the services, then the service restriction should probably be reflective of the services that he or she currently provides. Otherwise, this restriction may be considered too broad to be enforceable.

Enforceability Issues

To be effective, restrictive covenant agreements must be enforceable. And since enforceability issues vary from state to state, it is always a good idea to consult with an attorney who is well versed in this area of the law in your particular jurisdiction.

As previously indicated, covenants that are overly broad in terms of geographic scope, length of term or service limitations, will most likely be more difficult to enforce. However, in certain states, even well devised agreements are deemed to be fundamentally unenforceable for certain industries while they may be upheld by others. For example, in Tennessee where the authors of this article reside, non-competition agreements between physicians have been deemed to be unenforceable regardless of the terms. In addition, certain states have laws that deem restrictive covenant agreements unenforceable regardless of the terms. For example, Alabama, California, Colorado, Delaware, Massachusetts and North Dakota all have statutes prohibiting noncompetition agreements.3

The following two cases illustrate the wide range of positions that various courts have taken regarding enforceability of non-competition agreements: 1) Murfreesboro Medical Clinic, PA v. David Udom, MD (this is the Tennessee case referenced above) and 2) Badr Idbeis, MD, Gary S. Benton, MD, Robert H. Fleming, MD, and John D. Rumisek, MD, v. Wichita Surgical Specialists, PA (Kansas). The Tennessee case found non-competition agreements to be unenforceable for physicians unless a hospital, hospital affiliate or faculty practice was the employer, yet the Kansas case upheld the enforceability of a non-competition agreement between physicians based on the fact that it was a valid contract.

A restrictive covenant agreement that is not enforceable does not have value and therefore should not be compensated for. Many take the position that continued employment serves as adequate compensation for signing a restrictive covenant even if it is enforceable. This, of course, only applies when the covenant is a component of on-going operations.

Non-competition agreements are generally required in most all business buy/sell transactions, such as with medical practices and clinics. Noncompetition agreements executed in connection with a buy/sell transaction should be based on the covenants fair market value. As discussed in more detail below, determining the fair market value of such an agreement requires a through analysis of the entity’s most likely net cash flows with the covenant as opposed to without the covenant.

Measuring the Impact on Value

Since medical clinics and practices are primarily service providers, restrictive covenant agreements can have a significant impact on the entity’s value. Therefore, when valuing these types of service providers, it is critically important to ascertain whether such agreements exist and if so, if they are enforceable.

Future volume projections are generally impacted substantially by the existence or non-existence of enforceable restrictive covenant agreements with key revenue producers. Absent such agreements, the entity’s future patient volume and revenue could be significantly lowered by departing physicians. Non-competition agreements give the practice an opportunity to recruit a replacement to take over the patient volume of the departing physician.

Determining the impact on value from non-competition agreements requires an in-depth analysis that compares the entity’s expected future cash flows “with” the enforceable agreement in place verses “without” such an agreement. The “without” analysis must consider and quantify the impact on the entity’s cash flows due to not having an enforceable agreement in place. For example, if the noncompetition agreement is with an individual that is retiring or moving to another geographic market, the likelihood of competition and resulting impact on value is diminished. However, if the individual plans to stay in the same geographic area and continue working, the non-competition agreement could have a significant value. Additionally, if the noncompetition agreement is related to a buy/sell transaction of a business subject to certificate of need (CON) requirements; the probability of competition would be diminished if it would be difficult for the seller to obtain another CON.

The existence of restrictive covenant agreements can also impact expense projections. For example, the entity may have to incur legal fees to enforce the agreement and additional marketing and advertising expenses to recover from lost patient volume. Additionally, absent an enforceable non-solicitation agreement, the organization may be forced to incur significant recruiting and training costs to replace key employees attracted away by former employees. All income and expense items should be evaluated when analyzing the expected financial impact of having an enforceable restrictive agreement in place verses not having one.

Impact on Operations

Some restrictive covenant agreements can be written with terms so onerous that employees feel as though they can never change jobs. Such agreements can actually be counter productive if the employee feels “trapped” by their current employer.

Recruiting the right employees is a difficult, time consuming and often expensive process. Overly broad restrictive covenant agreements can become an issue when attempting to recruit new employees, especially top candidates who have multiple employment offers. Therefore, employers must be careful to strike a balance between covenants that are restrictive enough to protect the company’s interests without being a deterrent to future employees.

Conclusion

Restrictive covenant agreements are complex legal documents that can have far-reaching implications for significant periods of time. Therefore, a competent attorney should be consulted regardless of whether you are an employer attempting to draft such an agreement, or an employee being asked to sign one.

The critical first step in assessing the value of a restrictive covenant is determining whether the agreement is enforceable. If it isn’t enforceable, then the covenant has no value. If the covenant is enforceable, the next step is to undertake a through analysis that compares the expected future cash flows of the entity with the covenant in place as opposed to without the covenant. Such analysis should consider all related factors such as the individual’s ability to compete (i.e., individual’s age, capital requirements for starting a competing business, and CON restrictions); the expected impact on patient volume; the time and cost to recruit a replacement; and the additional costs that will be necessary, such as advertising and marketing expenses, to recover from the additional competition. RBT

Carol Carden, CPA/ABV, ASA, is a director and W. James Lloyd, CPA/ABV, ASA, is the managing director of ValuePoint Consulting Group, Knoxville, Tenn. They can be reached at (865) 558-8118. For additional information regarding ValuePoint Consulting Group, visit www.valuepointconsulting.com

References

1. Estate Tax Reg. 20.2031.1-1(b); Revenue Ruling 59-60, 1959-1. C.B. 237.
2. Federal Register/Vol. 69, No. 59/Friday, March 26, 2004/ Rules and Regulations
3. Covenants not to Compete: A State-by-State Survey, by Arnold H. Pedowitz, Esq.