Valuators everywhere know that the interplay between goodwill and a noncompete is a tricky issue. A recent California case arising out of the sale of a medical practice complicates the picture but also provides a bright-line rule as to how to value a business so as to ensure the noncompete is enforceable.

Change of mind: A California-based doctor who wanted to sell her medical practice entered into negotiations with a larger healthcare provider. The potential buyer offered $1.7 million for the building, which the doctor owned, but said the medical practice had no monetary or goodwill value. The doctor responded she was not “comfortable with the concept that my business/practice has no value” and that she planned to continue her current practice.

Eventually, the parties came to an agreement. The asset purchase agreement specified a price of about $34,700 for the medical practice. It provided that the assets being sold included “[a]ll of the goodwill of ‘The Medical Practice,” but it allocated 100% of the purchase price to “[f]urniture, fixtures, equipment and supplies.” As part of the sale, the doctor was offered employment with the buyer and in exchange signed noncompete and nonsolicitation agreements.

When the doctor later decided to reactivate her practice, albeit in a different form, the buyer filed a complaint alleging breach of contract, interference with contract, and unfair business practices. It asked the trial court for a temporary restraining order against the doctor. The court granted the injunction as it related to the solicitation of patients but did not prohibit the doctor from starting up a new practice.

No goodwill value. The doctor subsequently challenged the injunction with the California Court of Appeal, arguing the trial court’s ruling was an abuse of discretion.

The appeals court agreed. It noted that, under California’s Business and Professions Code, noncompete and nonsolicitation clauses are generally not enforceable. But there is an exception for persons who sell the goodwill of a business. The law recognizes that it would be “unfair” to allow the seller to compete in a way that diminishes the value of the asset he or she sold to the buyer. Under controlling case law, for the exception to apply, “there must be a clear indication that in the sales transaction, the parties valued or considered goodwill as a component of the sales price.”

Here, the Court of Appeal found that the buyer did not pay anything for the practice’s goodwill. Although the asset purchase agreement stated that the goodwill of the seller’s medical practice was among the assets sold, it allocated no portion of the $34,700 purchase price to goodwill. Also, no part of the compensation offered to the doctor under the employment agreement was for the goodwill of the practice.

Since the buyer gave no consideration for the practice’s goodwill, the noncompete and nonsolitication clauses “were neither necessary nor enforceable to protect the value of the goodwill because the parties agreed the goodwill had no value.”

Takeaway. An appraiser wanting to protect a client’s interest must know that in California a noncompete/nonsolicitation agreement accompanying the sale of a business is only enforceable if the valuation allocates a percentage of the sales price to the business’s goodwill.

Find an extended discussion of Healthcare v. Orr, 2016 Cal. App. Unpub. LEXIS 440 (Jan. 20, 2016), in the April edition of Business Valuation Update; the court’s opinion will be available soon at BVLaw.