The Use of Covenants Not to Compete When Buying and Selling a Business.
If you are a buyer of a business, the last thing you need is the seller starting a new company and competing with you. If you are a seller and not ready to retire completely, a non-compete can significantly shrink your opportunities for work. For each side, covenants not to compete play a crucial role in M&A transactions. You may have heard that covenants not to compete for employees are increasingly disfavored and may even be illegal and unenforceable. But different laws govern these covenants when they are related to the sale of a business. If there is a post-closing dispute, it is important that these provisions be carefully designed.
Legislation on Non-Compete Clauses
On Jan. 5, 2023, the FTC released a notice of proposed rulemaking to prohibit employers from enforcing non-compete clauses with workers. However, there is an exception for non-competes related to the sale of a business or ownership interest in a business. Lawyers must be well-versed in this new rule when drafting non-competes for future deals. Buyers and sellers should also consider how this impacts non-compete clauses when buying and selling a company.
The first key element of a covenant not to compete is establishing reasonable consideration. The seller must be getting something of reasonable value compared to the scope of the non-compete. For example, one dollar is not enough to support a five-year nationwide non-compete. Even with good consideration, courts might invalidate them if the connection between the covenant and the consideration is not explicit. So, when drafting a merger agreement, it’s essential to include the specific terms of any non-competition covenant either within the contract itself or through an attached form letter of transmittal. Those terms have to explicitly state that the consideration for the non-compete is some amount. That means the purchase agreement will likely state some amount for the assets or stock and some amount for the non-compete.
Common Perimeters of Covenants Not to Compete
Next, consider the scope, both in geography and in length. If the business is local in scope (i.e., a coffee shop company), then a national non-compete is inappropriate and likely not enforceable. Consider where the company does business now and try to keep the scope generally in that same area. Likewise, consider how long the non-compete lasts. The longer, the less likely it may be enforced, though there is no hard and fast rule. The length must be reasonable.
Also consider the business scope. Take the coffee shop company example. Should the former owner be prevented from opening just another coffee shop or any other beverage business? What if they want to sell tea or roast coffee beans? Can they be a consultant for other coffee shops? All of those terms are negotiable but also must be reasonable. And the more restrictions, generally the more consideration is required.
What to Think About When Drafting Covenants Not to Compete
Critical issues you need to consider include:
- When and where to address non-competition matters in deal documentation
- Essential requisites for enforceability and proper documentation of non-competition covenants
- The different treatment of non-compete covenants when included in an employment agreement
- Steps for ensuring that a non-compete agreement also binds significant shareholders, affiliates, and sellers
Avisen Legal Can Help with Your Covenants Not to Compete
We understand buying or selling a business can be complicated and often frustrating. We have years of experience working with all sorts of buyers from big private equity and strategics to searchfunders. For sellers, we enjoy working collaboratively with family businesses looking for helpful counsel when selling, whether to those private equity firms or to the next generation.