Non-Competition Covenants: Seller Considerations and Approaches1
The benefits of selling closely held businesses range from the receipt of cash or stock and increased diversification of one’s assets, to the simplification of family relationships. But such benefits normally come burdened with certain restrictive covenants in favor of the buyer of a business, the principal one generally referred to as a “non-compete.”
A non-compete usually consists of more than one specific covenant, each of which may overlap with the others, but which together are designed to preserve the buyer’s “benefit of the bargain” of acquiring an asset that will not, for a certain period following the closing, be diminished in value due to certain actions of the seller. For instance, if you sell me your automotive parts manufacturing company, I will want you to promise to me that the day (or, indeed, some number of years) after the closing, you will not open up another similar manufacturing company across the road (or, moreover, within the same county or state, or even country).
Unreasonably broad in scope, geographically far-reaching or long covenants not to compete may not be enforced—or may be narrowed in their application—by courts. The general standard of reasonableness is whether such covenants protect a buyer’s legitimate business interests and are suitably limited by time and geographic area. But the ultimate determination of the enforceability of non-competes varies from state to state in the United States, and certainly by country, and therefore the limited scope of this article does not seek to address the myriad nuances of local interpretation.
As a general matter, sellers need to be comfortable that they can abide by the following aspects of non-competition covenants: 1) the definition of a competitive business or enterprise, 2) the duration of the covenant, 3) the geographic scope of the covenant, 4) restrictions affecting the seller’s ongoing relationships with (a) customers and (b) employees of the acquired entity, and 5) limitations on the use of presumed confidential information of the acquired entity and, by extension at times, of the buyer. A well-represented seller will carefully define and limit each of the foregoing in the definitive transaction documents.
Defining What Constitutes a “Competitive Business” or “Competitive Activity”
In the first instance, one needs to assess what would constitute “competition” that would violate the promise not to compete given by a seller to the buyer. A seller should be wary of agreeing to refrain from “any” type of activity conducted by a buyer, and certainly not from any activity that is not currently conducted by a buyer but in which the buyer happens to engage in in the future. Typically, it is wise to limit the definition of “competitive activity” or “business” to the type of business that is conducted by the seller (or the target being sold) as of the date of closing. It would be possible to expand this definition to include any business actively being pursued by the seller pursuant to written plans and board approval, but generally it is best to be as specific as possible regarding the definition of “competitive business” or “competitive activity” and relate it back to the precise type of assets, operations and business conducted by a seller at closing. It is the business of the seller as conducted at closing that should be the subject of the non-compete, not a generic reference to the business of the buyer and its affiliates; for it is the seller’s business that is being purchased and the buyer only has a legitimate business interest in restricting a seller from that particular activity.
The Temporal Length of the Non-Competition Restriction
The sale of a business will typically involve a request from the purchaser for a time period of between three to five years during which the prohibited activity may not be conducted by a seller. However, it is possible in certain cases to have no pure non-compete at all—subject normally to compliance with non-solicitation covenants and confidentiality restrictions discussed below. Anything more than five years would be highly unusual (and difficult to enforce)—provided that, as discussed below, a confidentiality restriction could theoretically be unlimited in time. A nuance to the term of a non-compete is the consequence of a violation and whether the term is “tolled” or extended during the period of such a breach, thereby increasing the length of the covenant. In the interest of certainty, sellers should resist such a remedy and push for a fixed period of the covenant while permitting the buyer to resort to attempting to prove actual money damages as its remedy for a breach in lieu of specific performance (which would extend the restrictive period by the period during which there was a breach).
The Geographic Scope of the Non-Competition Restriction
In this digital and interconnected era where many businesses are global and virtual in structure, the geographic scope of the non-compete covenant can sometimes be difficult to come to terms with, because any limitation at all sometimes seems to a buyer as inadequate protection. However, for many types of businesses (such as those that manufacture and ship tangible assets) it is possible to formulate a realistic range of miles from the selling business’s current locations within which a seller cannot engage in the competitive activity, particularly if, for example, shipping of the product becomes expensive outside of that range. For other businesses (e.g., those that engage in e-commerce) that can easily be performed anywhere in the world, a more global restrictive area may be appropriate.
Non-Solicitation Restrictions with Respect to Employees, Vendors and Customers
Along with a straight non-compete agreement, and even in the rare instance that a non-compete is not included in a sale transaction, buyers usually insist on restrictions that limit a seller’s ability after the sale to interfere with the employees, vendors and/or customers of the acquired business.
The restriction on soliciting or hiring employees is extremely common as the employees are a critical asset of most businesses and buyers do not want to have their human capital plundered post-sale by a seller with whom the employees of the target may have worked well and even developed friendships. Usually this restriction will run the same period as the non-compete (although for pure employees not constituting sellers of a business the non-solicit is typically two years or less). A seller should resist a flat prohibition on “hiring” any person (as opposed to actively soliciting a person for hire) as individual employees should be free to work for whomever they want so long as the seller has not initiated contact with them. In addition, employee non-solicits commonly permit hiring in response to general advertisements. Sometimes the employee non-solicitation covenant can be limited to specific key individuals, which is useful in a sale of a large enterprise.
The restrictions on soliciting or working with customers (and sometimes vendors) of the target is more controversial from a seller’s perspective, because the type of activity prohibited should, for a seller, tie back to the definition of the non-compete rather than preclude all interaction with those customers. A seller may have wide-ranging relationships with a variety of persons and companies and should be free to continue to engage in business with all such parties so long as the seller is not diverting business related to the assets purchased away from the buyer. In other words, so long as a seller is not intentionally interfering with a buyer’s business and the assets purchased, a seller can legitimately argue that they should be free to act as they please. This is particularly true of vendors, and a seller should resist any restrictions on activities with prior vendors to its business.
Of course employees, vendors and customers of a business are all critical assets, but a seller should carefully articulate the types of interaction with such parties that should be prohibited. Frequently this narrowing is most successful in the context of interactions with customers because the buyer does not have a legitimate business interest in restricting a seller’s activity with such parties unless it would compromise the specific business it has purchased.
Another vast store of value in many companies is intellectual property—whether registered patents, trademarks or copyrights or applications for the same, or general trade secrets and “know how.” Most definitive purchase and sale documents include a covenant of the seller that it will not use or disclose the confidential information of the target business being sold. This covenant often has no time limit associated with it. A seller should carefully review the confidentiality provisions to ensure that they cannot be used as a stealthy non-compete that would restrict business activities indefinitely. It is best to be specific about the nature of what is truly confidential, limit it to information concerning the business being sold (as opposed to general information of the buyer unrelated to the business being sold), and exclude information in the public domain or generally known in an industry. Other common exceptions to the definition of confidential information include independently developed products or concepts, or information that is subsequently obtained from third parties not bound by a confidentiality agreement with the buyer.
Valuing the Non-Compete
Certain transactions will involve a specific allocation of the purchase price to the non-competition agreement. Sellers should consult with their tax advisors as to the impact of such an allocation for tax purposes, as it could shift a portion of the goodwill being purchased into a non-compete payment and therefore possibly a different and less advantageous tax rate for the seller. An allocation of a specific portion of the purchase price to a non-compete could, for example, result in such portion of the purchase price being taxed at ordinary income rates rather than capital gain, and therefore should be avoided by a seller.
Sellers could consider asking for additional specific consideration outside the purchase price in connection with the non-compete, which would clarify the foregoing issue. This is particularly appropriate if not all sellers of a business are subject to the non-compete (for instance, many investment funds that are owners of a business being sold will not agree to be subject to a non-compete, whereas the founder of such business is frequently so burdened disproportionately). Frequently, a consulting agreement will be provided to a founder-type seller for periods following closing of a transaction that provides some of this additional compensation.
The non-competition covenants related to the sale of a business are complex and involve multiple layers of restriction. A seller must carefully separate and narrow the various aspects of these restrictions, and will be successful in this effort if the seller is able to convince the buyer that it is still receiving the benefit of its bargain with respect to protection of the asset purchased while permitting the seller to engage in general business activity. Good communication between a seller and its lawyer will assist in making sure that the transaction documents are thoughtfully drafted to capture the expectations of a seller going forward after a sale. Being more, rather than less, specific is, in the context of non-competes, almost always in a seller’s best interests.