California’s statutory ban on non-competes contains an exception for covenants given in connection with the sale of a business and its goodwill. The exception in California Business and Professions Code section 16601 (the “16601 exception”) was created to protect a buyer’s interest in enjoying the goodwill it purchased free from competition by the seller. With limited case law interpreting the exception, buyers often struggle with the question of how to best protect themselves against later competition from a seller who initially accepts post-closing employment with the buyer – must the restriction be tied to the closing date and the products and customers in place on that date or can it be tied to the employee’s later departure from the new entity and include post-closing products and customers? A recent decision from the California Court of Appeal, Fourth District, provides some guidance for those trying to draft enforceable covenants.

In Fillpoint, LLC v. Maas, No. G045057 (Cal. Ct. App. Aug. 24, 2012), the court analyzed two separate restrictive covenants given in connection with the sale of an ownership interest accompanied by an agreement to continue employment with the buyer. The former owner/employee agreed to two restrictive covenants:  a three-year covenant not to compete running from the date of sale (contained in the stock purchase agreement); and a broader, one-year non-compete, non-solicit restriction running from the date of termination (contained in the employment agreement). The owner/employee resigned from the new entity three years from the date of sale and commenced work for a competitor six months thereafter. 

The court analyzed the broader covenants in the employment agreement that prevented the owner/employee from soliciting actual or potential customers of his former employer; working for or owning an interest in a competitor; or employing or soliciting his former employer’s employees or customers, distinguishing it from the stock covenant that “focused on protecting the acquired goodwill for a limited period of time” and characterizing it instead as “a covenant that targeted an employee’s fundamental right to pursue his profession.”

In particular, the court concluded that the non-solicitation terms in the employment agreement are “too broad and inconsistent,” citing from Strategix, Ltd. v. Infocrossing West, Inc., 142 Cal. App. 4th 1068 (2006): “Non-solicitation covenants barring the seller from soliciting all employees and customers of the sold business, even those who were not former employees of the sold business, extend their anticompetitive reach beyond the business so sold.” 

The unenforceable restrictions in the employment agreement covered competition with the seller’s existing product portfolio and extended to any product or service that might be sold or developed between the closing and the termination of seller’s employment. In contrast, the covenant in the stock purchase agreement, which the court did not question, defined the competing business in very specific terms and as it existed as of the date of sale.

The restrictive covenant in the employment agreement ultimately failed for overreaching. It is well settled that a covenant not to compete given in connection with the sale of a business can restrict a seller from competing with the business he sold as well as from soliciting the customers and employees of that business at the time of sale. Here, however, the covenant in the employment agreement went further and prevented the former owner from solicitation of “potential customers” and barred solicitation of all customers and employees of the buyer at the termination of the owner/employee’s employment, regardless of whether they had any connection to the business at the time of the sale. 

Employers seeking to draft covenants that satisfy section 16601 should keep the Fillpoint reasoning and analysis in mind and consider the following:

  • Include representations that the restrictive covenant is consideration for, and a necessary condition of, the transaction.
  • If separate consideration is paid for the non-compete, that consideration should be separately recited in the purchase agreement.
  • To increase the likelihood that a court will construe a purchase agreement and employment agreement together, the agreements should cross-reference each other and include an integration clause. 
  • Be explicit that the seller agrees to the restrictive covenant in the capacity of selling shareholder and not as an employee. 
  • Restrictive covenants must be specific about the restricted business and the restricted geographic area and should describe the scope of the business at the time of sale. Non-solicitation provisions should refer to solicitation of employees at the time of sale and customers at the time of sale.