In most M&A transactions the purchaser usually requires the sellers to sign up to a number of restrictive covenants under the main acquisition agreement.
Such covenants are designed to prevent the sellers from forming or working in a competitive business that may diminish the goodwill and know-how of the newly acquired business.
M&A transactions, particularly those in the Media and Entertainment sector, are increasingly structured around the retention of certain key sellers heavily involved in the target business, and the skills and contacts they hold in order to help maintain the success and growth of the business post-completion. Restrictive covenants play an important role in preventing such sellers from leaving and competing with the business during the period immediately following completion of a transaction, and as a result, can often take a significant amount of time to negotiate.
Types of covenants
The most common types of covenants included in an acquisition agreement are:
- non-compete covenants – restricting the seller from carrying on business in competition with the acquired business for a specified period;
- non-solicitation covenants – preventing the seller poaching existing clients/customers/suppliers and employees of the acquired business for a specified period;
- non-dealing covenants – preventing the seller from dealing with existing clients/customers/suppliers for a specified period; and
- express confidentiality covenants.
Where to draw the line
The starting position is that the English Courts will not enforce a covenant, particularly a non-compete covenant, if that covenant constitutes an unreasonable restraint of trade on the seller.
From a purchaser’s perspective, it’s therefore important to ensure the covenants in place under the acquisition agreement don’t go beyond what is reasonably necessary to protect the legitimate interests of the business acquired at completion. So how is this achieved?
The things to consider when assessing the reasonableness of restrictive covenants under an acquisition agreement are:
- scope of the activities – a covenant should only seek to protect the acquired business as at completion – for example, it shouldn’t seek to cover products or services which the target business does not provide at completion.
- duration – the appropriate duration of a covenant will vary depending on the circumstances, however, generally speaking, a three year non-compete undertaking tends to be the maximum duration which can be justified where both the goodwill and know-how of a business is acquired, and a two year period if just the goodwill is sold. Longer periods can be justified in limited circumstances where the facts of the transaction and the business involved warrant an additional period of protection.
- geographical reach – the geographical reach of a covenant should be limited to the areas in which the acquired business operates at the time of completion. In some instances, particularly for media and content businesses, this means that world-wide or European coverage may be justifiable where the acquired business genuinely operates in such areas.
The good news for purchaser’s on M&A transactions is that the English Courts tend to presume the parties to the transaction have similar bargaining power and are the best judges of what is considered reasonable – so they are less likely to scrutinise the reasonableness of a restrictive covenant as they would do in an employment context. As a result, acquisition agreements generally include non-competes which are broader in scope and longer in duration of coverage than those found in a seller’s employment contract.
Watch out for penalty clauses
Clauses which provide the purchaser with a remedy for breach of a restrictive covenant, such as those designed to clawback or forfeit property or money (such as forfeiting deferred consideration or shares received as consideration in the purchaser), may be challenged if they are considered to be a penalty clause.
Penalty clauses are those which have the principal purpose of deterrence or which aim to punish a person in breach of a covenant and are unenforceable for public policy reasons. However, a clause seeking to provide a genuine pre-estimate of loss could be considered valid.
When negotiating restrictive covenants under an acquisition agreement:
- get the wording right – the English Courts won’t fix a bad bargain.
- think – does the covenant go further than is necessary to protect the legitimate interests of the acquired business as at completion? If so, it will not be enforceable.
- can the sellers reasonably comply with the restrictions having regard to their future plans? If not, should a carve-out be included?
- consider erring on the side of caution and putting in place a more balanced set of covenants to help increase the likelihood that the covenants will be upheld if ever challenged.