How Do Non-Compete Agreements Work in Small Business M&A?
Non-compete are one of the most important parts of the business buying process.
When you buy a business, you buy tangible and intangible assets, including goodwill—the business’s established reputation.
Without a non-compete, the seller could immediately compete with the business post-close. Your newly acquired clients would now have another option. And not just any option. An option that they know and trust.
The seller could destroy the goodwill that you’ve purchased.
Non-competes are all about goodwill protection.
What Is a Non-Compete Agreement?
A non-compete is a contractual clause that restricts the seller from engaging in a competing business within a defined timeframe and geographic area. It is often contained as a covenant (an obligation) in the purchase agreement, although sometimes the parties sign a separate agreement.
The purpose of the non-compete is to protect your investment by preventing the seller from using industry knowledge and customer relationships to create a rival business.
Key Elements of a Non-Compete Agreement in Small Business M&A
A non-compete is comprised of three restrictive terms:
Restricted Business. The specific business activities in which the seller cannot engage
Restricted Territory. The geographic area in which the seller cannot compete
Restricted Period. The time period during which the seller cannot compete.
Why don’t I just prohibit the seller from doing anything, everywhere, forever?
Because there are rules to this game. A non-compete isn’t worth anything unless a court will enforce it.
Enforceability of Non-Compete Agreements
The enforceability of non-competes in small business M&A depends on two related factors:
The reasonableness standard
State laws as they relate to non-compete agreements.
1. Reasonableness Standard
Non-competes are a creature of state law. Every jurisdiction has its own rules. But one thing binds them all: A non-compete must be reasonable in scope and duration.
What is reasonable?
A reasonable non-compete is sufficiently broad to protect the goodwill that you’ve purchased, but no broader.
What does that mean?
Broadly speaking:
First, the restricted activities must be no greater than the activities that the business engaged in at the time of closing.
You may have future plans to rapidly expand products and offerings. But if the business currently only offers landscaping services, the non-compete cannot prevent the seller from getting into HVAC installation.
Second, the restricted territory must be no greater than the go-to market footprint of the business at the time of closing.
You may have plans to expand the business into Southeast Asia. But if the business currently only sells products in Wichita, Kansas, the non-compete cannot prevent the seller from competing in Cambodia.
Third, the restricted period must be no greater than necessary to protect the goodwill of the business that existed at the time of closing.
Let’s unpack this third principle a little more.
A non-compete cannot continue in perpetuity. A business’s reputation is in constant flux. Google reviews accumulate. Word of mouth spreads. The goodwill that you purchase only lasts so long. At some point, your stewardship, not the seller’s, will drive the perception of the business in the eyes of prospective clients.
There is no bright-line answer to the question of how long is too long. I wish there were.
Five years is common in small business M&A. If you’re stuck for ideas, start there (consult your lawyer for legal advice specific to your deal).
2. State laws: Non-Competes 50 Ways
Non-compete laws vary by state. All states permit non-competes in the context of business acquisitions. But when it comes to the permissible scope of a non-compete (and the consequences of getting it wrong), different state courts have arrived at different answers.
Consideration
To be enforceable, non-competes must be supported by adequate consideration—i.e., the seller must receive something meaningful for agreeing not to compete.
That something meaningful is the price that the buyer pays to the seller for the business. And purchase agreements should include language making this quid pro quo clear.
Yet some state courts take consideration very seriously (for example, California state courts). And they may want to see some amount of the purchase price expressly allocated towards the non-compete.
Mere illusions to consideration might not be good enough. Some courts want to see dollars.
Modifications
What happens if a court rules that your non-compete is overly broad? Hopefully, the court will modify it, limiting its scope rather than striking it down completely. This is called blue penciling.
But not always. Some state courts (again, we’re looking at you California) refuse to blue pencil. If you’re completing a transaction in one of these states, it is essential that you get the non-compete right. There is no margin for error.
Non-Competes in Business Acquisitions vs. Employment Agreements
Non-competes generally appear in two contexts: business acquisitions and employment agreements. They are not the same beast.
While all states permit non-competes in business acquisitions, not all states permit non-competes in employment agreements. And many states have much tighter rules on permissible employer-employee non-competes than those that apply in small business M&A.
There are a number of reasons. Most forcefully: business acquisitions involve the transfer of goodwill; courts routinely hold that it would be fundamentally unfair to permit a seller to destroy the goodwill of a business that she has just sold.
That justification doesn’t apply in the employer-employee context.
You may have heard of the FTC’s attempt to ban non-competes?
That addressed non-competes in the employer-employee context. It did not apply to non-competes in the M&A context.
Read up on it for fun, by all means; it won’t impact your deal making.
Negotiating a Non-Compete
If a seller pushes back against a non-compete, take a pause and ask why.
Is there room to disagree over the scope of a non-compete? Yes. The reasonableness standard invites that debate.
But why?
The primary reason a seller will push back is because she wants to keep her options open. She may want to jump back into the game in a couple of years. Perhaps she plans on retiring but is worried that she’ll find it boring.
Whatever the reason, this is generally a red flag.
Don’t rush into the deal until you have fully understood the seller’s concerns. And consider terminating the deal if the seller insists on an unnecessarily short or narrow non-compete.
What Is a Non-Solicitation Agreement?
A non-solicitation agreement works in tandem with a non-compete. It prevents the seller from materially interfering with the business’s client, customer, or employee relationships.
Non-solicitation agreements are also often contained as a covenant in the purchase agreement. As with non-competes, non-solicitation agreements must be reasonable to be enforced.
What is reasonable in the context of a non-solicitation agreement? It varies by state. But the restricted period often mirrors the non-compete. And in the employee context, non-solicitation agreements generally do not apply to:
General solicitations. If the seller starts a non-competing business and advertises for employees through LinkedIn Jobs, that’s allowed.
Employees you fire. If you fire an employee, they are free to look for work elsewhere.
Employees who quit. But only after some amount of time has lapsed, normally 180 days or so. This is to stop the seller from engaging in clandestine poaching.
What language should I include in my LOI?
Under your list of conditions to closing, you could add the following language:
that Owner, Seller, and their affiliates enter into restrictive covenants, in a form acceptable to Buyer, agreeing not to: (i) compete with the Business for five years following the Closing, and (ii) hire or solicit any employee or customer of the Business, or encourage any employee or customer to materially change his, her, or its relationship with the Business, for a period of five years following the Closing;