How do you like your “Covenant Not to Compete” prepared? Covenants come in many different shapes, sizes and forms dictated by state law and the type of transaction involved. The sale of a business would generally include “post-employment covenants” and “owner covenants.” Each of these covenants is designed to protect the goodwill acquired by the buyer.
Where To Look First
Look first to see which state’s law governs the contract in question. The laws vary significantly from state to state regarding the scope and enforceability of covenants. In some cases, such as Texas, there may even be conflicts between the statutes and the common law as determined by the courts. Acquisitions often times require a legal opinion regarding the enforceability of a covenant. In certain cases that opinion cannot be given because the covenant is not enforceable under the jurisdiction of the state law chosen by the parties.
Subject To Covenants
Covenants are designed to prevent owners and key employees from competing with the buyer’s newly-acquired business. The distinction between a covenant with an owner who has sold an equity interest and a key employee (who will not benefit from the sale of the goodwill of the business) is extremely important in determining whether a covenant is enforceable. California, and a number of other states will not enforce a covenant against a nonowner employee. On the other hand California law is very clear (unlike many other state laws) that a covenant will be enforceable against the owner.
Don’t overlook the fact that the buyer may already have significant protection by way of a state’s trade secret laws. Trade secret laws generally prohibit an employee from using proprietary confidential information of the seller. That information would include customer lists, vendor lists, pricing information and other information you need to run the business. Trade secret laws, however, only get you half way there. Trade secret laws would prevent the seller from using proprietary information from his prior business, however, he would still be free to compete in the absence of a covenant.
Measuring the Ingredients
For the Covenant
As a general rule, the geographic area should be no greater than the area in which the seller conducts its business. Trying to extend the covenant by adding areas the buyer may want to expand into in the future could invalidate the covenant.
Duration generally varies depending upon whether the covenant is with the owner or with a key employee. In the case of an owner, covenants of up to five years are generally considered reasonable. In those states that allow for enforceable key employee covenants, the maximum time length is generally two years.
By a Covenant
Most covenants provide that the owner/employee cannot compete either “directly or indirectly” in a business that is the “same as or similar to” seller’s business. Separate or additional prohibitions may also be included for the purpose of prohibiting the solicitation of employees or customers.
Great care should be taken in mixing the ingredients to make sure that the end product is palatable to the judge or jury. The objective in drafting the covenant should be to include those restrictions that are reasonable to protect the legitimate interests of the buyer. In meeting this objective the restrictions should not preclude the restricted parties from making a living.
In the sale of a business, part of the sales price is generally allocated to the covenant. The question is generally not whether or not too little has been allocated to the covenant, but whether too much has been allocated for tax purposes. If the seller does not have the ability to compete the IRS could challenge the amount of the allocation. Volumes have been written about what kind of consideration needs to be given to a key employee (nonowner) in order to have an effective covenant. The general consensus is that the consideration should generally be provided at the time of initial employment. Unfortunately we do not live in a perfect world and the issue usually arises for the first time when the business is being sold. In those states that do enforce key employee covenants, the courts will generally look to see whether or not adequate consideration was provided to the employee and if the restrictions are reasonable.
Sometimes consideration will flow the other way. For example, an employee may contract to pay specified amounts of money for clients that are taken from the previous employer. This arrangement is viewed as a form of covenant and will not be enforced in those states that prohibit post-employment covenants. In addition, the question often arises as to whether or not payments can be made after death. As a general rule, post death payments should not defeat the enforceability of the covenant.
Enforceability is primarily a function of crafting the covenant in such a way that it fits within the parameters of the specific applicable state laws and the court cases of that state. Note that some states will provide for partial enforceability of covenants whereby the court invalidates only those restrictions that it deems to be unreasonable. The bottom line in most cases is that the covenant needs to be reasonable in scope to protect a legitimate interest of the buyer. Sometimes even reasonable prohibitions and adequate consideration may not be sufficient. There are states that prohibit certain types of covenants based on public policy issues such as the freedom to compete. Again, it is extremely important to look at the applicable state law and court cases in each state to determine enforceability.
For Breach Of the Covenant
Generally three forms of action are taken when there is a breach of a covenant in the purchase of a business; (i) injunctive relief to stop the competition; (ii) the buyer discontinues payments on an installment obligation; and/or (iii) an action for damages arising out of the competition. Unfortunately there are no bright lines as to what constitutes business that is “the same as or similar to” the sellers business or whether or not the competition constitutes “indirect” competition. If there is any doubt whatsoever as to whether or not the seller may be engaging in prohibited activity, the seller should contact legal counsel to avoid what could be some very harsh consequences. Generally it is difficult to prove damages and oftentimes the practical remedy is an injunction. The buyer’s biggest weapon to enforce the covenant in the case of an installment sale is to stop making payments.
Buyers need to be certain that they are getting the benefit of their bargain. Understanding the applicable state law is critical and then drafting the covenant in a way that meets the criteria of that law is equally important. One would think that as we approach the twenty first century that the rules regarding covenants not to compete should be clear and well defined. The fact of the matter is that there is great ambiguity and confusion in this area and it should be approached with a substantial degree of caution.
Roger L. Neu
This brochure was prepared by the Law Offices of Roger L. Neu, Inc.
Mr. Neu specializes in privately held company mergers and acquisitions. With over 20 years of experience, Mr. Neu
has been involved in successfully completing mergers and acquisitions for over
150 privately held businesses. Mr. Neu was a CPA with Price Waterhouse, later attended Loyola Law
School, graduating with honors, and worked with a large Orange County law firm for four
years before establishing his law firm in 1982.
Law Offices of Roger L. Neu, Inc.
Specializing in Mergers and Acquisitions, Entity Reorganizations,
Business Contracts, Capital Formation and Business Tax Planning
Phone (949) 863-1700 | Fax (949) 863-1701 | 2040 Main Street, 9th Floor | Irvine, CA 92614