Picture the following scenario: you spend $20 million to purchase the assets of a Boston company specializing in supply chain management and distribution in a highly negotiated asset sale. A few months after you close the deal, you learn that one of the company’s key employees, an industry expert with extensive knowledge on how to operate the business within the Boston metropolitan area, has used the money from the sale to form a new entity, buy new equipment, and go after the existing customer base he spent years developing. Subsequently, you begin losing customers and the value of the acquired business declines significantly.
While the scenario described above is theoretical, the fundamental oversight is all too real. Owners and investors often make the belated discovery that while they may have spent a significant amount of time and effort negotiating the asset purchase agreement, they did not focus on the details of the non-competition agreement. For example, neglecting to adequately address the geographic scope of the non-competition agreement could allow the employee in the example above to circumvent the provisions of the agreement by selling to customers in Cambridge.
This scenario, along with scores of other real-life situations, highlights the importance of properly negotiating the non-competition agreement in an M&A transaction.
Generally, non-competition agreements are used in two contexts: employment contracts and mergers & acquisitions (M&A). Non-competition agreements in employment contracts are commonly utilized by employers to ensure protection of various corporate assets, which include, among other things, certain proprietary information and goodwill. Such an agreement, entered into by an employer and an employee, typically focuses on imposing certain restrictions on the employee’s post-employment professional options. Commonly, an employee may be prohibited from working for a specific group of the employer’s competitors for a designated period of time.
Within the M&A context, non-competition agreements, which are generally entered into between a buyer and a seller, focus on restricting the seller and its affiliates from engaging in a business that competes with the buyer and/or the acquired business for a specified period of time and within the boundaries of a designated geographic area. It is important to note that employer/employee non-competition agreements are often also relevant to M&A transactions to the extent the buyer desires to retain certain employees of the seller who have special talents, knowledge, and experience with business operations to help develop the business post-sale.
Broadly speaking, non-competition agreements in the traditional M&A context tend to trigger less scrutiny and are perceived as more liberally enforced than employment non-competition agreements. This is largely attributed to the fact that M&A non-competition agreements are generally acknowledged as bargained for in the sale of the business. As a result, it is understandable that a buyer should be allowed to safeguard its value in the acquired business.
Including non-competition agreements in M&A transactions is especially important where the seller’s owner’s and/or key personnel’s involvement in the acquired business was integral to the business’ overall success. Without such an agreement in place, the owner or key employees could, hypothetically, form a new entity and utilize their knowledge of the industry to compete with the business that the buyer acquired, reducing the value of the overall business. Therefore, buyers often insist that the seller’s owners and affiliates also enter into non-competition agreements. This ensures that the seller cannot circumvent the restriction by using an affiliate to compete with the buyer or the acquired business.
The legality and enforceability of non-competition agreements in employment contracts is a matter of state law and, consequently, varies considerably between different states and industries. While a discussion of the enforceability and importance of employment-based non-competition agreements is meaningful, this article focuses on the importance of non-competition agreements in the M&A context, which, if properly drafted, are legal in all 50 states.
Non-competition agreements tend to be more heavily negotiated in client-based industries where the seller’s brand and client list are well-developed, allowing the seller to retain a strong ability to compete with the buyer after the sale. Non-competition agreements may not seem as important in industries where replicating the acquired business would be challenging for the seller or its owners after the sale. Nevertheless, non-competition agreements are a crucial aspect of any M&A transaction, regardless of what industry the acquired business is involved in.
Structure of Non-Competition Agreements
Although each non-competition agreement is distinctively drafted to address the unique circumstances surrounding each deal and industry, all non-competition agreements typically include the following key components (all of which are heavily negotiated):
- Scope of restricted business
The duration of most non-competition agreements generally varies between three and five years. The negotiation of the duration tends to be more of a business issue that is discussed between buyer and seller, rather than a legal one negotiated by each party’s legal counsel.
The scope of each non-competition agreement (i.e., the nature of the prohibited activities) varies depending on the industry and should be clearly defined. Sellers typically aim for the scope to be as narrow as possible and only include the direct activities that the acquired business was involved in prior to the closing date of the transaction—while sometimes carving out certain activities that they want to be permitted to engage in after the sale. In contrast, buyers usually push for a wide-ranging description of activities, which also includes the activities that the buyer is involved in pre- and post-closing. For example, buyers may include a general statement such as “any business that would be directly or indirectly competitive with the company or buyer as of the Closing Date.” Furthermore, in addition to restricting the seller and its affiliates from engaging in business activities that compete with the acquired business, non-competition agreements are generally drafted broadly enough to restrict the seller and its affiliates from both direct and indirect methods of competition, which includes working with competitors or helping other parties compete with the buyer.
The geographic area covered by the non-competition agreement generally coincides with the market area of the acquired business. By way of example, if the acquired business’ customers are located within a 25-mile radius, most parties will agree to the 25-mile radius as the geographic scope. However, sellers often push for a more limited geographic scope, while buyers will ordinarily want the geographic scope to include any area in which the buyer or its affiliates may conduct, or take active steps to conduct, the acquired business. If the seller has no intention of participating in any facet of the acquired business after the sale, then the seller may offer a more liberal geographic scope that covers an entire state or even multiple states.
As discussed above, buyers typically want to define the scope of the restricted business and geographic scope as broadly as possible. However, buyers should be careful when drafting these provisions because they must be considered reasonable in order to be enforceable. In order to be enforceable, the duration and the scope should be limited to what the parties deem as necessary to safeguard the acquired business and the associated goodwill. While each non-competition agreement’s enforceability is determined on a case-by-case basis, non-competition agreements are more likely to be enforced and upheld if the duration is relatively short and the scope of the restricted business and the geographic scope are narrowly defined. Nevertheless, the nature of the specific industry of the acquired business may warrant broader definitions for those terms.
In the context of an M&A deal, non-competition agreements can be controversial. They are often used as a negotiation tool while drafting the definitive purchase documents. As such, it is important to discuss the use of non-competition agreements early on in any given M&A transaction in case it is considered a deal-breaker for either party. Non-competition agreements are of paramount importance, insomuch that they protect the buyer’s ability to effectively run the acquired business and preserve or grow the value of the business after the sale. Without such an agreement in place, or in cases where the agreement was poorly drafted, buyers open themselves up to potential risks whereby the seller or its affiliates/owners can strategically maneuver around the parameters of the duration, scope of restricted business, or geographic scope in order to directly or indirectly compete with the acquired business.