Restrictive Covenants: A “Tommy Boy” Case Study
The Anatomy of a Deal Newsletter October 23, 2020
Each month, Eric Duffee looks at a different piece of The Anatomy of a Deal – a series of easy-to-digest articles that break down complicated aspects of business transactions – helping you better understand terms + processes that can shape the direction of your business.
- M+A deals almost always require sellers to sign covenants restricting their ability to directly compete, solicit former employees, solicit customers, or utilize “confidential” information.
- M+A non-compete agreements are longer in duration and more reliably enforceable than more well-known employee non-compete agreements.
- Covenants not to solicit employees or customers/vendors of the new buyer are often far more complicated than they appear to be at first glance.
- M+A confidentiality agreements can be the most important of all restrictive covenants because they apply for an indefinite duration.
When I’m talking with business owners who are selling their business and the issue of the non-competition provision comes up, the answer I often get after raising the issue is pretty consistent: “Why the hell do I care? If I wanted to keep running the business, I wouldn’t be selling!”
Fair enough. But the non-compete (and the other “restrictive covenants” we’ll talk about later) do matter and—contrary to popular belief—are negotiable. Even if you don’t think you’ll ever get back into the business, things change. I spend more time than you might imagine helping buyers and sellers evaluate these post-closing restrictions because the seller often gets the itch to get back into the business, or do something in a related field. It would, of course, be much better for everyone if we had a meaningful conversation about these restrictions before the deal is done.
Why do these covenants exist? Simply stated, the buyer can’t enjoy the benefits of the business it’s acquiring unless the seller agrees not to interfere with the buyer’s ability to run the business and retain its relationships for some period after closing. These covenants are designed to protect this “goodwill” that the buyer is acquiring.
So let’s take a closer look at these restrictive covenants and how you might think about approaching them in your deal.
1. Non-Competition Restrictions
Most people are familiar with non-competition restrictions, in which an individual agrees not to compete with the business for some period of time in a specific geographical area. Non-competition provisions are pretty common in normal employment relationships, and they’re nearly ubiquitous in M+A transactions. However, there are some key differences between M+A non-competition covenants and employment-related covenants to consider:
- M+A covenants are much longer: In the typical employment situation (depending on your state), you might be able to get a duration of a few months up to 18 months (or maybe even 24 months for certain high-level people). Anything longer is almost sure to be unenforceable, unless you pay the person for the full duration of the covenant. In contrast, M+A non-competes regularly exceed two years. In fact, something in the 4-5 year range is the norm. And, while courts would almost never enforce such a long restriction in the employment context, courts generally view something in the 4-5 year range as reasonable in the context of a sale of business.
- M+A covenants cover a broader territory: In most employment-related non-competition agreements, the geographic restrictions of the non-compete only cover a few miles, a few counties, or sometimes a whole state. But going beyond that is almost surely a non-stop ticket to Unenforceable Town. In contrast, for M+A transactions, it’s not uncommon to see geographic restrictions that cover the whole U.S., North America, or even (sometimes) the entire world. This is because many businesses have nationwide—or global—reach and the buyer has a legitimate interest in protecting against the seller getting back in the game anywhere in which the seller could interfere with the business.
- M+A covenants are less susceptible to general attacks on enforceability: In addition to the above, M+A non-competition restrictions don’t face the same stigma as employment-related non-competition covenants. Whereas judges often view employment-related non-competition restrictions with a skeptical eye, they don’t see M+A covenants as equally threatening. Why? Well, the theoretical answer is that the buyer in an M+A deal has a greater claim for protection because the buyer bought the seller’s business, and it therefore wouldn’t be fair to let the seller, by competing, take back what it sold to the buyer. The more practical answer is that the seller often gets meaningful consideration—in the form of the purchase price—to compensate the seller for sitting out. And the bargaining power is not nearly as slanted in favor of the buyer in an M+A transaction as is the bargaining power of the employer in an employer-employee relationship.
If all of that’s true, then what happens if the seller is exiting the business under less-than-ideal circumstances? For example, in distressed transactions, the seller may not be getting much in the way of purchase price. And the seller’s bargaining power may be negligible. So does the seller still get stuck with the non-compete even in that case? Unfortunately for the seller in this situation, the non-compete probably still holds up. It’s important then for sellers in distressed situations to take into account the burden of complying with the non-compete in its cost-benefit analysis for deciding whether to even do the deal. In these cases, the seller probably has a legitimate basis for negotiating for shorter and/or tighter restrictions on the seller’s post-closing business activity.
In addition, while sellers are usually going to get stuck with some form of non-compete as part of the deal, sellers should think about exactly what they’re agreeing to. For example, most sellers probably would agree not to get back into the same business line as the seller conducted prior to the closing. But what if the buyer expands the seller’s historical business into a new business line? What if the buyer asks the seller not to compete with the buyer’s other businesses, which may have nothing at all to do with the seller’s historical business? These are some of the issues that sellers have to address in thinking about the non-compete.
One other point to mention briefly on the non-compete. As discussed in our prior installment on M+A tax issues, buyers often try to allocate purchase price to the non-compete covenant. In some states, that may be necessary to make the covenant enforceable, but in many states, it’s not necessary and results in driving up the tax cost to the seller. So sellers should be vigilant to ensure that the non-compete doesn’t end up generating avoidable taxes for the seller.
2. Customer/Vendor Restrictions
Most M+A transactions include specific covenants that restrict the seller from interfering with or taking the buyer’s relationships with key customers and/or vendors after the closing, usually for the same duration as the non-compete. Simple enough, right? And most courts see these types of restrictions as eminently fair and appropriate.
But you knew it couldn’t be that easy, right?
Let’s assume that Callahan Auto Parts, a maker of high-quality brake pads in Sandusky, Ohio, wants to sell to Zalinsky Automotive. And let’s assume our seller—we’ll call him Tommy—is asked to sign an agreement containing the following non-solicitation provision:
Seller shall not, and shall not permit any of its Affiliates to, directly or indirectly, solicit or entice, or attempt to solicit or entice, any former, current or future clients or customers of the Company or Buyer, or any former, current or future potential clients or customers of the Company or Buyer, in connection with any business or activity.
What’s the problem with that? Well, for starters, this doesn’t just stop Tommy from selling brake pads (or even other auto parts) to his former customers. It also stops Tommy from selling anything to his former customers. So if Tommy decides to get into the insurance business after selling Callahan Auto, he can’t even approach his old customers about buying insurance, even though selling insurance to them wouldn’t affect Zalinsky’s business in any way.
Tommy also missed the fact that this non-solicit covenant not only covers Callahan’s pre-closing customers, but it also covers customers of Zalinsky and post-closing customers of Callahan and Zalinsky. These are people that Tommy may not even know! Tommy boy has just signed up for a non-solicit that he can’t possibly comply with because he doesn’t even know who he’s restricted from soliciting.
That can’t be right, can it? Well, it certainly could be right. And even if it’s not right, does Tommy really want to go to court to find out?
Also, note that Tommy isn’t just agreeing to restrict himself, but also his Affiliates. Who are his “Affiliates” and what happens if those “Affiliates” violate the agreement?
Tommy probably should have gotten a little help on this from someone else who went to college for 7 years.
3. Employee Non-Solicitation/Non-Hire Restrictions
Wait, didn’t we just talk about non-solicitation restrictions? Yes, but now we’re talking about a different flavor: the employee non-solicit/non-hire.
Like the customer/vendor non-solicit, the employee non-solicit restricts the seller from going after the business’s employees after closing. Again, this restriction usually extends for the same duration as the non-compete. And when coupled with the non-hire restriction—which is very common—the seller can’t hire his/her former employees during the non-compete period, whether or not the seller actively solicits them for employment. The theory here is that the buyer should acquire the right to have a relationship with the target company’s employees after the closing without interference from the seller. After all, if the seller can lure away the entire team, the buyer doesn’t have much left to show for its acquisition.
But what if the buyer actually doesn’t care about retaining the seller’s team? What if Zalinsky—who is a strategic buyer (remember, we talked about those previously)—entered into the deal as a play to eliminate a competitor and take its customers? As part of that strategy, what happens if Zalinsky shuts down Callahan’s Sandusky facility entirely and lets go of all of the employees? Can Tommy hire them back then?
In true lawyer fashion, the answer is “it depends.” Did Tommy’s employee non-solicit/non-hire provision include an exception that makes employees terminated by Zalinsky fair game? What about the situation where Zalinsky keeps the Sandusky facility but some former Callahan employees—who despise working for Zalinsky—see a general “help wanted” post for Tommy’s new insurance business and decide to apply on their own and without any encouragement from Tommy? Does the non-solicit provision allow for that situation? It should, but in many cases, no one really thinks about these potential situations, and the agreement therefore doesn’t address them.
And many of the same issues as noted above for the customer/vendor non-solicit also apply here. For example, should the non-solicitation/non-hire covenant also cover Zalinsky’s employees or employees who first join Callahan only after the closing? And, again, what happens if Tommy’s “Affiliates” violate the restriction?
These—among other issues—are exactly the types of things Tommy and his lawyer should be addressing in the deal negotiations.
Confidentiality covenants seem to get the least attention of the restrictive covenants, but in some ways they can be the most significant. Why? Well, most notably, the confidentiality clause is the only one of the four types of covenants we’ve reviewed here that has an indefinite duration. And it’s also the one that is the most undefined in terms of its scope. Unless you’re the type of seller who truly intends to never do anything but play golf, sit on the beach, and never speak again about your company, this can be a little scary, huh?
So maybe Tommy can agree to sit out 5 years, but then decides to stick it to Zalinsky as soon as his non-compete expires. Can he do it?
Yes, but only if he doesn’t use any of the “confidential information” that he transferred to Zalinsky in the deal. What the hell does that even mean? What about all the business information still floating around in Tommy’s head that he can’t forget? These types of issues can make it harder for Tommy to get back in the game even after his non-compete has expired.
And lest we give too much confidence to the buyer, all of this ambiguity also makes it much harder for Zalinsky to enforce the confidentiality provision.
Again, this is an issue that doesn’t get much thought, but deserves careful attention from both sides.
It’s easy to dismiss the restrictive covenants as “standard” or “boilerplate,” particularly when the seller assumes that he or she will never have reason to compete after the closing. Many entrepreneurs eventually reach the point where they can no longer suppress the urge to do something new after selling the business. Unless they’re careful about what they sign up for on the front end, they may find that they’re actually restricted from doing much more than just directly competing with the business they just sold. So don’t be like Tommy. Spend the time before closing to understand what impact selling your current business might have on your potential future business.
Next Month: Deal Protection
Read last month’s piece: Due Diligence 101