In a free market, competition can help you build a sustainable business that delivers outstanding value for customers. But say you acquire a company and the seller instantly starts or joins a competitor that threatens your market share. Is that still healthy competition?
Given the seller’s established relationships with clients, partners, customers, and so on, you could argue they have an unfair advantage. You might even question whether your recently acquired business is still worth the same. Bad form aside, the seller’s actions will likely impact your return on investment.
To avoid this scenario, over 75 percent of acquisitions include a non-competition clause to prevent sellers from devaluing your business through unfair competition. A non-competition (or non-compete) clause is a legally binding provision that ensures a seller won’t compete with a buyer post-acquisition.
Most buyers include a non-competition clause in their asset purchase agreement (APA) or as an exhibit attached to the APA. Since you’ll rarely close a deal without a non-competition clause, here’s what you need to know and what it means for you post-acquisition.
What Is a Non-Competition Clause in Acquisitions?
Non-competition clauses are common in acquisitions to keep sellers (and their employees) from unfairly competing with buyers after the deal closes. Specifically, a non-compete agreement prevents sellers from competing within the industry via a new business or by working as an employee for a competing business.
Some buyers also require essential employees (like COOs) to enter a non-competition agreement, forbidding them from starting businesses or joining competitors. Trade secrets and other valuable information about the acquired business also move off the table thanks to non-competition clauses.
Aren’t most employees subject to confidentiality clauses, intellectual property provisions, and trade secret protection laws? Yes, but a non-competition clause adds a second layer of protection to prevent any advertent or inadvertent disclosure of sensitive or confidential employer information to a competitor.
What Is the Purpose of a Non-Competition Clause?
Ultimately, non-competition clauses protect buyers post-acquisition. As a buyer, you want to safeguard your newly acquired interests while maintaining a competitive advantage. It’s tough to do that when you’re battling someone with industry connections and intimate knowledge of your business’s strengths and weaknesses.
That’s why non-competition clauses for employees and sellers typically last between two and five years. Sellers are benched during that time unless you’ve negotiated for the seller to work in the industry under specific circumstances (such as working for the business they just sold).
What Must You Include In a Non-Competition Clause as a Buyer?
Like other legally binding provisions, non-competition clauses must include specific details clarifying what the seller can and can’t do and how the buyer is protected. We’ve outlined a few key elements below that you’ll commonly find in a non-compete agreement.
- Period. Non-competes can’t last forever (or courts will judge them as unreasonably long and void them), so pick a justifiable duration for the seller not to compete. Usually, the clause spans for months or years, depending on the seller’s plans post-acquisition, the competitiveness of your industry, and how much the seller depends on this field for their livelihood.
- Location. If your acquired business operates in or attracts customers from a specific region, non-competition clauses can prohibit sellers from operating in the same area. Why buy an ecommerce business selling Harvard basketball gear only for the seller to start an online store for all Harvard sports teams? You can also prevent employees from starting a business nearby or working for one of your local competitors.
- Type of work. What industry can’t the seller work in? What kind of work are they allowed to do inside or outside of that field? Be specific and include the exact procedures, techniques, and practices that might compete with the acquired business.
- List of competitors. As a buyer, keep your competitor list as general as possible, covering all possible related jobs or industries. The more specific the competitor list, the easier sellers can work around it and find a job in a business adjacent to yours (but not prohibited per the agreement).
- Damages. What are the consequences of breaking this legally binding agreement? Specify the liquidated damages the seller or employee has to pay if they ignore the non-compete agreement and violate the terms.
Curious about what this all looks like in an actual asset purchase agreement? Below, you’ll find an example of a section of a non-competition clause written by our own APA Builder, which drafts an APA in minutes.
How Enforceable Are Non-Competition Clauses for Sellers?
There’s no one-size-fits-all approach to enforceability and legislation for non-competition clauses in the United States. The rules and regulations vary from state to state.
If you’re a seller looking to challenge a non-competition clause and its terms, you must check your state’s non-competition laws first thing. Some states ban non-competition clauses up to a certain income threshold or require workers to receive consideration (payment or something else of value) in addition to an offer of employment before entering an agreement. Each state also makes its own rules for non-competition clauses used in acquisitions.
States that enforce non-competes typically look for evidence that the agreement’s overwhelmingly restricted or unreasonable. Those state court systems might ask the following questions to determine if they should enforce a non-competition clause or throw it out.
- Is the period too limiting? The courts don’t want to prevent sellers or employees from working in their field indefinitely. They just want the buyer to have enough time to establish and maintain a competitive advantage. While the term “reasonable” will vary from case to case, most periods won’t extend beyond five years for sellers.
- Is the location too limiting? Geographic scope affects physical, brick-and-mortar businesses more so than online startups. Founders and employees who live in the area of the sold business could challenge the non-compete if it requires them to travel an extensive distance to find new work. A state-wide restriction, for example, would not hold up in court as well as a city-wide restriction.
- Does it affect this person’s livelihood? If you’re a graphic designer and that’s the only way you can make a living, the courts will challenge a non-competition clause that restricts you from doing any graphic design. To help your case, emphasize how your new graphic design work uses a different style or applies to a different industry than the work you did for the acquired business.
- Does it protect a legitimate business interest? Examples of legitimate business interests include trade secrets, confidential information, and maintaining goodwill (customer relationships). These factors directly affect an acquired business’s success, and thus, courts will more likely uphold a non-compete agreement to protect them.
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What Happens If You Violate a Non-Competitive Clause?
If you violate a non-competition clause, you run the risk of the buyer initiating a private action against you in state or federal court. Their action will depend on how much money the buyer claims your breach of the non-compete clause lost them, and what jurisdiction and venue you contractually agreed to in the APA and its ancillary documents.
Let’s say the buyer decides to sue you. Your first step is to hire an attorney to defend you who is licensed to practice law in the court the buyer initiates the action. Hiring legal counsel can be expensive, and although your agreement may cover attorneys’ fees if you prevail in the lawsuit, you have to win by way of a dispositive pretrial motion or at trial. Otherwise, you’re responsible for the attorneys’ fees if you settle the case out of court.
To kick off the case, the buyer typically moves for a preliminary injunction in connection with their private action. A preliminary injunction is a court order prohibiting you from engaging in conduct that ostensibly violates the non-compete.
While a court may or may not grant this motion, if it does, the injunction effectively means that you cannot operate in your current position until the matter is resolved or the trial is concluded, whichever comes first. In other words, you could temporarily (or permanently) lose the ability to work your current job.
Many cases settle out of court, meaning you pay a sum in exchange for the buyer dropping the case. But the buyer doesn’t have to agree to this. If you lose the case by way of pretrial motion or at trial, the damages you owe will depend on what losses the buyer proves your breach caused them. And, in some circumstances and jurisdictions, there could be punitive damages or attorneys’ fees on top of these.
Why Is the FTC Proposing a Ban on Non-Compete Clauses?
On January 5, 2023, the Federal Trade Commission released a proposal to ban employers from imposing non-competition clauses on employees. The FTC views non-competes as “a widespread and often exploitative practice that suppresses wages, hampers innovation, and blocks entrepreneurs from starting new businesses.”
By implementing this new rule, the agency estimates that wages will increase by $300 billion annually and that one in five Americans will find better career opportunities.
So how does this proposed rule affect you when you’re buying or selling a business? Turns out, it does NOT apply to non-competition clauses directed at sellers in acquisitions.
Section 910.3 of the new rule states that it doesn’t apply to “a non-compete clause that is entered into by a person who is selling a business entity or otherwise disposing of all of the person’s ownership interest in the business entity, or by a person who is selling all or substantially all of a business entity’s operating assets.”
However, the new rule DOES prohibit a buyer from requiring existing employees to enter a non-compete agreement. Per the proposed text of the non-compete clause rule, the proposal “would not allow non-compete clauses to be applied to a business’s workers in connection with the sale of a business, where those workers are not substantial owners, members, or partners.”
The exception only applies to employees with more than a 25 percent stake in the business because someone with that level of ownership threatens “the value of the business acquired by the buyer.”
Additionally, the FTC wants employees to be able to leave their current occupation and enter into the same field to “promote greater dynamism, innovation, and healthy competition.”
These employees can start their own businesses or go work for the competition. What we don’t know is whether the ban now allows those same employees to take clients with them (though that’s typically covered in a non-solicitation clause).
If the rule passes, it will override state laws about non-competition clauses. It hasn’t passed yet, as the FTC seeks public comment on the proposal until March 20, 2023. You can read the document yourself and submit your feedback here.
What’s the Difference Between a Non-Competition Clause and Non-Solicitation Clause?
While non-competition clauses prevent sellers from working for the competition, non-solicitation clauses stop them from soliciting clients or hardworking employees after leaving the acquired business. New startup founders need new customers, and it would be simple for sellers to continue working with old clients at a different company. Non-solicitation clauses also prevent employee poaching, where the seller invites old employees to work for them at the new startup instead.
Is It Normal to Have a Non-Compete Clause?
In acquisitions, non-compete agreements are standard practice. Buyers don’t want their new startup to depreciate immediately because the seller created a similar business in the same market or neighborhood. The new owner needs time to learn how to run the business without battling an experienced adversary for clients from the get-go.
Employer-employee non-compete clauses are less common but still exist to the extent they are legal in the applicable jurisdiction. Between 36 and 60 million private-sector workers sign non-competition agreements with their employers, though that number may vanish if the FTC’s new rule passes.
Can You Ignore a Non-Compete?
You can ignore a non-compete at your own risk. If an employer or buyer catches you breaching your contract, they can take you to court. Potential charges include injunctive relief (likely being told to quit your new job), monetary and punitive damages, and depending on the agreement you signed, court and attorney fees.
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