20 November 2023: Selling a Business – Non-Competes
Non-compete agreements have been in the news this year.
It has been so as a result of the U.S. Federal Trade Commission (FTC) proposing a rule to make non-compete agreements illegal.
Non-compete agreements is a topic we bring up with every business owner who contacts us about the possibility of selling. In our world, this discussion falls in the category of “managing the client’s expectations“.
Why is a discussion of non-competes so important? Well, first we generally start off with what a non-compete is in the context of selling a business.
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And in that business context, there are actually two non-competes that business owners – and brokers – have to be aware of.
What is a Non-Compete Agreement?
Broadly defined, a non-compete agreement is a legal agreement or clause in a contract specifying that one party to the contract may not compete with the other party of the contract.
But depending on the circumstances, there are limitations.
For example, an employer will often require an employee or prospective employee to sign a non-compete agreement that stipulates that the employee will not enter into competition with the employer during, and for a certain period after, the employment period. However, courts have ruled that in such cases there are generally two limiting factors: time and distance.
Courts have considered that open-ended non-compete agreements unfairly and unreasonably impact an employee’s ability to earn a living with the skills he or she has acquired over the years. In many instances that we’re familiar with, such non-competes are generally limited to a maximum of two years and within a certain geographic range of, say, 25 or 50 miles.
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There are other, more wide-ranging non-compete clauses when the subject matter is highly-confidential proprietary information such as technical or methodological know-how that, if ever disclosed anywhere would damage the employer.
These agreements also prohibit the employee from revealing proprietary information or secrets to any other parties during or after employment.
Many contracts specify a certain length of time during which the employee is barred from working for a competitor after their employment period. Often, those competitors are named in the agreement.
Employers may require employees to sign non-compete agreements to protect their existing market advantage. Those required to sign these agreements often include independent contractors and consultants.
These types of non-compete agreements are an important consideration for a buyer. Buyers want to make sure that key employees are tied to the target business in two ways:
- An employment contract that ensures the employee will continue to work for the target business for a defined term thereby providing some sense of continuity to the buyer, and;
- The employee will not seek nor except employment from a competitor during, or within a certain defined period after, their employment period with the target business.
The validity and enforcement of such agreements vary by jurisdiction and may require the former employer to keep paying the ex-employee a base salary during the non-compete period. Some states, like California, refuse to enforce non-compete agreements claiming that non-compete agreements can prevent workers from getting a job in their field if they leave a position.
But significantly, on 5th January this year, the FTC proposed a ban on non-compete clauses stating that such restrictions unduly impact employees and some related parties. This new rule would apply to employees and independent contractors, paid and unpaid. In fact, it would require employers “to rescind existing non-competes and actively inform workers that they are no longer in effect.”
The Other Non-Compete
But when selling a business, the owners are impacted by another kind of non-compete agreement – one that doesn’t exist until they agree to sell. This one prohibits the seller from competing with the business they are selling.
When we have this conversation with business owners contemplating selling a business, we don’t get much push back because most sellers understand the need and, in any event, have other plans – like golfing in Pebble Beach or fishing for blue marlin off Bermuda.
But there are some sellers who obviously had other, less commendable, plans.
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Buyers understandably want to make sure the seller doesn’t open up shop down the metaphorical street to compete with the business the seller just sold. This is where managing the client’s expectations come in.
Early in our relationship, along with the discussion of the desirability of non-compete clauses in employment contracts with key employees, we have to let our clients know that they will most likely be required, as part of any acquisition, to sign their own non-compete agreement that will eliminate their ability to compete with the business they just sold.
In the wake of the rule proposed by the FTC, people have been wondering how that rule, if ultimately adopted, would impact business acquisitions. How would buyers react if a non-compete was unenforceable or even illegal? How, if at all, would valuations be impacted? After all, non-competes have a certain value to both parties and that value, often ascertained toward the end of the due diligence period and is used to adjust the acquisition price.
Well, the good news here is that the rule proposed by the FTC, once it was clarified, specifically exempts non-competes as they pertain to the sale of a business.
The Bottom Line
Non-compete agreements have been important aspects of selling a business for years and these proposed rules, if formally adopted, will impact our clients to some greater or lesser degree. But the important point here is that explaining the importance of both types of non-competes to our sellers – as well as the potential for this rule to effect the sale of their business – is essential in managing their expectations.
As always, unless our brokers are also licensed as attorneys, we disclose that we are not and cannot offer legal advice. But we always suggest that they consult their counsel for a legal opinion as to how – if at all – the evolving situation on non-compete agreements might effect them.
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I’ll be back with you again next Monday. In the meantime, I hope you have a safe and profitable week.
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The author is the founder, in 2001, of Worldwide Business Brokers and holds a certification from the International Business Brokers Association (IBBA) as a Certified Business Intermediary (CBI) of which there are fewer than 600 in the world. He can be reached at jo*@Wo*******************.com