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Non-Competition Agreements in the Sale of a Business

Practice Briefs

M&A Practice Brief  

 

By: Annalise Perry and David Creekman

When buying a business, obtaining an effective non-competition agreement from the seller is typically a critical component of the deal in order to protect the buyer’s post-closing business interests. Determining the enforceability of a non-competition agreement requires a fact-specific analysis that depends on the location of the business, type of work performed by the seller, and applicable state law. Additionally, overly restrictive non-competition agreements are considered contrary to public policy and, as a result, courts review them with close scrutiny.

Parties to a non-competition agreement should carefully address enforceability requirements to increase the likelihood of withstanding legal challenges and adequately protect the acquired business. Non-competition agreements entered into in connection with the sale of a business may generally be written more broadly than non-competition agreements entered into in the employment context. In North Carolina, a non-competition agreement entered into in connection with the sale of a business must (1) be in writing; (2) be reasonable as to time and territory; (3) be reasonably necessary to protect legitimate business interests of the purchaser; and (4) not interfere with the interest of the public. If a non-competition provision is challenged in court, the party seeking enforcement (i.e., the buyer of the business) has the burden of proving that these requirements have been met.

A non-competition agreement that is reasonable in one context may not be reasonable under a different set of facts. A buyer should take care to ensure that its specific non-competition restrictions are specifically tailored to meet the substantive requirements for enforceability in the present circumstances, and it is recommended that a buyer work with its legal counsel on this critical determination.

Reasonable as to Time & Territory

North Carolina courts consider together the geographic scope and the length of time the restrictions last when determining if a non-competition agreement is reasonable. Therefore, for example, a restriction on competition that lasts for three years may be reasonable within one geographic territory, but unreasonable within a larger geographic area.

While non-competition agreements entered into in an employment context generally need to be limited in length to a period of six months to three years, in connection with the sale of a business, North Carolina courts have been willing to enforce longer non-competition periods, such as five years. However, a longer time period must correspond to a smaller geographic area within which the non-competition restriction applies, so it is important to consider these elements together when negotiating either term.

Regardless of the duration of the restriction, the geographic scope must reasonably correlate to the business being acquired. Geographic restrictions may be tied to a designated location (such as a specified area surrounding the acquired business’s principal location) or to all locations where the business is conducted or where customers or clients are located, but the restrictions may not prohibit competition in areas where the seller did not conduct business or otherwise have contacts and customers. For example, courts have found a restriction covering an entire state to be unreasonable when there were large areas within the state that did not contain any customers of the acquired business, even though the business conducted operations in various counties throughout the state.

Protection of Legitimate Business Interests

The analysis of whether a non-competition agreement is necessary to protect legitimate buyer interests is also fact-specific. The restriction should only cover the business in which the seller was engaged and, therefore, for which the seller has a competitive advantage. If the buyer is engaged in business activities unrelated to the business being acquired, then the non-compete may not properly restrict the seller from engaging in those other activities of the buyer that are unrelated to the seller’s business.

In the event that the buyer of a business seeks to enter into non-competition agreements with individuals other than the seller(s) of the business, then a similar analysis of legitimate business purpose will need to be performed. For example, greater restrictions may be appropriate for executives or other high-level employees of the acquired business to protect sensitive information about the business or customer or industry information that would be known to senior employees. Similar restrictions placed on rank and file employees who do not have access to sensitive information, however, may not be enforceable for failing to be necessary to protect a legitimate business interest. Also, it would be difficult to support a non-competition agreement as protecting a legitimate business interest where it seeks to restrict a person from competing in an area in which he or she did not perform services or have expertise. Thus, non-competition agreements should be customized to reflect the particular circumstances of each individual who will be subject to the restrictions.

Interest of the Public

Courts also consider the effect the non-competition agreement is likely to have on other persons, such as customers and other beneficiaries of a business. If the public have alternative sources to obtain the goods or services provided by the seller, then North Carolina courts will be more likely to enforce non-competition restrictions imposed on the seller. However, if a court finds that the elimination of the seller’s competition would be detrimental to the public interest, it will be less likely to enforce the agreement, even if otherwise reasonable.

Other Considerations

Buyers also should consider whether any additional payment is needed as consideration for a non-competition agreement in addition to the purchase price being paid for the acquired business. If the buyer is seeking to enter into noncompetition agreements with any individuals who are not receiving sales proceeds (e.g., employees), then it will be particularly important to provide some consideration to such individuals. If the deal is structured as an asset sale, then employment with the buyer is treated as new employment and, therefore, a non-competition agreement would be supported by consideration in the form of such new employment. However, in a transaction structured as a merger or stock sale, an employee is treated as being continuously employed through the closing of the transaction and, as a result, the buyer would need to provide additional consideration to the employee in exchange for signing a non-competition agreement. This can be accomplished by providing for a payment to be made directly to the non-seller individual being asked to sign a noncompetition agreement. The sufficiency of this payment will depend on the particular circumstances.

Additionally, it is worth noting that North Carolina has adopted the “strict blue pencil doctrine” meaning that a court may not rewrite a non-competition provision, but it may strike any unenforceable portions of a non-competition agreement and still enforce those portions that remain. Buyers should seek to draft non-competition provisions such that, even if certain provisions are struck down, the less restrictive provisions will remain and have meaning and therefore be enforced.

In conclusion, when it comes to addressing non-competition restrictions, one size does not fit all and buyers should carefully consider the specific facts and circumstances to ensure that they have enforceable non-competition agreements.

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Annalise Perry and David Creekman are attorneys in the M&A practice group of Wyrick Robbins Yates & Ponton LLP, which represents clients across a broad range of industries in connection with their significant corporate transactions. The group publishes Practice Briefs periodically as a service to clients and friends. The purpose of this Practice Brief is to provide general information, and it is not intended to provide, and should not be relied upon as, legal advice.