Updated: Jan 27, 2022
By Tsu-Li Liew
Selling a business is not an easy affair. After all, an owner who wants to pass on their business will have to find a buyer and then negotiate the best outcome. Oftentimes, in order to sweeten the deal for a buyer, an owner will have to consider signing a non-compete agreement, even though it does not benefit them. Therefore, it is important for a business owner to know what goes into a non-competition agreement, so that they can protect themselves and use the agreement to their best advantage.
What is a non-compete agreement?
Non-compete agreements, also known as non-competition agreements, are contracts between two parties, where one party agrees not to compete with the other party. Competition can come in many forms, such as joining a rival company or starting another business in the same market as the first business. For example, if the employer runs a restaurant, a non-compete agreement may prevent the employee who is leaving from joining another restaurant or opening their own.
These types of agreements are usually between an employer and an employee, in order to prevent an employee from spilling company secrets at their next job or using company strategies to build their own business. However, a non-compete agreement can be used in the sale of a business as well between the buyer and the business owner. In this case, the buyer will be the party that benefits the most from having a non-compete agreement in place. If the business owner agrees to not compete with the buyer, then the owner will not be able to open a new business in the same area as the former business. For example, if the business sold is a jewelry store, the agreement will prevent the business owner from opening another jewelry store in the same area, where it might compete with the former business.
The goal of a non-compete agreement is to protect the value of the business sold. When a business owner sells their business, not only are they selling their assets and their location, but they are also selling the goodwill of a business. This goodwill is what the business owner has built-up over the years of running the business, such as relationships with suppliers and brand recognition. The Chron has a list of what constitutes the goodwill of a business. These include personal goodwill, intellectual goodwill, business goodwill and valuing goodwill. When someone buys a business, they also want to reap the benefits of that goodwill. If the owner is able to open a new business with the same goodwill, the buyer is at a disadvantage since they are starting from scratch. Therefore, the non-compete agreement will prevent the owner from using the goodwill they sold to the buyer.
Important provisions to consider for your non-compete agreement
Like any other contract, each non-compete agreement will be different. Most important to a non-compete agreement is that the agreement has to be crafted in such a way that it is both fair and equitable to either parties. Even though a non-compete agreement will largely benefit only one party at first, in this case the buyer, the agreement has to protect the business owner’s career and right to make a living as well. This means that even though a buyer can prevent the business owner from opening a new store in the same area for a period of time, they will not be able to do so indefinitely.
Non-compete agreements also require specific information in order to be valid. These include: 1) the beginning date of the agreement, 2) reasons for enacting the agreement, 3) duration and location entailed, and 4) details of compensation. A non-compete agreement should have the start date included in its text. This is to ensure that both parties know when the agreement takes place and when the non-competition period will be lifted. If the start date is vague, there might be a disagreement about when the owner can start a new business in the same area, which might lead to a breach of the agreement and a potential lawsuit. A non-compete agreement between an employer and their employee will include some compensation for the employee since they will be restricted in their future job search for a period of time. However, since the owner is selling the business, compensation for the non-compete agreement will be less relevant in this case.
The non-compete agreement should also include the reasons for why both parties are signing the agreement. This will outline the parameters of what the business owner can or cannot do once the business is sold and while the non-compete agreement is in effect. The Chron provides information on why a buyer would want a non-compete agreement. For the buyer, it will be important that the reasons include the goodwill of the business as well as a promise from the business owner not to work for rival businesses. This will allow the buyer to reap the benefits and prevent the business owner from sharing their success with rival businesses. For the business owner, it will be important to include any exceptions that the buyer promised. Getting those promises in writing will prevent the buyer from being able to sue the owner, if they do engage in activities that could constitute as competition, even if the buyer promised that it will be okay.
A non-compete agreement should also describe the scope of geographic limitation and the duration of the agreement. These have to be reasonable, but what constitutes as reasonable will depend on the size of the business and its projected growth. In terms of geographic limitation, for example, if a business only operates in a city, it might be considered unreasonable if the buyer tries to prevent the business owner from operating another business in the entire state. However, on the other hand, if the buyer had plans to expand the business to the surrounding cities, it might be reasonable to prevent a business owner from opening a store in more than one county. Greenwald Doherty has some examples of what constitutes as a reasonable geographic limitation.
As for the duration of the agreement, a reasonable length of time will depend on state law and the industry of the business. Some states have the presumption that two years is a reasonable length of time for a non-compete agreement. However, some states might look at the industry norms to determine what is reasonable instead. For example, if the trends of the business tend to change in just a year’s time, a one-year duration for the agreement will be reasonable because relevant data that the former business owner collected will be outdated in a year. The Balance and Gunderson, Denton & Peterson, P.C. provide a general guide on non-compete agreements.
Validity and Enforceability of non-compete agreements
While it is important that the specific provisions listed above appear in the non-compete agreement, business owners have to consider whether the contract is valid and can be enforced at all. One such important aspect that business owners and buyers need to consider is that the validity of a non-compete agreement will depend on state law as well. Beck Reed Riden LLP provides a list of whether a state will allow non-compete agreements and other restrictions. Certain states, such as California, North Dakota and Oklahoma, do not allow the use of non-compete agreements altogether, while some states will only allow non-compete agreements in certain situations, such as protecting trade secrets or goodwill.
Courts might also look at the parties involved when deciding the validity of a non-compete agreement. Generally, if one party has significantly less bargaining power during negotiations, the court will not enforce the agreement if it is very restrictive to that party. However, in the case of a buyer and a business owner, the court may find that both sides have equal bargaining power in a negotiation. After all, either side could walk away from the deal if they do not like the terms of the agreement. In comparison, a new employee at a company will not have as much bargaining power as the employer who crafted the agreement. MacElree Harvey has a list of common mistakes to avoid when drafting a non-compete agreement.
Certain states, such as Arizona, North Carolina and Mississippi, have something called a “blue pencil doctrine.” This blue pencil doctrine allows courts to strike down certain provisions that are unreasonable, but enforce the parts of the agreement that they consider reasonable. For example, if the geographic scope is the only provision found to be unreasonable, the court may strike it out of the agreement. However, the agreement may still last for the duration that was agreed upon. Kirk Kirk Law has more information on the “blue pencil doctrine” in North Carolina.
Benefits for the business owner
A non-compete agreement might be a turn-off for any business owner. After all, it will restrict the ability of a business owner to make a living for a certain time period in a certain area. However, the one big benefit of a non-compete agreement is that during a sale of a business, a buyer will more likely be interested in closing the deal. To the buyer, not having a non-compete agreement might be too risky because they will have to worry about the business they just bought and also the owner’s future actions. Therefore, signing the agreement might entice the buyer to close the deal, if they know that the owner will not compete with them for a period of time.
Another benefit is that the terms are not set in stone. A business owner, unlike an employee, will be on equal footing with the buyer and have the ability to negotiate better terms for themselves. Better terms for the business owner would include a shorter duration or a smaller geographic scope. By limiting the duration or the geographic scope, a business owner will be able to get back into the scene quicker.
Even if a non-compete agreement is a restriction on the owner’s right to make a living as a whole, the terms of the agreement have to be reasonable in order for the agreement to be valid. Therefore, a court might strike down the agreement if it is overly broad. However, it might be an expensive endeavor for the business owner to get the court to invalidate the agreement. Also, despite the agreement, a business owner could start a new business in another area away from the former business or start a new business in a different field. A non-compete agreement does not shut out all the possibilities for a business owner who signs it.
Even though a non-compete agreement might restrict a business owner’s ability to start a new business, it is important to a buyer when buying a business and therefore beneficial to an owner who wants to sell their business. It is important to remember that despite the restriction, a business owner has the same bargaining power as the buyer and can use this to their advantage during negotiations. Also, a business owner should be aware of whether a non-compete agreement will be enforced in their own state, since not every state will enforce such an agreement. However, if a state enforces non-compete agreements, the terms will have to be reasonable. Therefore, a business owner should not worry about giving up too much when signing a non-compete agreement for the sale of their business because they still have opportunities to start a business in a different place or time.
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