M&A Monday: Seller Non-Compete in M&A Transaction

In almost every sale of a business, the seller should sign a non-compete, non-solicit, non-disparage agreement. This is either included in the purchase agreement or a stand-alone Restrictive Covenant Agreement.

The rationale for this is that no one in the world is better able to compete with the buyer’s new business.
A year ago, I got a call from a mid-market PE client. He said, remember when you insisted on a 5-year non-compete, but we agreed to 2 years because the seller was 65 years old? 2 years have passed, the seller is now stealing our customers. What do we do?
I said, do you have a time machine?
Be prepared for Sellers to negotiate the non-compete section. I think this is often because it is an easy way for a seller's lawyer to add value.
In this post, I will discuss (i) market terms of non-competes; (ii) how to frame non-competes with a seller; (iii) enforceability; (iv) consequences for a breach and the cross-default requests from sellers.
A few preliminary points:
1. I like to include the non-compete, non-solicit, non-disparage (restrictive covenants) in the purchase agreement because it is easier to enforce it through the indemnifications as a covenant (see Section IV###-###-#### If there are multiple shareholders not signing the purchase agreement, you will need to use a separate agreement and incorporate it into the purchase agreement.
2. The non-solicit and non-disparage are relatively straightforward and rarely negotiated, so I will focus on the non-compete.

(i) Market Terms. There are three major terms: (1) duration, (2) geography, and (3) scope of competitive business.

(1) Duration. The market for non-competes is 5 years. I have seen longer and I have seen shorter (wince). Your lender will almost certainly require 5 years unless there is a compelling reason. Be careful to specify when the period begins. If the seller is remaining as a rollover owner or employee, the non-compete should start when their relationship with the business terminates.

(2) Geography. The non-compete zone needs to be specified (see Section III). I like to ask for the zone to be anywhere the business has customers as of the date of closing. A more aggressive approach is anywhere the business has customers during the non-compete period. The market standard is where the company is located plus contiguous states. If the business in national, the zone can be, anywhere in the United States.

(3) Scope of competitive business. Buyers must be very careful to define the business broadly enough to include any competitive business. A buyer may request this to include any planned expansion of the business after closing.

(ii) How to discuss non-competes with a seller. It has to be explained in no uncertain terms that part of the purchase price is for the seller not to compete. The conversation usually goes like this:

Seller: Non-compete should be 2 years, 5 years is too long, what if I need to work? Buyer: That is exactly what I need to prevent. If you compete, you will destroy my business. You know my customers, suppliers, and the ins-and-outs of this business. Seller: Well, I’m not planning to compete. I’m retiring and want to spend time with the grandkids, but this is too restrictive. Buyer: Well, if you are not planning to compete anyway, it should not be a problem for you to agree to do what you are telling me you plan to do.

Ultimately, if a seller protests too much or refuses to agree to a non-compete, this should be a massive red flag for the buyer. I can’t emphasize this enough, a seller who competes after closing will destroy your business.

(iii###-###-#### Enforceability. People hear non-compete and think it is not enforceable. While each state is different, a non-compete in connection with the sale of a business is treated differently than an employee non-compete. Whereas many states restrict employee non-competes, sale non-competes are widely enforceable, provided they are reasonable in duration, geographic scope, serve a legitimate business purpose, and seller is receiving meaningful proceeds. Courts will give much more deference to enforcing a non-compete when it is part of a sale. For a much deeper dive, go listen to Eric B. Pacifici and Kevin Henderson's latest Mundane Millionaires podcast - it is amazing, as always.

(iv###-###-#### Consequences for a Breach and Cross Default Consequences. This may be the most important point in this entire post. The consequences for a breach should be drafted into the purchase agreement. Preferably, since the non-compete is a covenant, it can be enforced through the indemnifications in the purchase agreement. It should be excluded from any survival limitations, caps, or baskets. Meaning, if the non-compete covenant is breached, the buyer can claw back damages from the promissory note, escrow, earnout or any other enforcement mechanism included, rather than having to sue them. I say this often, but keeping indemnity recourse through promissory note, escrow, holdback, or earnout is so important. If you do not, it could be too expensive to sue a seller even if they violate the non-compete.
Cross-default. Sellers will often ask for a cross-default with the promissory note or other buyer post-closing obligations. The rationale is if the buyer stops paying the promissory note or earnout, then the seller should not be restricted from competing. The problem with this rationale is if the business is struggling and buyer defaults on the promissory note, the last thing buyer wants is for seller to start competing. Furthermore, the senior lender will want rights to step in and take the business without seller competing. The non-compete, non-solicit, and non-disparage are essential parts of an M&A transaction and will need to be handled correctly.

[1] I know the separate restrictive covenant agreement can be enforced by incorporating it as an ancillary agreement, but it is more clearly enforceable as a covenant in the purchase agreement.