Non Compete Covenants in the Sale of a Business

During the course of negotiating a purchase and sale contract for a business, Non-Compete Covenants need to be addressed.  Just for reference,  Non-Compete Covenants are also referred to as Covenants Not To Compete.

Let’s get down to it.  What is a Non-Compete Covenant?

In the case of the sale of a business, it is contractual covenant that dictates that the selling party will not compete against the buying party by opening or partnering in a competitive business.  For example, if you are to sell a business manufacturing Printed Circuit Boards, you would be violating the Non Compete Covenant should you open or partner in another Printed Circuit Board Manufacturer after the sale of your original business.

What are some important components of a Non Compete Covenant?

#1.  It has to specify a timeframe.   A common timeframe would for a period of Three (3) to Five (5) years,

#2.  It has to specify a territory.  Common territorial restrictions may be measured in miles, or counties, even states, etc.

You may have heard that Non Compete Covenants are illegal in California, which is true for employer/employee relationships.  However, they are valid in the case of the sale of goodwill in a small business transaction, as specified in Business & Professions Code § 16601.

When preparing a business for sale, it is important to offer a Non Compete Covenant that does not raise red flags in the mind of potential buyers.  For example, only offering a One (1) Year time frame makes it seem like you may be trying to get back into the business sooner than later to compete against the buyer.

Even trickier is to manage the geographical restrictions that are placed in a Non Compete Covenant for a business.  For Brick and Mortar Retail businesses, the geographical restriction is fairly simple.  However, for online businesses, are there any real restrictions on geography.  Also, the same issue applies to Distribution Businesses and Manufacturers, as they may have a pretty geographic region to which they sell.  For Service providers, a common geographic restriction would be the geography in which the current customers are located in.

The number one most important factor in entering into a business transaction is to trust the other party.  If you have any reason to not trust the other party, you should look elsewhere.  Enforcing Non Compete Covenant clauses can be challenging due to the complexity of fighting a legal battle.  You have find a good legal firm, then you have to build the case, then you have mediation, arbitration, deposition, litigation, etc.  In most cases you are better off utilizing your resources (time, money and mental creativity) to growing your business.

Another important fact to keep in mind is that Non Compete Covenants need to be a part of the Purchase Price Allocation between the buyer and seller.  The Non Compete Covenant is an intangible asset, so it can be amortized by the buyer on the business tax returns.

For more information on Creating an Exit Strategy for Your business and maximizing its value, please contact our Client Care Manager Sonia Chhabra by telephone (888) 926-9193 or email cs@justelementary.com