Restrictive Covenants: Protecting Goodwill After the Sale

When acquiring a company, the buyer typically wants to ensure that the seller—along with any departing key personnel—does not immediately start up a rival operation or poach valuable clients and employees. Restrictive covenants, such as non-compete and non-solicitation clauses, serve to protect the company’s goodwill, intellectual property, and customer relationships. Below, we examine how these clauses are structured, their enforceability, and the potential remedies for breach.

Non-Compete & Non-Solicitation Clauses

1. Duration & Geographic Scope
   • Timeframe: Most non-competes last between 2–3 years post-closing, though high-risk industries or transactions involving unique intellectual property may demand longer durations.
   • Geography: Clauses might prohibit competition within a specific country or region; narrower scopes (focused on actual markets where the company operates) increase enforceability.
2. Permissible Activities
   • Core vs. Ancillary Services: If the seller wants to remain in a broad industry, the clause may only ban exact competing products/services.
   • Carve-Outs & Exceptions: Some agreements allow the seller to own a small, passive share in a competing company, especially if publicly traded, to avoid overly restricting legitimate investments.
3. Non-Solicitation Provisions
   • Targeting Clients or Employees: Prevents the seller (and certain related parties) from luring away customers, suppliers, or employees.
   • Reasonable Contacts: Often, the seller can still do business if approached spontaneously by a customer, provided no active solicitation occurred.

Practical Tip: Overly broad non-compete or non-solicitation clauses can be deemed unenforceable if they exceed the minimum needed to protect the buyer’s legitimate interests.

Legal Enforceability

1. Proportionality & Justifiability
   • Legitimate Business Interests: Courts generally uphold restrictive covenants only if they protect something substantial, like trade secrets, specialized skills, or brand goodwill.
   • Reasonableness in Scope & Duration: Clauses must not unnecessarily restrict the seller’s right to earn a livelihood or compete fairly in unrelated markets.
2. Local Jurisdictional Nuances
   • Different Legal Standards: Some jurisdictions impose strict limits on non-compete clauses (e.g., requiring payment to the restricted party).
   • Blue-Pencil Doctrine: In some places, courts may modify (rather than void) an overly broad clause to make it reasonable if the parties’ intent is clear.
3. Balancing Freedoms vs. Protection
   • Seller’s Perspective: Argues that broad restrictions are anti-competitive and hamper entrepreneurial freedom.
   • Buyer’s Perspective: Emphasizes the need to safeguard the acquired goodwill and prevent the seller from undermining the newly purchased business.

Standard Duration & Exceptions

1. Typical 2–3 Year Range
   • Rationale: Courts often view this as sufficient time for the buyer to stabilize the acquired business, integrate customers, and replace key personnel if needed.
   • Extended Terms: In deals involving complex technology or specialized industries, some parties negotiate a 4–5 year restriction if justifiable.
2. Common Exceptions
   • Minority Share Ownership: Sellers might be allowed to hold small shares (often under 5%) in competing entities if not actively involved in management.
   • Buyout of Non-Compete: Occasionally, additional compensation is provided to the seller, justifying a longer or more restrictive covenant.
3. Consequences of Unrealistic Durations
   • Risk of Invalidity: An excessively lengthy or geographically limitless clause could be struck down entirely, leaving the buyer with no protective covenant.

Alternatives & Enforcement

1. Monetary Damages
   • Proving Loss: If the seller breaches a non-compete, the buyer must typically show how the breach caused measurable financial harm.
   • Liquidated Damages: Some SPAs include predetermined amounts payable upon breach to avoid lengthy damage calculations.
2. Injunctions
   • Immediate Relief: Courts can issue injunctions preventing ongoing or repeated violations, particularly if damages alone won’t protect the buyer’s interests.
   • Threshold for Granting: The buyer must demonstrate the breach poses an irreparable threat to trade secrets, customer relationships, or overall goodwill.
3. Practical Protective Steps
   • Confidentiality Agreements: Reinforce the non-compete with robust clauses preventing misuse of proprietary data.
   • Monitoring & Audits: Periodic checks or agreed-upon reporting to confirm the seller isn’t infringing the covenant.
   • Employee Training & Confidentiality Policies: If key former employees remain, ensure they understand and respect their obligations.

Tip: Clear, narrow, and well-justified restrictive covenants are likelier to hold up in court. Overreaching invites legal challenges.

Conclusion

Restrictive covenants—be they non-compete or non-solicitation agreements—play a pivotal role in preserving the buyer’s newly acquired goodwill. Yet these clauses must be precise, proportionate, and backed by a legitimate commercial rationale. In practice, a 2–3 year restriction over a well-defined geographic area often provides enough protection without overstepping legal bounds. Should breaches arise, buyers typically seek damages or injunctive relief, but well-crafted clauses, aligned with local enforcement standards, remain the best defense. By balancing the buyer’s need to safeguard key relationships and intellectual property with the seller’s right to work in the broader industry, both parties can agree on a fair and robust mechanism for post-transaction peace of mind.