Last Updated on February 20, 2023 by lukesguide
Non-Compete Agreements mean very different things to buyers and sellers.
On the buyer side, you have someone who is looking to preserve the value of their newly purchased business by restricting the previous owner from competing with them.
On the seller side, you have an individual being told that they cannot start a new business or work for another business that is similar to the one that they have just sold.
When it comes to Non-Compete Agreements, the stakes are high for both buyers and sellers so each party must understand what entering into a Non-Compete Agreement means for them.
In this article, we will explain:
- what Non-Compete Agreements are;
- the purpose of Non-Compete Agreements;
- when you might need a Non-Compete Agreement;
- the key elements of a Non-Compete Agreement; and
- the enforceability of Non-Compete Agreements.
In the context of an online business sale, a Non-Compete Agreement is a legally binding, written agreement between a buyer and a seller that formalizes certain restrictions to be imposed on an outgoing seller to not compete with the business that they have just sold.
The buyer of a business will usually look to impose a restraint on the former owner of the business for two reasons:
- the previous owner will have acquired commercially sensitive and confidential information about the business; and
- the previous owner will have developed significant relationships with the customers/clients and key suppliers of the business.
Without a carefully drafted Non-Compete Agreement in place, the buyer of the business is taking a huge risk.
Not having a Non-Compete Agreement potentially allows the previous owner to set up a competing business and use their in-depth knowledge of the business to gain a competitive advantage.
While a standalone Non-Compete Agreement is common in the context of a business sale, it is also possible to incorporate a covenant not to compete directly into an Asset Purchase Agreement.
The main purpose of a Non-Compete Agreement is to protect the legitimate business interests of an incoming buyer of a business by preserving the value of goodwill and assets of the business such as its intellectual property, know-how, trade secrets, etc.
In most cases, by signing a Non-Compete Agreement, the seller is assuring the buyer of the business that after the sale they:
- are not going to take the buyer’s money and then go set up a new business that competes with the business they just sold;
- will not accept a role (in any capacity) with a competing business or start working for a competitor;
- will not try to entice their former employees to join them at a competing business;
- will not divulge any sensitive business information to a competitor or other third party (without the permission of the buyer);
- will not otherwise do or say anything that would be harmful to the business or its reputation.
While the main purpose of a Non-Compete Agreement is to protect the interests of the buyer, the covenant not to compete should not be overly restrictive on the seller as this could make the Non-Compete Agreement difficult to enforce.
Non-Compete Agreements may be required in many situations.
We have already covered why a Non-Compete Agreement would be used in the context of a business sale but Non-Compete Agreements may also be used by former employers (to stop an employee from going to work for a competitor) or as part of joint venture arrangements.
Let’s look at both situations in some more detail.
A former employer may use a Non-Compete Agreement to prevent a former employee:
- from working for a competitor;
- starting a business that is the same or substantially the same;
- using trade secrets to develop competing products or services; and
- soliciting former colleagues to move across to a competing business.
Usually, a covenant not to compete that applies to a former employee under a Non-Compete Agreement is limited in one or more ways.
What this means is that the non-compete restrictions:
- must be reasonable;
- only apply to a certain industry and/or geographic area; and
- for a pre-defined period of time.
A Non-Compete Agreement that is overly restrictive or that prevents the person from plying their trade to earn a living may not be enforceable (more on this below).
The parties under a joint venture arrangement may use a Non-Compete Agreement to prevent the other party from:
- carrying on a similar business outside of the joint venture;
- having ownership in a similar business outside of the joint venture; and
- solicit or persuade customers of the joint venture to deal with another business.
As you can imagine, the parties to a joint venture would want to do everything they can to prevent the other parties from funneling customers and clients away from the joint venture to another business.
While a separate Non-Compete Agreement may be used in this situation, it is also common for the noncompete clauses or covenants to be built into the joint venture agreement or stockholders’ agreement.
No matter the reason for having a Non-Compete Agreement in place, it is important to have an attorney prepare your Non-Compete Deed to ensure it will be enforceable should an issue arise.
Every Non-Compete Agreement is going to be different but there are some common elements that you will find in almost every Non-Compete Agreement.
The key elements of a Non-Compete Agreement include:
- the recitals;
- details of the restrained person(s);
- type of restraints;
- geographic scope;
- permitted activities;
- dispute resolution; and
- governing law.
We provide more detail on each of the key elements that should be included in a Non-Compete Agreement below.
The recitals in a Non-Compete Agreement do not form part of the operative provisions and are not legally binding in their own right.
However, the recitals of a Non-Compete Agreement are useful as they provide a summary of the background and useful context to the non-compete arrangement.
The recitals should include a summary of what the Non-Compete Agreement is aiming to achieve, who the parties are, and the intentions of the parties when entering into the Non-Compete Agreement.
A Non-Compete Agreement should make it very clear to whom the non-compete applies.
As much information as possible about the restrained person(s) should be included in the ‘parties’ section of the Non-Compete Agreement. At a minimum, these details should include the restrained person’s full name and contact details (i.e. email address, phone number, postal address).
Specific details of the restraints that will apply to the restrained person(s) need to be included in Non-Compete Agreements.
We covered the key types of restraints earlier in this article. However, in general terms, the restraint should prevent the restrained person from competing with the business of the person that is imposing the restraint.
In most cases, a court would consider a restraint that applies to an extensive geographic location too restrictive and most likely unenforceable.
Most Non-Compete Agreements are drafted in a ‘cascading’ or ‘laddered’ format. This means that the geographic area of the restraint can start very broad but continue to become narrower.
The purpose of drafting the restraint in this way is that it allows a court to ‘read-down’ the restraint and ‘sever’ the unreasonable parts of the restraint until they reach a fair ‘balance’ for both parties.
Non-Compete Agreements must specify how long the restraint is applicable.
How long the restraint should apply will depend on the circumstances but it can apply anywhere from a few months up to several years.
In the same way as the geographic location of the restraint, the duration of the restraint can be drafted in a cascading format.
Generally, a court will be reluctant to enforce a Non-Compete Agreement that will prevent an employee from plying their trade for a period of more than six months. The reason for this is that the restraint is potentially limiting that individual’s ability to earn a living.
However, there have been cases where restraints of longer duration have been enforced, especially where the employee held a very senior position or was considered in the market as ‘the face of the company’.
There have been cases where courts have upheld restraints for a sale of a business that had a duration of two years and in rare cases, up to four years.
Generally, restraints with a long duration have been upheld in circumstances where the seller was well compensated for the sale of their business or continued as an employee or consultant to the business after the sale.
Non-Compete Agreements cannot be drafted as a blanket restriction on all actions of an individual. Non-Compete Agreements of this type are usually very difficult to enforce.
A Non-Compete Agreement must include a list of ‘permitted activities’ that the restraints do not apply.
Permitted activities of the restrained person may include:
- acquiring stock or shares in a company listed on an official stock exchange (up to a certain percentage); or
- The employer and the employee agree that the employee may work for a competitor that operates a ‘restrained business’ in circumstances where the ‘restrained business’ only forms a small part of the overall business and the competitor has limited market share.
A Non-Compete Agreement should include details of the dispute resolution process that should be followed in the event there is a misunderstanding between the parties.
This will usually set out details of the dispute resolution process including the forum where disputes will be heard (i.e. litigation, mediation, or arbitration), any time periods that must be met by the parties, and details about who must cover the cost of a dispute.
Non-Compete Agreements should include details about the remedies available to a party that is impacted by the other party that has breached the Non-Compete Agreement.
One remedy that is useful if a party breaches their obligations under a Non-Compete Agreement is an injunction.
An injunction is an order from a court that prevents a restrained person from breaching or continuing to breach its obligations under the Non-Compete Agreement.
For example, the court may order that the restrained person cease their employment with a competitor or cease operating a competing business if these activities are deemed a breach of the Non-Compete Agreement.
Damages are another remedy that may be available to an affected party under a Non-Compete Agreement as a result of a breach. Usually, damages are awarded in the form of financial compensation which is calculated based on any loss that has been or may be incurred by the impacted party.
The governing law under a Non-Compete Agreement is very important. This is because the interpretation of the terms of the Non-Compete Agreement, and ultimately whether it is enforceable or not, will be subject to whichever country’s laws govern the contract terms.
The parties under the Non-Compete Agreement must agree to the governing law under the Non-Compete Agreement and reflect this in the governing law clause.
A key question that often comes up when Non-Compete Agreements are being talked about is the enforceability of Non-Compete Agreements.
The reason for this is that Non-Compete Agreements are notoriously difficult to enforce and the enforceability of Non-Compete Agreements has been the subject of many proceedings before the courts over the years.
Generally, courts are more prepared to enforce so-called ‘goodwill covenants’ commonly found in business sale agreements (as opposed to an employee restraint), which may also have restraints with a longer duration and cover a broader geographical area.
How a Non-Compete Agreement is enforced will vary depending on the governing law that governs the contract.
This is because some jurisdictions have specific legislation or statute (e.g. Federal or State laws) that governs whether Non-Compete Agreements are enforceable or not.
Whereas other jurisdictions rely on ‘judge-made law’ or legal precedent when determining whether a Non-Compete Agreement is enforceable.
Some common law jurisdictions take the view that Non-Compete Agreements are invalid and not enforceable unless the restraint is reasonably necessary to protect a legitimate business interest.
Let’s look at each key principle in more detail.
Before a court will deem a Non-Compete Agreement enforceable, the person looking to enforce the restraint must prove that there is a ‘legitimate business interest’ to protect in the first place.
Legitimate business interests could include:
- Customer connections and relationships, whether they are former, current, or prospective customers. This is often referred to as the ‘goodwill’ of the business.
- The intellectual property of the business, including any patents or designs.
- Confidential information, including trade secrets, know-how, or operating procedures. These items may also be protected via a non-disclosure agreement.
If the party looking to enforce the restraint can show that there is a legitimate interest to protect, they then also need to show that the restraint is ‘reasonably necessary’ to protect that legitimate interest.
That is, the restraint isn’t unreasonable or excessive having regard to the circumstances.
When determining whether a restraint is ‘reasonably necessary’, the courts will look at:
- The respective bargaining position of each party – this factor will be given more weight where the restraint is between an employer and the employee (as opposed to a business sale arrangement). This is because an employer will probably have more resources to draw on and a stronger bargaining position than the employee. Whereas, the seller of a business will be duly compensated as part of the sale.
- The amount of any compensation provided in consideration for the restraint.
- The type of business being sold and the role of the seller (or another restrained person) in the business. For example, if the seller was the ‘face of the business’ and a key part of the business’s success, the courts would likely consider this factor as something that supports the restraint being reasonably necessary to protect the buyer.
- The duration of the restraint. Generally, the longer the duration, the less likely it will be considered reasonable.
- The geographical area that the restraint covers. Usually, the broader the area, the less likely the restraint will be considered reasonable.
As you can see the enforceability of Non-Compete Agreements depends on whether the interests of both parties are balanced and fair. The key takeaway here is that it is best to engage an experienced lawyer to help you get it right.
If you are selling an online business, you must be prepared when a buyer asks that you sign a Non-Compete Agreement and that you understand how the restraints will affect you.
As a buyer, it is crucial that any Non-Compete Agreement you sign is carefully drafted and strikes a balance between protecting your interests and the interests of the seller.
Striking this balance can be tricky. Hiring a good lawyer to draft the Non-Compete Agreement for you is an important step to ensuring the Non-Compete Agreement is fit for purpose and not too restrictive.