Negotiating Covenants Not to Compete

To continue my previous discussion of buying and selling a business, I will now discuss several covenants that are typically written into a contract, and which need to be negotiated. If you have not yet read my previous posts, you should reference both blog posts. The first examines the process of buying a business, and the second examines the process of selling a business.

In this entry, I am going to discuss the negotiation of the terms in a covenant not to compete. If you are unfamiliar with a covenant not to compete, I recommend reading a previous blog entry of mine which examines the topic; you can read that entry here.

Three Aspects of Negotiation in Covenants Not to Compete

The reasoning behind a covenant not to compete when buying or selling a business is fairly simple. The seller of the business finds a potential buyer. However, before buying the business, the buyer may arrange an agreement which restricts the seller from operating a similar, competing business within a specific area and for a specific length of time. This will protect the buyer from losing potential customers to the seller.

Thus, within this covenant, there are three key aspects that must be negotiated: the competition, the length of the covenant, and the geographical area the covenant applies to.

Competition in a Covenant

What does the word “competition” mean in a covenant? One can compete in many different ways. The main purpose of a covenant not to compete is to prevent competition between your own business and the business of another person in the marketplace. Losing a sale because a similar business was chosen, instead of yours, is the essence of competition.

Within the covenant, what exactly is considered off-limits in terms of competition? It is understood that any portion of the existing business at the time of purchase and sale of the business is off-limits. However, you could also include any element of the business or any product of the business that is simply being considered for potential production and sale. As a buyer, it is important to tie the seller to a list of such potential elements if possible. Enforcing a covenant not to compete between your potential products and the seller’s products is very difficult when one must prove that the seller did not think of it, before closing.

Length of a Covenant

There are statutes on the books with respect to the reasonableness of the length of time that a covenant not to compete can be enforced. Obviously, the length of time that a buyer wants is as long as possible. The seller will likely agree to a reasonable length of time which is necessary for the buyer’s business to be solidly in the marketplace. Of course, that length of time is subject to opinion and negotiation. In my own experience, I have seen negotiated covenants not to compete from one year to five years. Three years is typical.

The Area of a Covenant

There are also statues on the books with respect to the area in which competition may not occur. This area typically includes at the very least the area in which the seller’s business is being operated at the time of closing. One can negotiate as to what this area is.

Obviously, the buyer will want a no competition clause in as broad of an area as possible, and at least the area in which the buyer plans to expand. It is not unusual for the defined area to include areas where sales are occurring, plus additional counties that are close by. Or even the states that are close by. But you must be careful. Saying the “USA” when only a few states are involved may be stricken by a judge.

Next Time…

In my next entry, I will point out the key points in covenants not to solicit and covenants not to disclose that should be negotiated.

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