What are restrictive covenants?
Restrictive covenants, as the term suggests, restrict a part to a contract from engaging in certain types of conduct. They’re commonplace in M&A transactions – whether you’re selling a lower middle market business or a larger company. The Asset Purchase Agreement or Stock Purchase often contains restrictive covenants. However, you’ll sometimes find them in a separate agreement. Regardless of where they appear, they serve to limit the actions of the seller and / or the selling shareholders after the closing of a sale. In this essay, we will explore how buyers use restrictive covenants in M&A transactions. We’ll also review the types of conduct that they restrict. Lastly, we’ll assess how they can impact the parties to an asset purchase or stock purchase agreement.
What is the purpose of restrictive covenants in M&A transactions?
Restrictive covenants protect the buyer’s investment in your business. Without them, buyers would be unlikely to invest substantial sums in acquisitions. After all, would you want someone you paid use that money to compete against you? Accordingly, they’re included in virtually all M&A transactions, whether stock sales, asset sales, mergers, or other combinations.
What are the typical restrictive covenants in M&A transactions?
There are several types of covenants that will typically be included in an M&A contract. Some of the most common types include:
Non-Compete Clauses
A non-compete clause limits a seller’s ability to compete with the buyer. However, it can’t be overbroad. To be enforceable, non-competition clauses or agreements must be reasonable in scope, territory and time. The restricted activities should mirror the seller’s and/or the buyer’s lines of business. The restricted territory is usually a reasonable radius around the seller’s facilities. However, you operate nationally you should expect that the non-competition agreement will be national in geographic scope. It’s common for non-compete agreements to last from 3-5 years following the closing of your sale.
Confidentiality Agreements
A confidentiality agreement is a type of covenant that prevents one party from disclosing confidential information to third parties. As a seller, you should expect that the buyer will restrict you from disclosing confidential information after the sale.
Non-Solicitation Agreements
A non-solicitation agreement prevents the seller from soliciting the buyer’s present or former employees, contractors, vendors or customers. Also, it typically applies during the same period as the non-compete.
Enforcing Restrictive Covenants
Enforcing restrictive covenants can be a complex and challenging process. Foremost, to enforce a covenant, the party seeking to enforce it must demonstrate that the other party has breached the agreement.
In many cases, the buyer will seek a restraining order or injunction to stop the prohibited conduct from occurring. Eventually, the buyer will likely seek a permanent injunction and/or monetary damages.
Challenges to Enforcing Restrictive Covenants
Poorly drafted restrictions may be unenforceable for several reasons. Courts generally disfavor restrictions on competition, but there is significantly more latitude to enforce them in the context of a business sale as opposed to non-competition agreements with employees in the employment context. If the restrictive covenant is overbroad in time, scope or geography a court may decline to enforce it. Many APAs and SPAs contain clauses pursuant to which the parties agree to permit courts to “blue pencil” the agreements to narrow overbroad restrictive covenants to make them enforceable rather than invalidating them.
Also, to obtain an injunction (as opposed to monetary damages), the buyer must not only show that it is likely to prevail on the merits of its case that the seller or selling shareholder breached the restrictive covenant, but also that the buyer would suffer irreparable harm (i.e., monetary damages would be insufficient) unless the court stops the offending conduct.
Conclusion
In conclusion, restrictive covenants play an important role in virtually M&A transactions. As a seller, you should expect that the definitive purchase agreement or a separate agreement will contain them. Absent restrictive covenants, most buyers would be unwilling to invest their money to acquire your business. Thus, you should, in fact, understand and welcome their role for without them, businesses would be much harder to sell.
If you’re thinking about selling your business, and you want to discuss restrictive covenants or any other aspect of the business sale process, please contact us.
