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Non-Compete Agreements in the Sale of a Business
The process of buying or selling a business is long and requires attention to detail (see our previous article entitled Using a Letter of Intent to Reduce Risk in the Process of Purchasing a Business). One aspect of the final sales agreement is, or at least almost always should be, the non-compete agreement. This is an agreement between the seller and the buyer in which the seller agrees not to compete with the new owner of the business within certain parameters. It is easy to see why a buyer should be sure to have this agreement in place before signing on the dotted line and consummating a large purchase. The buyer must make sure that the seller does not open up shop with the same product or service next door shortly after the transaction. This article will address what courts look at when considering whether or not a non-compete agreement is valid and enforceable. After all, a non-compete agreement that is ultimately found invalid could cost more than not having one at all.
When determining whether to find a non-compete agreement enforceable, a court looks at whether the limitations placed on the seller after the transaction are “reasonable”. Courts to balance the interest of the buyer of a business in protecting his business with the right of the seller to make a living. In Arizona, when deciding if a limitation is reasonable, the court will look most heavily at two limitations that are placed on the seller: the geographical area and the time period.
A non-compete agreement will often limit a seller of a business from competing within a particular geographical area. For instance, an agreement may state that the seller may not conduct business of the type of product or service within 50 miles of the city limits of Phoenix. Or it may prohibit this activity within Arizona, or west of the Mississippi. If the agreement is challenged in court, the court will decide whether that restriction is reasonable. So what is reasonable? Is it unreasonable for the prohibition to extend to an entire state, or half the country? The answer, as usual, is “it depends”. A company that conducts virtually no business outside of Phoenix likely will not be able to enforce an agreement that prohibits competition in Tucson. Then again, it could be that part of the valuation of the company was the planned expansion into Tucson in the following year. In that case, such a restriction may be reasonable. A good practice is to take a look at a proposed geographic restriction and list out why the buyer has an interest in that particular restriction. Listing this interest in the agreement can assist the court in determining that the parties agreed that such an interest was reasonable.
Time Period Restriction
The second major factor that Arizona courts traditionally consider is the length of time that the seller of the business is restricted from a given competitive activity. Often the non-compete agreement will restrict the seller from engaging in a particular activity within a geographical area (see above) for a specified period of time such as a year or five years, etc. Again, the court will determine whether the agreed upon period of time is reasonable by evaluating the type of business and the interests of the two parties.
Blue Pencil Rule
In some states, such as Arizona, a court has two choices when it has decided that a provision within a contract is not enforceable. It may find the entire agreement or provision unenforceable, or it may “blue pencil” (or cross out), the part it finds unreasonable and enforce it without that portion. It is important to note that the court may not write anything into the contract, it can only blue pencil “grammatically severable, unenforceable contract provisions.”
There is a way to build into the contract a way to avoid a situation in which a court disagrees with the buyer and decides that a restriction is unreasonable. The goal is to avoid leaving it up to the court to either find the entire agreement or provision unenforceable or blue pencil it by removing something. Parties have begun to use step-down provisions in an attempt to increase the predictability and control over the outcome of non-compete agreements. A step-down provision is worded in a way that sets an initial restriction, such as a time period of five years, but provides alternatives if the court decides the term is unreasonable. For example, take a non-compete that restricts the seller from competing for five years. However, if five years is found unreasonable, the agreement would allow the court to allow the seller to be restricted from competing for 3 years instead. An Arizona case determined that step-down provisions must be:
2. Consistent with the underlying provision,
3. Easily severable from unreasonable provisions,
4. Have a narrow duration range, and
5. Have a reasonable geographic scope.
The use of step-down provisions is a recent development, and there is still some question as to how exactly they will pan out when challenged in court.
Sale of a Business vs. Employment Contracts
When determining whether an agreement is enforceable, courts also consider the ability each party had to negotiate the terms of the agreement. Many of the cases we see in the area of non-compete agreements are in employment contracts in which newly-hired employees agree not to compete with their employer. In that scenario, a newly-hired employee generally has no ability to change or determine the terms of the non-compete agreement. Further, these situations often involve a company attempting to prevent an employee from working in the same industry for a competitor. These situations have resulted in cases that seem to suggest that non-compete agreements are often found unenforceable. However, it is important to note that this article addresses non-compete agreements in the sale of a business, not in an employment contract. In the sale of a business, both parties are in a much more equal position to negotiate terms of the agreement. Therefore, buyers of a business can have more confidence that a well-written non-compete agreement will be enforced if challenged.
It is vital to ensure that your non-compete agreement is enforceable. Do not leave it to chance. The best practice is to have an attorney draft the agreement after you have explained what you are trying to accomplish. At the very least, have an attorney review your non-compete agreement to ensure that you will have the best chance to have it found enforceable if challenged in court.
GDP Business Blog
Mesa, AZ 85213