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Buckingham, Doolittle and Burroughs’ Michael A. Ellis

Noncompete agreements can easily become a point of conflict in M&A transactions

Michael Ellis

October 26, 2018

By: Mark Scott

Michael A. Ellis has always preferred corporate transaction work over litigation in his legal career. For nearly 40 years, he’s brought his understanding of the law to mergers and acquisitions, early stage venture capital deals and corporate securities. Ellis understands as well as anyone that time is money when he’s involved in M&A work.

“If a business transaction hasn’t moved in two or three months, it is likely dead,” says Ellis, a partner at Buckingham, Doolittle and Burroughs. “I enjoy being an implementer who is able to get clients and the other side to win-win situations.”

A noncompete agreement, in which one party agrees not to enter into or start a similar profession or trade that competes against another party, is almost always part of the sale of an enterprise, Ellis says. It’s not always easy, however, to bring the two sides together.

“A buyer doesn’t want to give the seller a boatload of money and then have that money used by the seller to start a new competing business,” Ellis says. “From a seller’s perspective, you do the preplanning before the sale.”

In this week’s Dealmaker Q&A, Ellis talks about when noncompete agreements come into play and how to avoid a prolonged legal confrontation.

How common are noncompete agreements in business transactions?

Asking for noncompete agreements from individuals who do not own any part of the business and who are not getting any proceeds from the sale — or are minority owners — can cause issues. Non-owners might think, ‘Why should I give something away now when I haven’t given it to you before? If I’m going to give you something, I want something in return.’

Similarly, the minority owner of the business who may own 10 or 15 percent could say, ‘I came in as the manager, I’ve agreed that I’m going to sell.’ But a noncompete given by the private equity firm or a family that’s not involved in the day-to-day operation of the business, that’s not meaningful for them. ‘I’ve been in this business for 30 years,’ this minority owner might say. ‘If I’m going to stay out of the business for another two to three years, then I want consideration, above that which I may be getting as the owner of 10 percent of the business.’

This leads to negotiation. A buyer’s perspective is, ‘I’m paying X dollars for the business, which includes noncompetes. As the buyer, I don’t care how you divide that among yourselves. This is what I’m asking for,’ and that can provide for some tension. You can address those issues in some respects by pre-planning. Have a noncompete that is already in effect for your employees, whether they are owners or not, that can be transferred to a buyer in connection with the sale of all or substantially all of the business.

What are some other important things to know about noncompete agreements?

From the seller’s perspective, the seller needs to know that most buyers will ask for noncompetes from key employees. If those key employees are owners, it should not be an issue. If the key employees are not owners or are minority owners, then you’re going to want to consider making sure you have noncompetes in place before the buyer asks for them. You don’t want to give employees the leverage to ask for more consideration. Maybe you tell the employees when you hire them, ‘I’m going to hire you and I want a one-year or a two-year noncompete that you can’t go after any customers that you talk to or any potential customers that you have spoken to.’

You have to recognize the differences in employees. If you’ve just hired a sales manager from a competitor, that manager is not going to give you a noncompete for the entire industry because that’s the industry you just hired him or her from. You may be able to get a noncompete from customers you already have that you introduce him to that is limited in scope. ‘If you leave me after six months, you can’t call on the customers we had before you got here or that you developed for us. But you’re free to compete in the industry with anybody else.’

From a buyer’s perspective, the buyer, as part of their due diligence, will ask the seller what noncompetes do you have with your employees? Then that buyer has decisions to make. The buyer may say, ‘I’m going to condition the sale on you getting something from your sales manager.’ Or the buyer may say, ‘Because you don’t have anything and these people can leave immediately, the price is not as high as you may want it to be.’ The buyer might add, ‘As part of giving the sales manager a three-year employment contract and a severance package if they leave with a year’s worth of compensation, they have to give me a noncompete.’