Buying a business – can I stop the old owner from competing?
“How do I know that the vendor won’t open up another business down the road?”. This is one of the many important questions that you need to ask if you are looking to purchase a business.
The answer is that with a properly drafted restraint of trade or non-compete clause included in the purchase contact you may be able to stop the old owner from competing with you.
What is a restraint of trade clause?
If you’ve just bought a business, it goes without saying that you want to protect the value of your investment. It’s reasonable to be concerned about competition from the old owner of the business. After all, the old owner knows everything about the business: how to run it, who the suppliers are, who the employees are and importantly, who the customers are. It would be relatively easy for the old owner to set up a new business in competition to the business you just bought from them.
The most common way to ensure that there is value in the business after a sale of business has completed, is to include a restraint of trade or non-compete clause in the contract of sale. This type of clause operates to stop the vendor from doing certain things after sale of the business.
How do they work
A restraint of trade clause generally operates by providing that certain people can’t do certain activities for a certain time and in a certain area.
People. The clause generally applies to the vendor and entities controlled by the vendor. However, it’s often important to go further than this. For example, if the vendor is a company, it’s often necessary to restrain the activities of the director/s of the company. Further, the general manager or head of sales may also have a similar ability to set up a competing business as the vendor – especially if they did it together – so it’s important that they are restrained too. Business purchasers need to carefully consider which people in the business (apart from the vendor) are positioned to set up in competition with the business and ensure that those people sign up to the restraint of trade clause as part of the business purchase.
Activities. Generally the restraint of trade clause has 2 key parts:
• the vendor can’t establish or be involved with a competing business in any way – this is a called a non-compete. The non-compete needs to be drafted to cover all the different ways that the vendor could be involved with a competing business. For example, as owner, part owner, director, employee, agent etc.
• the vendor can’t approach the suppliers, customers or employees of the business – this is called a non-solicit. Like with the non-compete, this clause needs to be drafted to cover all the things that you wish to prevent from happening. For example, for a services business you would not want the vendor approaching any business customers from the 2 years before completion of your purchase. This probably won’t be a concern for a café (unless the café has significant catering contracts).
Time. This is how long the restrictions on the vendor and key people will operate – for example, 2 years from completion of the sale.
Area. This is the geographical distance where the restrictions will operate – for example, 3km from the business premises or all of NSW
Restraint of trade clauses must be reasonable
It’s important to note that you can’t put just anything in a restraint of trade clause. Public policy is generally that anything that restricts the freedom of people and companies to obtain employment and run businesses is undesirable. These clauses are only upheld if they are reasonably necessary to protect your legitimate interests. Importantly, simply restricting competition is not a legitimate interest. Legitimate interests include: goodwill, confidential information and intellectual property.
With that in mind, it’s critically important to carefully consider the nature of the business and what is necessary to legitimately protect your interests when preparing a restraint of trade clause. Courts will look at the reasonableness of all the factors above – people, activities, time and area – when assessing these clauses. One way of managing the risk of the restraint of trade clause being held to be unenforceable is to adopt a “cascading clause”.
What is a cascading clause?
A ‘cascading’ clause is just like a regular restraint of trade clause but provides alternative limitations and different options to the vendor. Typically, a cascading clause will begin with the broadest and most burdensome option followed then by options that decease the scope of the restraint (geographic, time and activity).
If there is a dispute about the application of the restraint and the most broad and burdensome option is determined by the Court as being unreasonable, then the court can sever the section and ‘read down’ the unreasonable limitation imposed to the next option. For this reason, to ensure that a restraint of trade clause is rendered reasonable and enforceable, a cascading clause should be adopted.
For example, a cascading clause may include the following time options: 3 years, 2 years, 1 year, 6 months. This means that the Court can strike out the 2 and 3 year restraints leaving a 1 year restraint as reasonable.
Another application of restraint of trade clauses
Restraint of trade clauses are also found in employment contracts. In that context, employees are restrained after they leave their job with the business. If you are buying a business it is important for you to consider inserting a restraint of trade clause in the employment contracts of the key employees.
Restraint of trade is a complex area and important issue to consider when purchasing a business. It’s imperative that you assess the situation carefully and determine the risks which may threaten the business and address those risks in a reasonable and enforceable way. It would be devastating to see the goodwill and value of your new business eroded by actions of the vendor and / or key employees, when those actions could have been prevented with a properly drafted restraint.
Restraints are one of the many critical issues that you should consider if you are looking to buy a business.
Get in touch with us here if you would like to talk about buying (or selling) a business.