Non-compete Agreements

May 21st, 2015

When negotiating the purchase and sale of a business, buyers and sellers often fail to spend sufficient time and effort addressing whether the seller is prohibited from operating an enterprise that competes with the buyer’s newly-acquired business.  Whether this is caused by a lack of foresight of potential problems, or an uneasiness individuals have about restricting a person’s ability to make a living, ignoring non-compete provisions in a purchase agreement for a business may cause significant headaches for buyers who suddenly find themselves in direct competition with sellers soon after purchasing the business.

 

New York law recognizes an implied covenant in each sale of a business that prohibits the seller from soliciting his or her former customers.  This implied covenant is notable in what it allows sellers to do.  First, sellers are free to accept business from former customers.  Also, the implied covenant’s restriction on soliciting former customers is not absolute.  Indeed, sellers may solicit former customers through advertisements so long as the advertisements are not directed towards an individual customer.  Therefore, absent an express agreement to the contrary, a seller of a business is free to accept business from former customers, and even advertise in ways likely to attract former customers.

 

To avoid the implied covenant governing a particular purchase and sale agreement, parties may, by contract, curtail the seller’s ability to compete with the buyer through express covenants not to compete.  New York courts generally uphold these covenants if they are reasonable in time, scope, and area of exclusion.  If the court finds that the covenant is unreasonable, it may modify the agreement to make it reasonable.  The objective of the court in upholding the reasonableness of a non-compete covenant is allowing the buyer sufficient time to secure ownership and the goodwill in the acquired business.  Whether or not the agreement reasonably allows the buyer this opportunity will turn on the terms and conditions of the non-compete agreement and the nature of the business acquired.

 

It is important to note that there are no “bright-line” rules for determining the reasonableness of a restriction in time, scope, or area of exclusion in a non-compete agreements.  Courts have upheld non-compete agreements that are unlimited in duration, or encompass large areas of exclusion.  A determining factor in the reasonableness of duration or area of exclusion clauses in a non-compete agreement is the type of business acquired.  Typically, courts assume “professional” businesses, such as consulting firms, physicians’ practices, and accounting firms are carried out over larger geographic area than businesses like restaurants, bars, nightclubs, or retailers, which are carried out from fixed “storefronts” and cater to smaller geographic areas.  With these factors in mind, counsel to parties negotiating non-compete agreements can offer guidance on the enforceability of these provisions based on the nature of the business and the scope of the restriction.

 

For example, suppose an owner of a deli in Brooklyn sells his business.  In the agreement, the buyer negotiates for the inclusion in the purchase agreement of a covenant not to compete that prohibits the seller from operating a deli in Brooklyn for a period of five years.  In determining the reasonableness of this non-compete agreement, the court will look to the nature of the business, the scope of the restriction, and the area of exclusion.  In an actual case with similar facts, the court held that the non-compete agreement was unreasonable because of the size of area of exclusion.  Businesses like delis are quintessential “storefront” businesses that operate in small, fixed geographic area.  They typically draw their clientele from the local neighborhood and do not operate throughout a city, county or borough.  Therefore, it is unreasonable to prohibit the seller from operating a similar business in Brooklyn.  Instead of declaring the non-compete unenforceable, the court is likely to reduce the area of exclusion to make it reasonable.  In the example above, the court may reduce the area of exclusion to a few blocks surrounding the deli, while upholding the scope (operating a competing deli) and duration (five years) in the non-compete agreement.  In this example, while a non-compete agreement that excludes all of Brooklyn is likely unreasonable, one limited to a neighborhood or a few surrounding blocks is not.

 

An effective non-compete covenant addresses other contingencies besides duration, scope, and area of exclusion.  The covenant should also clearly identify the party bound by the covenant not to compete (in sales involving corporations, LLCs or other entities) and whether the covenant restricts the seller from expanding an existing business to the detriment of the buyer.  Careful consideration of all of these issues while drafting a non-compete covenant will aid the buyer and seller in achieving their goals, while minimizing future disputes should the seller contemplate operating a competing business.

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