Buyer Beware: Enforceability of Non-Competes in M&A Transactions
M&A professionals and buyers have long taken comfort that courts will more broadly enforce non-competition and non-solicitation covenants in mergers and acquisitions in contrast to non-competes and non-solicits in employment agreements and other contracts which are more heavily scrutinized. The rationale for broader enforceability of non-competes in M&A being that buyers have a “legitimate economic interest” in protecting the goodwill of the business and assets they just acquired. Buyers need certainty that they will not have to compete immediately or in the near term with the sellers they just rewarded, especially when those sellers would likely have close contacts with former customers and employees of the acquired business.
It is not uncommon therefore to see buyers in M&A transactions pushing for broad geographic coverage of non-competes like specific regions of multiple states, the entirety of the United States, North America or even worldwide. The temporal duration of non-competes in M&A transactions is typically at least 2 or 3 years after closing but often buyers push for 5 or even 7 years. The scope of M&A non-competes are broadly drafted to cover all business lines and products of the selling business but also buyers sometimes insist that entire industries or sectors and even areas of the buyer’s own business lines and products unrelated to the seller’s business be covered.
While the trend has certainly been to have broader and more expansive non-competes, a recent October 2022 opinion by the Delaware Chancery Court in the case Kodiak Building Partners, LLC v Adams, reminds buyers and their advisors that even in the context of mergers and acquisitions, public policy still mandates that non-competition and non-solicitation covenants be reasonable and fair. The facts of the Kodiak case are important – the defendant Philip Adams was a general manager and a minority 8.33% shareholder of a roof truss manufacturer, Northwest Building Components, Inc. Northwest had a single location in Rathdrum, Idaho with a customer base of an approximately 30-60 mile radius. The plaintiff Kodiak Building Partners, LLC was a private equity group that had previously acquired 25 other companies in the building materials and distribution space. Kodiak had 81 locations throughout the United States and its businesses were in engaged in other product lines such as drywall, steel construction supplies and kitchen interiors in addition to roof trusses. Adams received approximately $900,000 in sale proceeds but resigned within 3 months of closing and joined a competing truss company only 24 miles away from Northwest’s location.
In denying Kodiak’s request for an injunction, the Delaware Chancery Court found that Adams’s non-compete was overly broad in that it went beyond Northwest’s roof truss business and attempted to cover Kodiak’s other business lines and products. The geographic scope of Adams’s non-compete was also found to be unreasonable by the Delaware Chancery Court since it extended to the 100-mile radii of all 81 of Kodiak’s locations throughout the United States. Adams did not challenge, and the Court did not opine as to the 30-month temporal duration of Adams’s non-compete. Adams’ non-compete included a “blue pencil” provision that authorized courts to rewrite the non-compete to make it enforceable to the maximum extent that the law permitted. While acknowledging that Delaware is a blue pencil state, the Court in Kodiak declined to take on such endeavor citing that in Delaware courts have discretion as whether to blue pencil and arguing courts’ willingness to modify overly broad non-competes creates confusion, encourages overreaching and litigation.
While the Kodiak decision is highly fact dependent, a few lessons and reminders can be taken from the case:
- The scope of non-competes in M&A transactions should be limited to the seller’s business, goodwill and assets being acquired and should not extend to the buyer’s business more broadly.
- The geographic coverage of non-competes in M&A transactions should be limited to where the seller engaged in business before closing.
- Buyers should consider modifying and specifically tailoring non-competes for smaller minority owners and lesser management – a broader non-compete may have been appropriate for the majority shareholders and C-suite executives who were receiving millions of dollars and potentially retiring from the business but not for a senior manager and 8.33% shareholder like Adams.
- Buyers should consider structuring a portion of the sale proceeds so there are retention bonuses for key employees that extend over a period of time after closing creating a potential “carrot” to go along with the “stick” of a non-compete.
- In blue pencil states, courts are generally reluctant to completely re-write overly broad non-competes and instead reserve their right to blue pencil only in circumstances where the non-compete is generally fair absent only a small adjustment or two (e.g., reducing a non-compete’s duration from 30 months to 24 months) that will make the noncompete enforceable.
This article was published in Finance & Commerce.