Restrictive Covenants in M&A Transactions
As most, if not all, M&A advisors have likely noticed, restrictive covenants, primarily in the form of non-competition and non-solicitation agreements or provisions, are customarily included in M&A transactions. The main purpose of including restrictive covenants in an M&A transaction is to safeguard the buyer’s value in the purchased business. By restricting the seller’s ability to compete with the purchased business, for a certain period of time following the closing of the transaction, the buyer is looking to ensure that the business that the buyer just acquired does not lose value due to the seller competing with that business post-closing. Including restrictive covenants in an M&A transaction is especially important where the seller’s principal’s (i.e., owner) participation in the operation of the business has been vital to that business’s success.
It is common practice that a prospective buyer will not agree to acquire a business (whether via an asset purchase or an equity purchase) unless the seller will be legally prohibited from opening a competing business or working for a competitor of the acquired business after the transaction closes. As restrictive covenants have become so conventional in M&A transactions, M&A advisors may lose sight of notion that restrictive covenants can be used as a tool while negotiating the purchase agreement, rather than simply memorializing those restrictions in the purchase agreement using boilerplate language according to legal principles applying to such restrictions the employer-employee context. Failure by an M&A advisor to recognize distinctions between “default” legal principles that govern restrictive covenants in the employer-employee context and the legal principles that apply restrictive covenants in an M&A transaction could result in potential value being left on the negotiating table after a transaction closes.
Laws Governing Restrictive Covenants in an Employer-Employee Context:
In Wisconsin, where our firm is located, restrictive covenants within the employer-employee context are governed by Wis. Stat. § 103.465, which provides that a restrictive covenant that imposes an unreasonable restraint is illegal, void, and unenforceable. As with most jurisdictions, Wisconsin courts look upon restricting competition with disfavor and “the public policy underlying [Wis. Stat. §103.465] is that Wisconsin law favors the mobility of workers.” Genzyme Corp. v. Bishop, 463 F. Supp. 2d 946 (W.D. Wis. 2006). With that in mind, a restrictive covenant is enforceable under Wisconsin law only if it satisfies all of the following: (1) it is necessary for the protection of the principal; (2) it provides a reasonable time period; (3) the restriction covers a reasonable territory; (4) the restriction is not unreasonable or oppressive in nature; and (5) the restriction is not unreasonable to the general public. Chuck Wagon Catering, Inc. v. Raduege, 88 Wis. 2d 740, 277 N.W.2d 787 (1979). If any provision of a restrictive covenant is deemed unenforceable under any of the foregoing factors, the entire covenant is typically deemed unenforceable. Within the employer-employee context, it is widely accepted that a reasonable time period for a restrictive covenant is two years, though the reasonableness of both duration and geographic scope will vary based on the facts and circumstances of each case.
Legal Principles Applying to Restrictive Covenants in an M&A Transaction:
Due to pro-competition predilection, many M&A advisors incorrectly assume that the foregoing (and relatively narrow) laws concerning restrictive covenants also govern non-competition agreements in the M&A context. This is not the case, as restrictive covenants and non-competition agreements entered into incident to the sale of a business are subject to much less scrutiny. Courts evaluate restrictive covenants and non-competition agreements differently depending upon whether such covenants or agreements arise from an employer-employee relationship or are incident to the sale of a business. The test of reasonableness imposed by courts on restrictive covenants entered into incident to the sale of a business is less strict than the test imposed on restrictive covenants in employment contracts due to the difference in the nature of the interests protected by those covenants. A restrictive covenant or non-competition agreement entered into incident to the sale of a business protects the goodwill acquired by the buyer and ensures that the seller (i.e., former owner) does not walk away from the completed transaction with the business’s goodwill and customers, leaving the buyer with a purchase that is merely illusory, as such covenants or agreements are generally a significant part of the consideration for the purchase of the business.
In Reiman Associates, Inc. v. R/A Advertising, Inc., 102 Wis.2d 305, 306 N.W.2d 292 (1981), the Wisconsin Supreme Court held that “covenants not to compete incidental to the sale of a business are not subject to exacting scrutiny [concerning the five elements above].” When it comes to this contrast in the test of reasonableness for restrictive covenants and non-competition agreements, courts in several other states, such as Delaware, Georgia, Illinois, and New York follow substantially similar legal principles as Wisconsin. See Turek v. Tull, 37 Del. Ch. 190, 139 A.2d 368, aff’d, 38 Del. Ch. 182, 147 A.2d 658 (1958); See Health Professionals, Ltd. v. Johnson, 339 Ill. App. 3d 1021, 791 N.E.2d 1179 (2003); See Hicks v. Doors By Mike, Inc., 260 Ga. App. 407, 579 S.E.2d 833 (2003); See Shearson Lehman Bros. Holdings v. Schmertzler, 116 A.D.2d 216, 500 N.Y.S.2d 512 (1986). Accordingly, an appropriately-tailored restrictive covenant or non-competition agreement can provide a buyer with a much longer period of protection from seller competition than what would otherwise be deemed reasonable under the laws applicable to the employer-employee context.
Common recognition that restrictive covenants incidental to the sale of a business must be viewed with less scrutiny than those arising under the traditional employer-employee context creates an opportunity for M&A advisors to add value for their clients during the negotiation process of a transaction. A pragmatic buy-side advisor would put his or her client in an advantageous bargaining position by leveraging a restrictive covenant’s duration and scope, depending on the industry of the business being acquired.
M&A advisors may overlook the opportunity to use restrictive covenants as tools for developing other terms of the transaction. This may be attributable to M&A advisors incorrectly assuming that the enforceable provisions for restrictive covenants, in terms of duration and scope, is well-worn territory, incapable of any material deviation. As this article highlights, this is not the case, and the terms and provisional byproducts of restrictive covenants are just as negotiable as any other part of the transaction. Equipped with this knowledge, advisors on both sides of a transaction have an opportunity to add value for their client by strategically leveraging the intricacies made available by expanded restrictive covenants as a means of further achieving client goals.