If you are buying a business, the chances are, you will want some form of comfort in knowing that the seller will be prevented from setting up a new business that directly competes with your newly acquired business after the sale. This is where restrictive covenants come in.
A restrictive covenant is a clause in a contract that is designed to prevent the seller from undertaking certain commercial activities which they would otherwise be free to undertake, and typically include:
- restrictions on participating in a competing company;
- restrictions on soliciting or dealing with customers / clients of the business;
- restrictions on poaching staff; and
- restrictions on interfering in relationships with suppliers.
It is important to note that the restrictions should be specific to the products or services of your new business.
As described above, a non-compete clause will prevent the seller from establishing a new business in the same line of business as the one you have recently purchased. These types of covenants may be justifiable for a certain period, and will be more justifiable if trade secrets used in the business you have purchased are no protected (e.g. patent or copyright).
Non-solicitation clauses are arguably the easiest form of restriction to justify a covenant to prohibit the seller from soliciting or canvassing the customers of the business you have purchased, after the sale and for a certain period. Non-solicitation clauses are usually limited to circumstances whereby the seller offers customers goods or services which are likely to compete with those of your new business, or where the seller approaches existing employees of your new business with a view to soliciting them to resign from their employment.
Restrictive covenants for geographical area are typically confined to territories where your new business is operating at the time of purchase.
Restrictions can also be put in place to prohibit the seller from using a name which is similar to that of the newly acquired business. You would also be entitled to impose restrictions on the seller from using a name or description that trades on their association with the business you are buying, for owner-managed businesses.
How long can a buyer be protected for?
These restrictions would usually last for two to three years after completion on average. The scope and duration of these restrictions is often one of the big negotiating points during the sale process.
Is a restrictive covenant enforceable?
This is a little tricky, as it mostly depends on a variety of different factors. The Court is normally opposed to clauses in contracts which operate as a ‘restraint of trade’ and are not open-minded to readily enforce them.
However, if it can be established that the restrictions imposed do not go any further than what is considered reasonable to protect a legitimate business interest, then the Court will depart from that approach.
Determining whether a restrictive covenant is ‘reasonable’ will, again, depend on a variety of different factors. Historic case law shows that the Court has made it clear that enforcing a restrictive covenant is highly sensitive to the individual facts of each particular case.
How are restrictive covenants enforced if successful?
If the Court has found that a restrictive covenant is breached, this will give rise to a claim for damages in the same way any breach of contract would. The breached party would therefore be entitled to seek damages from the opposite party to reflect the loss it has suffered as a result of the breach of contract. There are various ways that the Court can assess those losses, but it is dependent on the nature of the breach and the circumstances surrounding it.
If you are looking for advice on buying or selling a business and the inclusion of restrictive covenants, Farleys’ corporate law specialists can help. Get in touch with the team on 0845 287 0939 or contact us by email.