Non-Compete, Non-Solicitation, and Non-Disparagement Covenants Clause
(CA)

Summary

This clause contains non-competition, non-solicitation, and non-disparagement covenants, and a clause that addresses the severability of the covenants to the extent all or any part of them is found to be prohibited or unenforceable under California law. This clause includes practical guidance, drafting notes, and alternate clauses. The alternate clauses are pro-seller and modify these covenants into versions that are less restrictive to the seller. For additional information about restrictive covenants in acquisition transactions generally, see Non-Competition, Non-Solicitation, Non-Disparagement, and Confidentiality Agreements in M&A Deals. For a jurisdiction-neutral clause, see Non-Compete, Non-Solicitation, and Non-Disparagement Covenants Clause. What are Non-Compete, Non-Solicitation, and Non-Disparagement Covenants? After the closing of a transaction, the buyer of a target company or business will not want to find itself competing with the seller of such company or business. A non-compete covenant addresses this issue by prohibiting a seller from engaging in a business that competes with that of the acquired company or business for a certain period of time, and generally within a certain geographic region. A non-solicitation covenant, on the other hand, protects the buyer following an acquisition from the seller soliciting (1) the retained employees of the acquired business, (2) business from the customers of the acquired business, and (3) trade with the vendors of the acquired business, in each case to do business with the seller's current enterprise. A non-disparagement covenant serves to protect the buyer from negative remarks, either written or oral, by the seller about the buyer and the acquired business. Drafting a Non-Compete Covenant When drafting a non-compete provision for an acquisition agreement, the following aspects of the typical non-compete clause need to be considered: (1) the applicable law, (2) the definition of a competing business, (3) the length of the restriction, and (4) the geographic scope of the restriction. Yes, non-compete agreements are enforceable in connection with the sale of a business under California law, provided they meet the statutory exception outlined in § 16601. Sale of goodwill or corporate shares. This statute permits non-compete agreements when they are executed as part of the sale of a business, including the sale of its goodwill or all or substantially all of its operating assets. The purpose of this exception is to protect the buyer from unfair competition by the seller, which could diminish the value of the business purchased Samuelian v. Life Generations Healthcare, LLC, 104 Cal. App. 5th 331, Fleming v. Ray-Suzuki, 225 Cal. App. 3d 574, In re Marriage of Greaux & Mermin, 223 Cal. App. 4th 1242. For a non-compete agreement to be enforceable under § 16601. Sale of goodwill or corporate shares, the sale must include the goodwill of the business, as goodwill is considered a key asset that the buyer is entitled to protect. Courts have inferred the inclusion of goodwill in sales transactions where the agreement or circumstances indicate that the parties valued goodwill as part of the sale price. For example, in cases where the seller agrees to transfer customers or refrain from soliciting former customers, courts have found an implied sale of goodwill Samuelian v. Life Generations Healthcare, LLC, 104 Cal. App. 5th 331, In re Marriage of Greaux & Mermin, 223 Cal. App. 4th 1242, Handyspot Co. of Northern California v. Buegeleisen, 128 Cal. App. 2d 191. Additionally, the non-compete agreement must be reasonable in terms of time, activity, and geographic scope to ensure it is necessary to protect the buyer's interest without imposing undue restrictions on the seller. California courts have consistently upheld such agreements when they are narrowly tailored to achieve this purpose Start-up Businesses and Growing Companies: Key Employment Law Issues (Federal and CA), Monogram Industries, Inc. v. Sar Industries, Inc., 64 Cal. App. 3d 692, Vacco Industries, Inc. v. Van Den Berg, 5 Cal. App. 4th 34. California Law Under California law, non-competes in connection with the sale of a business are enforceable when the sale includes the goodwill of the business or all or substantially all of its assets. Cal. Bus. & Prof. Code §§ 16601. It should be noted that California courts will look for a clear indication that in the sales transaction, the parties valued or considered goodwill as a component of the sales price. The purpose of this exception is to protect the buyer from unfair competition by the seller after the closing, which could diminish the value of the business purchased by the buyer. Samuelian v. Life Generations Healthcare, LLC, 104 Cal. App. 5th 331, Fleming v. Ray-Suzuki, 225 Cal. App. 3d 574, In re Marriage of Greaux & Mermin, 223 Cal. App. 4th 1242. The non-compete must be limited to the geographic areas where the relevant business was carried on or transacted prior to the closing. For additional boilerplate terms to consider when incorporating a non-compete into an agreement under California law, see Non-competition Agreement (CA). Competitive Business or Activity Defining the scope of the business and/or activities from which a seller will be prohibited from engaging is one of the key considerations in drafting a non-compete clause. A buyer will seek to define the competitive business or activity as broadly as possible, including any business or activity the buyer is engaged in as well as any contemplated future business or activity. The seller, on the other hand, will look to narrowly tailor the definition of a competitive business or activity. In particular, the seller will negotiate for a definition that is closely aligned with the business and/or scope of activities engaged in by the target company or for which the acquired assets are used as of the closing date. A definition tied to the business or assets being acquired by the buyer may be expanded to include additional businesses or activities that are being actively pursued by the seller (for instance, pursuant to board approval or formal business expansion plans) at the time of the closing. However, such a broad definition is likely to be more closely scrutinized under California law. Duration of Non-compete A non-compete clause also must contain a period of time during which its restrictions are enforceable. Under California law, non-compete agreements are limited to the period of time that the buyer, or any person deriving title to the goodwill or ownership interest from the buyer, carries on a like business therein. Cal. Bus. & Prof. Code §§ 16601. Customarily, a non-competition provision will be in place for three to five years following the closing of the acquisition. Geographic Scope of Non-compete The definition of the geographic territory in which the seller will refrain from competing with the buyer and the acquired business is another important consideration. Under California law, the non-compete must be limited to the geographic areas where the relevant business was carried on or transacted prior to the closing. Not surprisingly, the buyer may seek to define as large a territory as possible to which the non-compete covenant will apply. However, a court is likely to scrutinize an overly expansive geographic scope. The definition of the geographic scope of the non-compete will also depend on the nature of the business. For example, a narrow geographic scope would be appropriate for a local manufacturing operation, while a global restriction may be defensible for a business engaged in e-commerce. Enforceability of Non-compete As is the case in most jurisdictions, courts will use a general reasonableness standard to review the enforceability of a non-compete under California law. The review focuses on whether the buyer has a legitimate business interest for the restrictions placed on the seller. The buyer will likely find it difficult to validate a legitimate business interest in a non-competition covenant if (1) the scope of the competing business or activity is tied to competition with the buyer's pre-acquisition business and/or activities rather than that of the acquired company or business, (2) it runs for an unreasonably long period of time, or (3) it restricts the seller from engaging in a particular business or particular activities within a wide geographic region, unless such restriction is supported by the nature of the acquired business or assets. Drafting a Non-solicitation Covenant Non-solicitation provisions may cover three categories of parties related to the acquired company or business: employees, customers, and suppliers. The discussion below touches upon certain issues to be considered in the drafting of a non-solicitation covenant for these groups. Employees Retaining employees who are knowledgeable about the products of the acquired business, or who provide the services to the business, can be a valuable part of an acquisition for a buyer. Through the non-solicitation covenant, the buyer can safeguard that it does not lose this value from the seller hiring away employees who may be loyal to the seller or with whom the seller otherwise has a strong relationship. Depending on the size of the acquired enterprise, a non-solicitation covenant may apply to all of the retained employees or to a subset of employees who are particularly important to the operation of the acquired business. Customers and Suppliers A seller is likely to insist that any limitations on its interactions with customers and suppliers relate to specific effects on the business or assets being acquired rather than agree to any blanket prohibition on a relationship between the seller and such parties. If the seller's ongoing relationships with customers and vendors do not reduce or divert business or supplies away from the acquired company, the buyer will find it difficult to assert that it requires an outright restriction on a seller's dealing with these parties to protect a legitimate business interest. Duration of Non-solicitation A non-solicitation provision is typically shorter in duration than the non-competition covenant and may apply for one to two years after the closing of the transaction. Drafting a Non-Disparagement Covenant In addition to non-competition and non-solicitation provisions, a buyer will frequently require a seller to agree to a non-disparagement covenant that prohibits the seller from negatively portraying either the buyer or the acquired business. To reduce disputes over the scope of a non-disparagement clause, the clause should specify the scope of the entities, persons, and products and services that are covered and the types of actions (oral and written) that are restricted.