Noncompete Clauses for Business Owners

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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If you were to sell your business, it's likely that the buyer would ask you to agree to a noncompete clause in the sales contract. Where a noncompete clause in an employee's contract prevents that employee with taking a similar job with a competing business, a noncompete clause for a business owner is a little different. It essentially says that the seller cannot start a new, competing business that could take business away from the company up for sale.

The terms of a noncompete clause, which are often referred to as "covenants not to compete," can vary. They typically lay out a specific geographic area where the seller cannot create a competing business, although with the advent of businesses based primarily online, the geographic territories are becoming broader. A covenant not to compete will also list the length of time that the seller must refrain from starting a similar business.

Protecting the Buyer and Adding Incentive

The main purpose of a noncompete clause is to protect the buyer taking over your business. When the business changes hands, it's possible that your clients will want to continue to work with you, rather than signing on with a new owner. But access to those clients is one of the assets the buyer wants when purchasing the company. It's also possible that the buyer will not be as knowledgeable about your industry as you are, leaving a chance that you could recreate your previous business under a new name, making it harder for the buyer to make money.

If you're ready to get out of the business, though, you can turn a covenant not to compete into a selling point for your business. It depends, of course, on what you have in mind for after you sell your business, but you can offer a stronger noncompete clause as an incentive to win over buyers. A stronger noncompete clause often results in a higher sales price, especially when you allocate how much of the price goes to purchase each asset the business has to offer. That consideration, along with the fact that such an allocation can have beneficial tax implications, can make it more equitable for a seller to agree to a non-compete clause.

The Seller's Rights

A well-written noncompete clause is very careful to lay out those actions that a seller cannot take. However, as a seller, you do have rights with regards to a noncompete clause and the contract should reflect those rights. A covenant not to compete typically includes a promise on the part of a seller not to compete directly or indirectly. It's useful to make sure that the contract describes what is meant by both directly and indirectly. If, for instance, you sell a shop selling sporting goods, starting another sporting goods store would clearly violate a noncompete clause. But would becoming a private coach be indirect competition? If you were selling sporting goods directly to your coaching clients, it could be considered so. If you can iron out the specifics of an agreement not to compete during the sale, you won't have to do so later in court.

It's important to have a lawyer on your side when you're selling a business, especially when negotiating a noncompete clause. Coming to an agreement that is enforceable can be surprisingly difficult. Unless you have legal help experienced in writing sales contracts for businesses, it's possible that the covenant not to compete could quickly be rendered void.

If issues regarding a noncompete clause go to court, it's important to realize that not all such clauses will always be held up. If your agreement is fairly narrow, describing the specific actions that would be considered competitive, it's more likely to be considered valid. But if a noncompete clause is overly broad, especially if it prevents the seller from being able to earn a living, many judges will throw it out.

Negotiating a Noncompete Clause

As the seller, you can and should negotiate the terms of your noncompete clause. Because such an agreement can be long-lasting, it's important that you set a length that allows you to re-enter the field if you decide that you want to start up a similar business down the road. A lengthy noncompete contract can shoot you in the foot, especially if it has a broad definition of direct and indirect competition. You may not be thinking of setting up any sort of business that would directly compete with the business you're currently selling. But the fact of the matter is that, since you're already an expert in your field, it's not so likely that you'll try to get out of the field or industry you're in right now entirely. The key is making sure that you won't have problems with any new business due to a question of indirect competition.

The geographic area your noncompete clause covers is also an important opportunity for negotiation. When you consider what your next steps will be after selling your business, it's important to evaluate how certain you are that you'll stay in your current location. It's not out of the question for a business owner to sell a business and then start a very similar business in another place. It's not unreasonable to ask for a payment specifically earmarked for your agreement to stay out of a particular industry as a condition of the clause — when you break down the purchase price, such an approach can actually reduce the taxes you can expect to owe from the sale. It is important to discuss the tax burden with a professional specializing in business sales.

If, however, you're planning to entirely get out of the type of business that you're selling, you can use the non-compete clause as a bargaining chip in other ways. If you need a buyer to make concessions on other grounds, agreeing to a broader noncompete clause can help you get the concessions you want elsewhere in the contract.