Thompson Hine | Creative Solutions for Buyers as Non-Compete Bans Increasingly Affect M&A Deals

You may have heard murmurs about significant new prohibitions on non-compete covenants (“non-competes”) and might be concerned about how these developments could threaten your current, past and future deals. In the M&A context, buyers often rely on non-competes as part of a broader strategy to retain the value of the businesses they are purchasing. If any of the target company’s executives, salespeople, owners, developers of IP or others who hold important client relationships or trade secrets can easily leave and compete against the target company, the buyer immediately loses some of the assets and value they just purchased. On the other side, sellers might worry about not receiving the anticipated or desired price for their businesses if they feel they cannot adequately assure buyers that they will receive the full benefit of the transaction.

While these are legitimate concerns, particularly in jurisdictions that have enacted near-total bans on non-competes, here we summarize current and proposed restrictions (and applicable exceptions) and, most importantly, introduce potential workarounds that may preserve value and deter unethical or bad-faith competition.

CURRENT RESTRICTIONS

State-Level:

California, North Dakota, Oklahoma and Minnesota have all banned non-competes, with narrow exceptions for the sale of a business. New York will soon follow. Similar to the National Labor Relations Board (NLRB) and Federal Trade Commission (FTC) actions described below, even with exceptions for seller non-competes, there are potential key employees who may not legally enter into non-competes due to these prohibitions. Most states limit employers to some degree so that non-competes will not be used in anti-competitive ways or to restrict the free movement of low-paid employees. Employers are already familiar with these restrictions, which don’t typically interfere with M&A activity.

National Labor Relations Act (the “Act”):

This year, the general counsel of the NLRB published a memo stating that non-competes violate the Act. This finding may impact a business being purchased if that company has relied on non-competes to preserve the value of its IP or customer relationships, but the Act excludes managers and supervisors (as defined in the Act or NLRB case law) from this prohibition and would therefore not directly interfere with non-competes a buyer might want to enter into with executives of a seller company. The restrictions could, however, be a potential roadblock if a company’s value resides in a few key people who are not managers or supervisors (e.g., small biotech companies that rely on a few scientists or companies that have a few major customers kept happy by deep relationships with key salespeople).

Congressional Activity and FTC Enforcement and Rule Proposal:

At the federal level, lawmakers and rulemakers have been busy proposing increased restrictions on non-competes including a number of proposed bills to enact near-total bans. More pressingly, the FTC has stepped up enforcement actions and proposed a ban on most non-competes. Some experts speculate that the ban will be more narrowly tailored than the initial iteration and that it will likely be challenged, but this all remains uncertain. The FTC’s proposed rule is essentially a complete ban but includes a narrow carve-out for acquisitions where buyers may enter into a noncompete with a seller who holds at least 25% of the equity of the target company. As currently written, this carve-out would prohibit non-competes with minority owners who hold less than 25% of the target, non-owner salespeople, executives, IP developers, and others who might be considered key employees to potential buyers.

The comment period on the FTC’s proposed rule has ended and the publication of a revised rule or other response to public comment is expected by spring of 2024.

WORKAROUNDS

Ultimately, in situations where non-competes are illegal but the potential consequences of seller- or key employee-competition would damage the business to be purchased, buyers have to preserve value by building relationships and structuring the deal to encourage loyalty and commitment. As a buyer, you can work with your legal counsel to consider either structural deal changes or specific types of agreements or tools to protect your investment. Some of these may be considered positive incentives (i.e., carrots) while others introduce negative consequences for competition (i.e., sticks), such as the following:

• Employment Agreements may provide employees with a sense of security that is sometimes lacking during the upheaval of an acquisition. Existing agreements can also be amended as a closing condition to extend terms and build in useful provisions that are narrowly tailored to be enforceable and effective.
• Restricted Stock or performance share awards can be granted with forfeiture provisions that may persuade employees to stick around and reap the benefits of long-term loyalty with the company.
• Consulting Agreements for key people for whom an employment relationship may not be ideal (consider founders or executives) but who may enjoy a continued connection to the business and some consideration for less formal services to the company post-acquisition.
• Transition Services Agreements that are thoroughly negotiated and highly detailed can lead to a deep knowledge and relationship transfer to the buyer’s team, which might lessen concerns about competition in many industries.
• Earn-outs and other contingent models of consideration rely on performance metrics to determine the full value of the enterprise post-closing. Sellers are less likely to compete or otherwise make decisions that could harm the business if a significant portion of the consideration for the deal will be paid only if the business meets negotiated financial targets or extended post-closing timeframes. If a business model is particularly vulnerable to the potential competition of sellers without a non-compete, you could consider a longer than typical earn-out period while you build systems to mitigate this vulnerability.
• Trade Secrets Protection Programs should be in place, but if not, you can work with the seller pre-closing to begin building robust programs that include training and appropriate physical and cybersecurity measures. The Defend Trade Secrets Act may be an important avenue to federal enforcement in the event of trade secrets disclosure.
• Intellectual Property Assignments and Registration are essential for protecting the business and its assets, even if you cannot retain key employees or prevent them from competing. Requiring sellers to have all employees assign inventions to the company and ensure that all IP is properly registered in all necessary jurisdictions is among the most critical ways to protect your investment as a buyer. You may not be able to prevent a former employee from opening their own shop, but you can seek an injunction if they use the acquired company’s IP.
• Extra-Contractual Relationship Building and Social Sanctions refer to operating outside of contracts and the legal system and instead building relationships and reputations that strengthen a business and lead to compliance with norms in an industry. The professionals in the business you are acquiring are vulnerable to reputational consequences if they behave in unethical ways. Many studies show that, particularly in certain types of industries, there are tight networks of influential actors. If you are not already submersed in the culture of the industry, deepening your connections and building relationships can be a highly effective strategy to ward off some of the concerns that lead contracting parties to enter into non-competes in the first place.

Though M&A practitioners have come to rely on non-competes as a first line of defense to protect acquired businesses from unethical competition from sellers or sellers’ key employees, as new policies make these restrictive covenants less available, buyers can work with their legal teams to tailor creative solutions to best protect their investments.

For more information, please contact:
> Courtney Flowers, Attorney – Cleveland, THOMPSON HINE
> Emma Off, Partner – Cincinnati, THOMPSON HINE

Compliments of Thompson Hine – a member of the EACCNY.