We are increasingly acting in transactions where the purchaser is requiring that the vendor, or the vendors if more than one, continue to be employed in the business post settlement. This is a function of the knowledge oriented nature of today's economy where value lies in intangibles such as specialized skills, knowledge, reputation and relationships with clients.

In many business transactions today what purchasers are really acquiring are the people whereas in past decades value may have been in tangible assets such as plant, equipment and leasehold or freehold interests used to conduct the business.

Purchasers of knowledge based businesses today will often try to eliminate risk by including earn out provisions in the transaction documents tying the quantum of consideration to the financial performance of the business over a specified period post settlement. For instance, one to three years. From the purchaser's perspective this helps to ensure that the vendors remain incentivized to continue to manage the business in the manner it was pre settlement and allow the purchaser sufficient time to cement relationships with key clients and stakeholders.

However to provide the purchaser additional comfort and protections the transaction documents will also contain restrictive covenants seeking to prohibit the vendors from damaging key relationships which the business has if the vendor does depart the business, either voluntarily by resignation or even if the termination is at the initiative of the new owner of the business. For instance, if the working relationship between such parties has broken down.

The restrictive covenants are generally of three forms:

  • a non-compete clause seeking to prevent someone from operating in the industry generally for a specified period of time following the termination of employment or a settlement of a sale of business or sale of shares.
  • a non-solicitation of clients clause.
  • a non-solicitation of employees clause.

At law the prima facie position is that any restraint of trade provision is invalid and the onus rests on the party seeking to enforce it to demonstrate that it is reasonable in all the circumstances. In terms of the question of reasonableness, regard must be had to the geographical scope of the restriction and the time period it purports to operate for.

Courts are more inclined to uphold some terms of restraint more readily than they are with others. For instance, as a general proposition a non-solicitation of clients clause will be more readily upheld by a court than a general non-complete clause. And non-solicitation of employee clauses are notoriously difficult to enforce due to the difficulty in quantifying the exact loss occasioned by the movement of an employee to another business. Though NSW courts do appear more amenable to upholding non-solicitation of employee clauses than Victorian courts.

To add to the complexity, what a court may view as reasonable in one form transaction document may be regarded as unreasonable and unenforceable in one of the other transaction documents even if the drafting is broadly the same. For instance, a non-compete clause in a sale of assets/sale of shares agreement prohibiting the vendor from working in the same industry for say three years post completion may be viewed by a court as entirely reasonable, whereas a non-compete clause contained in the employment contract of the vendor prohibiting them from competing for say three years (or even a much lesser period such as three to six months) following the termination of employment may have very little prospect of standing up in court.

The different approach adopted by the Courts is very much linked to the fact that any form of restraint is easier to uphold if person bound by the restraint has received some consideration for entering into it.

The situation is complicated even further by the fact that what might be reasonable in relation to a major shareholder vendor may be unreasonable if applied to a minority shareholder vendor who may be receiving minimal consideration for the sale of their shares. For instance, employee shareholders who may have acquired shares as part of an employee share program. It might be entirely legitimate to impose a general non-compete clause upon a major shareholder vendor whereas in the case of a minority employee shareholder it may be that the best that can be achieved is a non-solicitation of clients clause applying for a specified period of time post completion and for up to twelve months following the termination of employment.

Another instance where difficulties can arise even in the case of majority shareholder vendors is if the purchaser seeks to impose a general non-compete covenant upon such vendor in their employment contract following the termination of employment. That non-compete clause can therefore potentially spring into operation at a time after the non-compete clause in the sale agreement has expired. There is a risk therefore that a court will regard the purchaser as overreaching and will strike down the non-compete clause in the employment agreement on the basis that the purchaser is already adequately protected by the restraint in the sale agreement.

Given all of the above, the negotiation and inclusion restrictive covenants in sale agreements and the associated employment agreements if the vendors are remaining with the business require careful analysis and consideration.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.