Non-Compete Agreements When You Sell Your Business

You will almost certainly sign one. What matters is the scope, the geography and the length, and what you are still free to do afterward.

Why buyers will not close without one

A lender financing the deal usually requires it. An SBA lender, a bank or a private equity firm's lenders all want to know that the person who built the customer base is not going to take it back. A buyer who asks for a non-compete is being normal. A buyer who does not ask is unusual enough that we would want to know why.

How California treats them

California is stricter about non-competes than almost any other state. As a general rule, California law makes contracts that stop someone from working in their trade or business void, which is why most employee non-competes do not hold up here.

The law makes an exception for the sale of a business. A person who sells the goodwill of a business, or sells all of their ownership interest in it, can agree not to compete with the buyer. The restriction has to be limited to the geographic area where the business operates. That exception is what makes non-competes in a business sale enforceable in California when most other non-competes are not.

Two practical points follow. First, the non-compete should be tied to the sale itself, in the purchase agreement or a separate agreement signed at closing, with the seller named as a seller. Second, if you stay on as an employee after closing, a non-compete written into your employment agreement is on much weaker ground in California than the one in the sale documents. Your attorney should draft them to work together.

Other states have their own rules, and most of them treat a non-compete given by a seller more favorably than one signed by an employee, because the seller was paid for the goodwill. If your business operates in more than one state, the agreement needs to account for each.

The parts of a non-compete

Scope. What you cannot do. A good non-compete describes the competing activity specifically, such as owning, running or working for a business that provides commercial HVAC service. A vague one says "any business similar to the business," and similar can mean a lot of things in a dispute.

Geography. Where you cannot do it. A plumbing company serving three counties should have a non-compete covering those counties. A software company selling nationally may need a national one. In California the area has to match where the business operates, so a buyer asking for more than that is asking for something that may not hold.

Term. How long it lasts. Three to five years is common. Longer terms show up on larger deals and when the seller is staying on, in which case the clock often runs from the end of the seller's employment or consulting role. Ask when the clock starts, because a five year non-compete that begins after a two year consulting agreement keeps you out for seven years.

Non-solicitation. Most agreements also include a promise not to recruit the business's employees or approach its customers for a period. These are usually less controversial than the non-compete itself, and they are often what the buyer cares about most.

What you should still be free to do

Think about what you want to do next before you sign. Common carve-outs, meaning exceptions written into the agreement, include passive investments such as owning publicly traded stock, working in a different part of the industry that does not compete, teaching or writing about the trade, and businesses you already own that do not overlap with the one being sold. If you plan to consult, invest in other companies in your industry or start something adjacent, say so during the letter of intent stage and get the carve-out in writing. After closing is too late to ask.

When there is more than one owner

If two or three partners own the business together, the buyer will usually ask each selling owner to sign. That includes a partner who has been less involved day to day, because a passive owner with industry connections can still compete. The terms do not have to be identical. A partner who is retiring may accept a broad restriction. A partner who wants to keep working in the trade may need a narrower one, or a specific carve-out, and the price allocated to each owner's agreement can reflect that.

Key employees are a different matter. In California, an employee who owns no part of the business generally cannot be held to a non-compete, even in connection with a sale. Buyers protect themselves there in other ways, with stay bonuses paid for remaining after closing, confidentiality agreements, and rules on use of customer lists and trade secrets. If the business depends on one or two people who are not owners, plan for that before going to market, because the buyer will ask how those relationships are protected.

How the non-compete is taxed

In an asset sale the buyer and seller agree on how the price is divided among the assets, and the non-compete can get its own share of the price. That allocation matters to you. Money allocated to a non-compete is generally taxed to the seller as ordinary income, at the same rates as wages, while money allocated to goodwill generally gets the lower capital gains rate. The buyer, meanwhile, deducts the non-compete payment over 15 years. That is the same period as goodwill, so buyers do not usually gain much by pushing a large amount into the non-compete, and sellers have good reason to keep it modest. The allocation is filed with the IRS on Form 8594, which we explain in Purchase Price Allocation and Form 8594. Talk to your CPA about the number before it goes into the letter of intent.

What happens if you break it

The buyer can go to court to stop you from competing and can sue for damages. Some agreements set a dollar amount in advance, called liquidated damages, and some let the buyer stop paying a seller note if the non-compete is breached. Read those provisions as closely as the restriction itself. A buyer who believes you broke the agreement can stop paying on a note and leave you to sue for the balance.

Negotiating it

We treat the non-compete as a business term, settled in the letter of intent with the price and the structure, so it does not become a fight in the purchase agreement. A reasonable buyer wants protection for what they paid for. A seller wants to know what their life looks like for the next few years. Those two can usually be written into the same paragraph.

The non-compete also connects to how long you stay after closing. Read How Long Do I Have to Stay After I Sell My Business? before you agree to both, and have your attorney review the final language. We are not attorneys, and the details of a non-compete are legal work.

This article shares our opinion and general information. It is not legal or tax advice. Always speak with a licensed attorney for legal advice, and a qualified tax professional for tax questions, before you act.