Non-Competition Agreement & Non-Solicitation Agreements: The Most Heavily Negotiated Aspects of an Agreement
Previously, we have discussed several key closing documents necessary for any purchase or sale of a business. In this article, we will discuss the Non-Competition Agreement and Non-Solicitation Agreement.
Non-Competition & Non-Solicitation Agreements are closing documents found in 95% of deals. It is usually the most heavily negotiated aspect of an agreement. At its core, it restricts the Vendor from operating a similar business within a geographical area. It also restricts the Vendor from contacting any of the employees or customers of the selling business.
Non-Competition Agreement (also known as a Non-Compete Clause NCC or a Covenant Not to Compete CNC) is a clause under which one party (the existing owner) agrees not to enter into or start a similar profession or trade that will be in competition with or is a similar business to the purchased business. Some courts refer to these agreements as ‘restrictive covenants’ and, unless certain criterion are satisfied, are void for violating public policy.
A Non-Competition Agreement thus has to be limited in temporal (time) and geographical (space) scope. The agreement must only restrict for a certain period of time, usually less than 5 years. It cannot restrict the vendor from operating a similar business anywhere in the world; rather, its geographical scope must be reasonable, which is usually between 5 and 10 km from the location of the purchased business. Only where the temporal and geographical scope of a non-compete are limited and reasonable is the document binding on the existing seller.
Selling Pure Goodwill
Pure Asset Sale
However, when one is selling pure goodwill, which occurs when a business sells its client lists and trade-name, it becomes crucial for the deal to include a non-competition agreement. This is because the crux of the purchase price is comprised of the goodwill of the seller. There are no hard or physical assets such as product, equipment or inventory that make up the value of the business.
The goodwill of a business is intimately tied to the seller who has generated that goodwill in the marketplace. If the seller continues to operate a similar business, the value of the goodwill is reduced to NIL, effectively destroying the purchase.
If the vendor isn’t restricted by a non-competition agreement, the seller can open up shop across the street. Of course, all of the business’s existing clients, which were ostensibly sold to the purchaser, will purchase product from the person with whom they already have a relationship (the Seller).
For this reason, non-competition agreements are crucial in goodwill sales. However, these agreements remain extremely important in sales of assets or shares, regardless of the business.
A Non-Solicitation Agreement is a contract in which the existing seller agrees not to solicit the business’s clients or customers for his or her own benefit or for the benefit of a competitor after leaving the company. Whether one is selling the assets or shares of a business, Non-Compete and Non-Solicitation Agreements are key closing documents.
When you sell a business and sign a non-competition covenant, the purchase price for the sale of the business has to be allocated to the actual sale, which includes amongst its assets, the non-competition covenant. That is, how much of the value of the business is allocated to equipment, goods, fixtures, products, intellectual property and goodwill, and how much value is allocated to the promise that the owner will not operate a competing business? Under the natural operation of law, the selling party allocates some of the sale price to the non-compete, which is an intangible asset.
Under the Income Tax act, the compensation received by the owner for the non-compete is taxed as business income. However, there is a tax planning strategy under section s56(4), whereby the owner can elect to convert the business income to capital gains, which provides a greater tax advantage as capital gains is taxed at a lower rate than business income.
-Shira Kalfa, BA, JD, Partner and Founder
© Kalfa Law, 2020
The above provides information of a general nature only. This does not constitute legal advice. All transactions or circumstances vary, and specified legal advice is required to meet your particular needs. If you have a legal question you should consult with a lawyer.