How Do Restrictive Covenants Work In A Business Sale?

Restrictive covenants serve as an important function in the purchase of any business (be it share purchase or asset purchase) to protect the value and goodwill of the business following sale. The coverage of the restrictions and the individuals bound to the same are fundamental considerations in determining the protection offered by such restrictions.

Following the purchase of a business, restrictive covenants provide the buyer time to establish their ownership of the company and crucially the opportunity to build relationships with the key players without the seller’s interference.

The absence of restrictive covenants in a business purchase agreement creates the risk that the value of the business diminishes or is possibly lost entirely following its sale.

Who should be bound to the restrictive covenants?

This is arguably the most important question of all.

It is futile spending hours negotiating restrictive covenants in a purchase agreement if in fact the person or company bound to them is not a threat to the business and its operations after its sale. It may even be that the person bound to the restrictions is a limited company which will no longer exist following completion in which case the restrictive covenants have no bearing.

It is imperative to recognise the importance of highlighting the key players during the due diligence process to optimise value of the restrictive covenants.

Once the key players are established, it is important to consider the basics of the purchase agreement. Usually, the parties to the contract are buyer and seller and the restrictive covenants would typically apply to the seller.

If the seller is not the ‘key player’ consideration must be made as to whether it is possible to tie the key player to the business purchase agreement. It may be that the seller is a limited company and the key player is the director or shareholder of the company in which case it would be appropriate to tie the director and/or shareholder to the contract as covenantor to covenant the actions of the seller and tie them personally to such restrictions.

What should a restrictive covenant clause cover?

Generally, restrictive covenants should provide sufficient coverage to minimise the risk of business interruption following completion of a business purchase.  A business sale may create a risk that key players leave or cease to stop trading with the business. Key players often have been running and/or working with the business for some time possibly since its incorporation. A lot of successful businesses are built on strong relations with the key players who may be very loyal to the business perhaps even working with them on an exclusive basis.

Therefore, restrictive covenants would usually prevent the key player from setting up a competing business and taking staff, customers, suppliers away from the business and using the business name at any time following completion. The primary goal of the restrictions are to preserve the value and goodwill of the business. However, there is no ‘one size fits all’ when it comes to restrictive covenants and the risk established in the due diligence process is key in mapping out the appropriate restrictions.

Are restrictive covenants enforceable?

Generally, restrictive covenants are enforceable so long as they are reasonable.

Therefore, you will often see that restrictions are capped in time in that they often last for a number of years and sometimes capture a specific geographical region when referring to setting up a competing business.

A reasonable balance must be struck in allowing the seller to operate as intended following completion whilst providing the buyer with the protections necessary to run the business and preserve its value without interruption.

When should restrictive covenants be considered?

Consideration should be made for the restrictive covenants as early as possible in the transaction process and ideally at the due diligence stage when establishing what risk there may be to the business following completion.

We advise that a provision for restrictive covenants is made in the first draft of the business sale agreement so that all parties are aware early on in the drafting process of expectations on one another post sale.

Where should the restrictive covenants be listed?

The restrictive covenants must be in the sale agreement. As discussed above, any person whom you wish to be bound by the restrictions will need to be a party to that agreement even if they are not themselves a Seller.  For example, it may be that the Sellers spouse is a key person in the business and needs to be subject to the restrictions but is not themselves a Seller. It may therefore be necessary to add that individual into the agreement as a covenantor.

In such a scenario it is also prudent to check any existing key player contracts and determine how much notice the key player must provide before they terminate the contract and to also consider if they too have restrictive covenants in their contract that prohibit them from taking any value away from the business if they were to exit.

It may be the key player does not have a contract with the business and/or if they do that there are no restrictions in the same. In such a scenario it is recommended that the seller implement the necessary contracts (including restrictive covenants) before completion to minimise the risk of the key player causing damage to the business and its value post sale.

Why are restrictive covenants necessary?

It is always advisable to have restrictive covenants in a sale agreement however, the context behind the sellers exit and who the sellers are is always important in analysing how important the restrictive covenants are in practice.

The sellers may be exiting the business to move on to an entirely new field of work, perhaps they are even retiring in which case a buyer may take a commercial view as to whether to include at all in the sale agreement or how heavily to negotiate the restrictive covenants.

It may be the business being sold is owned by a professional seller meaning it could be a company or an individual that operates multiple businesses and/or companies some of which or perhaps all of which operate in the same sector. The seller may be selling one branch of the existing business or a subsidiary and intends to operate the remaining elements of the business as usual post sale. In such circumstances, the seller will naturally resist blanket restrictive covenants and it would be commercially inappropriate to stop the seller running their other existing businesses if they are only selling one branch. This is not to say that restrictive covenants do not have a place in such a transaction,however, careful thought should be placed on the coverage of the restrictions to allow a balance of protection in the agreement for both buyer and seller.

How do you enforce Restrictive Covenants?

If it becomes necessary to enforce restrictive covenants then this may require legal proceedings which may result in an injunction being granted or damages awarded where a breach of restrictive covenants is established. It is however essential that action is taken urgently as soon as you become aware of a potential breach of restrictive covenants.

In certain situations, a delay in enforcing a restrictive covenant could limit the remedies available to a Buyer. For example, a Court may refuse an injunction if the Buyer has delayed in enforcing a restriction after they become aware of the breach.

Ison Harrison Solicitors regularly advise on the drafting and enforcement of restrictive covenants. Please get in touch by calling us on 0113 284 5000.