Katie O'Brien, Esquire

When lenders finance business acquisition transactions, they must obtain and closely review the purchase agreement as well as any ancillary agreements, which may include a non-compete agreement. Non-compete agreements are a type of restrictive covenant which restrict the seller from performing similar work for a certain period of time within a specified geographic area. Although the U.S. Small Business Administration ("SBA") does not have specific requirements regarding non-compete agreements, the SBA does require that lenders use "prudent lending" standards when closing SBA loans. Therefore, it is important that lenders review these agreements closely as a non-compete covenant can be crucial to ensuring a new business owner's success. One of the quickest ways to put a new business owner out of business is for the seller to continue to operate its business at a new location and lure all of its old customers and clients away from the new business owner. 

The laws regarding non-compete agreements vary greatly from state to state, but many courts use a "reasonableness" test to determine if a non-compete agreement is enforceable. The agreement must be reasonable in terms of:

• Duration - Some courts deem five years to be a reasonable time frame, while courts in other states may deem any amount of time exceeding one year to be unreasonable. It is important for lenders to be aware of the varying laws in each state. The Borrower's Attorney can be a good resource in determining what is considered reasonable in that particular state.
• Geographic scope - A non-compete agreement is more likely to be enforceable if is limited to a certain geographic area, but lenders must carefully consider what would be a reasonable, yet effective, geographic area instead of using a "one size fits all" approach to their loans. While an agreement which restricts competition in a 15 mile radius of the business may be sufficient to protect a borrower purchasing a business in a city, a 15 mile radius may not be sufficient in a rural area.
• Industry - A non-compete agreement has a better chance of being upheld by the courts if it is limited to a specific industry or sector. It would most likely be considered unreasonable to limit a Seller from engaging in a type of business or industry which is unrelated to the business that the borrower is purchasing.

In addition to applying a reasonableness test, two other factors that courts often consider in determining if a non-compete agreement is enforceable is whether the agreement was negotiated in good faith and whether it is supported by consideration. Because the value given to a covenant not to compete has tax implications for the buyer, lenders should encourage their borrowers to consult an accountant before negotiating what portion of the purchase price is to be allocated to the non-compete covenant.

Some states' courts take a very strict approach to reviewing non-compete agreements, while other states' courts go so far as to actually revise portions of the non-compete agreement to render the agreement enforceable. Courts in states such as Arkansas, Nebraska and Wisconsin will determine that a non-compete agreement is unenforceable if any portion of the agreement is considered overly broad or unreasonable. On the contrary, courts in other states such as Colorado, Pennsylvania and North Carolina follow the "blue pencil doctrine" which allows the courts to strike or revise certain parts of the agreement that are overly broad or unreasonable to make the scope of the agreement narrow enough to be enforceable.

When a buyer is purchasing the goodwill of an existing business, negotiating an enforceable covenant not to compete with the seller can be extremely important to the success of the buyer's new business. Moreover, imprudent practices could jeopardize the performance of the lender's loan to the buyer. Therefore, although a buyer should seek guidance from his or her attorney and accountant, it is also important for lenders to analyze and determine whether the terms of the non-compete agreement are sufficient for each specific transaction.  

For more information regarding non-compete agreements,please contact Katie at KOBrien@StarfieldSmith.com or (215) 542-7070.

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