PREVENTING A LETHAL THREAT TO YOUR BUSINESS

If you buy a business, and there is no covenant to not compete, you may have financed a competitor who could steal your business away from you.

If you do not have key employees sign covenants to not compete, they could take your critical business information and/or key customers and vendors with them if they leave.

To prevent these lethal threats to your business, you should enter into covenants to not compete with any Seller of a business you buy, as well as with your key employees.

  • Introduction
    • COVENANTS TO NOT COMPETE ARE ENFORCEABLE
    • These are written documents[1]
    • In the absence of a covenant to not compete, sellers and former employees are allowed to compete with buyers and/or employers[2]
    • Covenants to not compete prohibit unfair competition by restricting competitive activities for a period of time
    • Payment for entering into the covenant to not to compete
      • We normally recommend that something specific and reasonable be paid by the party benefited by the covenant to the other party.
        • This avoids claims that the other party did not know that they were contracting for something of value (i.e. they didn’t know the importance of what they were signing)
        • This limits claims that there was no consideration for the covenant to not compete
      • It has become the standard practice to incorporate a covenants to not compete in the purchase of a business, with a negotiated amount of the proceeds to be allocated to the covenant. This can have tax ramifications for both parties.
      • For covenants to not compete with employees
        • Continued employment is legally sufficient consideration to enforce a covenant to not compete[3]
        • Employers are not REQUIRED to pay an employee to enter into the agreement
        • In the absence of an employment contract or other impermissible basis for firing, refusal to sign a covenant to not compete is not a wrongful termination
        • An employee may quit rather than sign a covenant to not compete
        • The fact that the benefitted party will not accede to the requests of the other party (i.e. “take it or leave it”) does not mean that the covenant is unenforceable[4]
  • Standard of review
    • THESE ARE HIGHLY FACT SPECIFIC CASES
    • Greater restraints are allowed for covenants to not compete entered into in conjunction with business sales than covenants to not compete in conjunction with employment[5]
    • Balancing of interests- a “reasonableness” test [6]
      • The restriction must be reasonably necessary to protect the party whom is benefitted
      • The restriction must NOT be unreasonable or excessively [oppressively] restrictive to the party who is restricted
      • The determination of reasonableness is viewed at the time the covenant not to compete is MADE. If the covenant is reasonable at its making, it is reasonable throughout its term[7]
    • Considerations in striking the balance between competing parties’ interests[8]
      • Time, area, and scope of restriction
      • Whether there was sufficient contact and relationships with customers so that “pirating” could take place
      • Whether the breech was the result of application of training or acquisition of specialized knowledge during the prior relationship
      • Whether enforcing the covenant would unnecessarily interfere with allowing the pursuit of employment
      • Whether one party’s gain from enforcing the contract was disproportionate to the harm to the other party.
  • Judicial Reformation[9]
    • Enforcement of a covenant to not compete is not “all or nothing”
    • If the Court determines that the covenant is unenforceable as written, the court will determine what terms are reasonably necessary to protect the legitimate interests of the benefited party without causing undue hardship on the burdened party.
    • A covenant which is deliberately unreasonable and oppressive may be entirely unenforceable and ineligible for judicial reformation
      • Cases reviewed for this article did not provide much guidance on how much business or how often business is done for a described territory to be appropriate
      • This will probably depend on the damage to the protected party occurring from activities within the protected territory
      • If activities are occasional or non-recurring the territory may not be recognized by the court
      • The internet in general, and E-commerce in particular have impacted geographical descriptions of territories.
  • Proof
    • Burden of proving the necessity and reasonableness of the covenant to not compete is on party seeking to enforce covenant[10]
    • To prevail, the party seeking to enforce the covenant must also show[11]
      • The covenant was actually breeched
      • The breech resulted in some damages to the party seeking enforcement
    • Remedies for breach of covenant[12]
      • Injunctions
      • Damages
    • WORDS MATTER
      • It is important to clearly and properly describe the “prohibited activity”
        • If there is a restriction on involvement[13] with a competing company it is important to describe the business of the PROTECTED party
        • If there is a prohibition of engaging in certain activities on behalf of others, the prohibition must be definite enough for enforcement, yet broad enough to provide adequate protection
        • When assisting clients with covenants to not compete, we often focus on protecting their existing customer/client base
    • It is important to clearly and properly describe the “prohibited territory”. The protected party should actually conduct business in the protected territory[14]

 

Contact the Kreamer Law Firm, P.C. at 515-727-0900 or at infor@kreamerlaw.com If you/your business need assistance regarding covenants to not compete.

[1] All the cases reviewed were based on written documents. There were no cases found based on oral agreements to no compete.

[2] Covenants to not compete are an exception to laws prohibiting restraint of trade Mutual Loan Co. v. Pierce 245 Iowa 1051; 65 NW2d 405

[3] Iowa Glass Depot, Inc. v. Jindrich 338 NW 2d 376, 381 (Iowa 1983)

[4] Sutton v. Iowa Trenchless, L.C. 808 NW2d 744 (Iowa 2011)

[5] Baker v. Starkey 259 Iowa 480, 491, 144 NW2d 889,895 (1966); see also Sutton v. Iowa Trenchless, L.C. 808 NW2d 744 (Iowa 2011)

[6] Lamp v. American Prosthetics, in. 379 NW 2d 909, 910 (Iowa 1986); see also Haggin v. Derby, 209 Iowa 939, 943, 229 NW 257, 259 (1930), Iowa Glass Depot, Inc. v. Jindrich 338 NW 2d 376,381 (Iowa 1983). Although mentioned in the cases, there is a third consideration: Whether there is some interest of the public which would be negatively impacted if the covenant was enforce. However, it is hard to see how this third consideration would be a primary concern.

[7] Sutton v. Iowa Trenchless, L.C. 808 NW2d 744 (Iowa 2011)

[8] Iowa Glass Depot, Inc. v. Jindrich 338 NW 2d 376 (Iowa 1983)

[9] Ehlers v. Iowa Warehouse Co. 188 NW2d 368 (Iowa 1971)

[10] Mutual Loan Co. v. Pierce 245 Iowa 1051, 1056; 65 NW2d 405,408

[11] Sutton v. Iowa Trenchless, L.C. 808 NW2d 744 (Iowa 2011). Arguably, a covenant to not compete is a contract between the parties. As such, because damages are an element to be proven in a breech of contract case, damages would be necessary in order to prevail in a non-compete case.

[12] Party seeking enforcement has burden to prove breech, and that there is/will be harm to it due to breech

[13] Either employment restrictions or ownership restrictions

[14] Ehlers v. Iowa Warehouse Co. 188 NW2d 368 (Iowa 1971); see also Sutton v. Iowa Trenchless, L.C. 808 NW2d 744 (Iowa 2011) and the cases cited therein

 

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