Key Considerations in the Purchase / Sale of a Partnership Interest
Part Four of a Series
Payne & Fears’ Business Litigation Group helps businesses and their owners with wide-ranging disputes. In our practice, we’ve noticed that in disputes among business partners there are common issues that often surface. This is part four of a series of articles highlighting some of the most common problems. The articles cover issues arising at several stages of the business relationship, from inception to ending the business. The topics in these articles are broadly applicable to all types of business entities from general partnerships, to LLCs, and corporations.
You and your partners plan on purchasing another partner’s interests and you’re thinking of ways to protect the value of the business you’ll acquire by including a non-compete or non-solicitation agreement for the selling partner. At the same time, you’re well-aware that (1) California generally prohibits the enforcement of restrictive covenants, but (2) there is an exception under Business & Professions Code section 16601 when the covenant is tied to the sale of a business. The following highlights a few important reminders to help ensure that your agreement will be enforceable if you’re ever forced to present it to a judge.
Make Sure Your Acquisition Qualifies for the Exception
Remember, not every purchase qualifies as exempt under section 16601. The exception is narrow, and it is entirely up to the buyer to show that the parties’ transaction falls within the limited statutory exception.
Section 16601 isn’t vague on what types of transactions qualify. The restrictive covenant must be directed toward: (1) a person selling the goodwill of a business; (2) an owner of a business disposing of all of the owner’s ownership interest in a business; (3) an owner of a business selling all or substantially all of its operating assets together with the goodwill of the business; (4) an owner of a business selling all or substantially all of the operating assets of a division/subsidiary of a business together with the goodwill of that division/subsidiary; or (5) an owner of a business selling all of the ownership interest of any subsidiary.
This results in the exception being limited to transactions where the seller is a sole proprietor, a partner with a partnership interest in a partnership, an LLC member with a membership interest in an LLC, or a capital stockholder in a corporation. Even a narrowly drawn, reasonable non-compete may fail unless it falls within one of applicable statutory exceptions to their invalidity. Your transaction to buy out a business partner, however, likely will qualify for the exception because the selling partner is an owner disposing of all of his or her ownership interest.
Always Remember the Purpose of the Exception When Crafting Restrictive Covenants
You should always remember that the Legislature enacted section 16601 to protect a purchaser of a partnership interest from unfair competition by the seller that diminishes the value of the purchased asset. To be exempt under section 16601 (and thus enforceable), the restrictive covenant must be reasonable in terms of time, activity, and territory, and must be necessary to protect your interest. It is imperative to prepare an agreement with language that is specific and, most important, directly tied to the covenant’s purpose, i.e., to protect your interest in preserving the expectation of patronage which has become an asset of the acquired business. The judge likely will consider the purpose behind section 16601 when it reviews your restrictive covenant. A buyer disregarding the purpose of section 16601 is often the main reason why non-compete and non-solicitation provisions end up being unenforceable.
First, it goes without saying that you should always include a specific, written non-compete or non-solicitation provision if you intend to enforce one. This seems obvious to many. But it isn’t uncommon for buyers of partnership interests to assume that a restrictive covenant is implied in a purchase of partnership interests. Some buyers even rely on oral promises to the same effect. But in fact, goodwill is often sold without any restrictive covenants. Thus, the sale of goodwill by itself will rarely support an argument that a non-compete or non-solicitation was implied in the transaction. Get the agreement in writing.
Second, any restrictive covenant should be limited to the area where the selling partner carried on business. Don’t overreach. Where you do business or intend to do business is often irrelevant – the permissible geographic scope is more often tied to the sold business, i.e., where the selling partner did business or intended to do business. Otherwise, the selling partner could be barred from engaging in his or her business in places where they pose little threat of undercutting the interests it sold to you. That may make your agreement unenforceable.
Third, showing a logical relationship between a restrictive covenant and the acquisition is particularly important when, as is often the case, the selling partner agrees to stay on as your employee, contractor, or consultant. It is not uncommon for buyers in that situation to include a non-compete that lasts for a certain number of years after the acquisition closing and/or the termination of the seller’s relationship with you. Including that second provision, which would tie the non-compete not just to the date of acquisition but also to the date when the seller’s engagement ends, is often fatal to the enforceability of non-compete provisions. Not only is the precise duration of the non-compete ambiguous when the agreement is signed; it may, in practice, result in a non-compete provision that remains in force for many decades after the acquisition. On the other hand, tying the commencement of the restrictive covenant to the date of the acquisition is not ambiguous as to the duration and helps demonstrate a relationship to the goodwill you purchased.
Another problem arises when a restrictive covenant prohibits both the solicitation of the selling partner’s customers and the acquiring partner’s customers. Like the situation discussed above, courts often see covenants barring the seller from soliciting all customers of the buyer, even those who were not the seller’s former customers, as extending their anticompetitive reach beyond the business that was sold. So limiting a restrictive covenant to prohibit the solicitation of the selling partner’s customers (or even the selling partner’s potential customers) is the better practice.
The best way to ensure that you have an enforceable restrictive covenant is to be proactive. Take the time to prepare a narrow, unambiguous written agreement to protect the value of the business and avoid future headaches. If you have run into a partnership dispute involving potential breaches of restrictive covenants, please contact the business litigation attorneys at Payne & Fears.