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November 11, 2015

Best Practices: The Importance of Non-Compete Agreements

by Kristen G. Dickey

A non-compete agreement, or covenant not-to-compete, is a contract between two parties whereby one party agrees not to enter into or start a similar business, profession or trade in competition with the other party for a certain length of time and with a certain geographical area.

The U.S. Small Business Administration (“SBA”) requires lenders to use “prudent lending standards” when closing SBA-guaranteed loans. Therefore, it is important that lenders financing a business acquisition closely review the purchase and sale agreement and any ancillary agreements for non-compete terms, as this type of covenant can be crucial to ensuring a new business owner’s success. Lenders should also analyze each specific business acquisition loan on its own and determine whether the terms of the non-compete agreement are sufficient for that type of business , the parties, and/or the market.

A non-compete agreement is especially important for a borrower that has agreed to purchase a business in which a large portion of the business assets is designated as goodwill. Just imagine the futility of a new business owner’s efforts if the former business owner simply moves to a new location nearby and manages to retain most of its prior customers by using confidential information about operations, trade secrets, or sensitive information such as business practices, products, and marketing plans.

The laws regarding non-compete agreements vary greatly from state to state, but courts will review the terms for reasonableness, good faith, and consideration (any) to determine if a non-compete agreement is enforceable. Typically, an over-broad non-compete agreement will be enforced only to the extent necessary to protect the legitimate business interests of the business owner.

The agreement must be reasonable in terms of:

  • Duration – Does the non-compete agreement last for a few months or multiple years? Courts in some states may deem a one year term to be excessive while courts in other states may find a five year term to be reasonable. It is important for lenders to be aware of the varying laws between, and even within, states. Borrower’s counsel can be a good resource in determining what is considered reasonable in a particular jurisdiction.
  • 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.
  • Industry – Any non-compete agreement that is not limited to a specific industry or sector would likely be considered unreasonable.

When financing change of ownership transactions, SBA lenders must ensure that their underwriting decisions are reasonable and are calculated to ensure the borrower’s success. Failure to address issues surrounding non-competes can jeopardize the lenders SBA guaranty if not fully and thoroughly reviewed.

For more information regarding non-compete agreements, contact Kristen at (407) 618-0698 or kdickey@starfieldsmith.com.