Best Practices: Non-Compete Agreements: When Does a Lender Need One?

When a Buyer is considering acquiring a new business, both the Purchaser and Lender should consider whether the Seller or any of its key employees could pose a threat to the newly acquired enterprise.  In order to protect the new venture, a non-compete agreement may be a useful tool to help ensure the new business’ success.

A non-compete agreement typically prohibits the Seller, or related parties – including the principal(s) or key employee(s) – from performing similar work in an industry over a certain period of time within a given geographic area.  While the SBA does not have specific requirements for non-compete agreements (other than the optional provision set forth on page 25 of the 2018 Loan Authorization Boilerplate), it does require that the Lender engage in prudent lending practices when closing SBA guaranteed loans.   If a Lender does not obtain a non-compete agreement, and the Seller continues working in the industry, directly impacting the new owner’s business, and the new business fails as a result, the SBA would have a strong basis to issue a repair or denial of the SBA guaranty.

Lenders should use at least the same care when financing SBA loans as they would for their conventional facilities.  This means that SBA Lenders should consider a non-compete agreement based upon the particulars of the transaction.  Some elements in a non-compete agreement to consider are industry type, geographic scope, and duration.

While the laws differ from state to state, generally courts look to whether or not the non-compete agreement is reasonable.  Lenders should work with Borrowers and Borrowers’ counsel to obtain as much comfort and protection from a non-compete agreement as possible, without overreaching to ensure a court will not strike down the agreement and render it unenforceable.

Often, the type of industry will determine the appropriate of geographic scope. For instance, if a Borrower purchases a local dentist’s office, a few miles may be adequate for a non-compete agreement.  However, if a Borrower purchases a manufacturing company that distributes products all over New England, then a larger restricted geographic area should be included in the non-compete agreement.

Geographic scope may also depend on the locality of the business.  If the Borrower purchases that same local dentist’s office in a city, then a geographic restriction of a couple of miles may be sufficient.  If the dentist’s office is located in a rural area, then a geographic restriction may need to be substantially greater.

The final element to consider is the duration of  the non-compete agreement.  States differ vastly in what they consider a reasonable length of time for a non-compete agreement to be enforceable. This is an area where having knowledgeable counsel can be beneficial to both the Lender and Borrower.  Each non-compete agreement’s terms should be appropriate for each transaction. Agreements with a duration longer than five years are often found to be excessive.

When a new business is purchased, including a non-compete agreement can make the difference between a successful business and an enterprise that fails. It can also help SBA Lenders protect the loan guaranty in the event of business failure. Accordingly, the Lender and its Buyer should determine carefully whether the terms of a non-compete agreement are appropriate and sufficient for their transaction.

For more information regarding SBA compliance, please email us at info@starfieldsmith.com.