Best Practices: Non-Compete Agreements: When Does an SBA 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.  If so, in order to protect the new venture, a non-compete agreement becomes a critical component to the purchase, one that helps to 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 the same or a similar 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 in the 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 when financing a change of ownership transaction with an SBA loan, and the Seller continues working in the industry directly impacting the new owner’s business, and the new business subsequently fails as a result, the SBA would have a basis to issue a recommendation for 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 particular facts of the transaction.  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 through a non-compete agreement as possible, without overreaching to ensure a court will not strike down the agreement and render it unenforceable.

Some common elements in a non-compete agreement that should be considered are industry type, geographic scope, and duration.  Often, the type of industry and geographic scope of the non-compete must be evaluated together.  For instance, if a Borrower purchases a local dentist’s office, a few mile circumference from the new location may be adequate for a non-compete agreement.  However, if the dentist’s office is located in a rural area, then a broader geographic restriction may be appropriate.  Similarly, if a Borrower purchases a manufacturing company that distributes products over many states, then a larger restricted geographic area should be included in the non-compete agreement.

Another element for lenders 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.  Although agreements with a duration longer than five years are often found to be excessive, the nature of the business and the state law will help guide you.  When in doubt, knowledgeable counsel can help the parties to achieve appropriate outcomes.  In sum, each non-compete agreement’s terms should be appropriate for each transaction.

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 Borrower should determine carefully whether the terms of a non-compete agreement are appropriate and sufficient for the transaction.

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