Drafting Non-Compete Clauses in Small Business Purchases: What Buyers Need to Know

Introduction

Drafting non-compete clauses is pivotal for buyers in small business transactions, ensuring that sellers do not engage in or support competing ventures post-sale. These agreements are essential for maintaining the value and integrity of the acquired business, preventing former owners from leveraging sensitive information or client relationships to establish rival enterprises. 

Moreover, non-compete clauses serve to protect the buyer’s investment by restricting the seller from entering markets or industries that directly compete with the business being purchased. This guide offers valuable insights into the formulation of effective non-compete agreements, highlighting key considerations to help buyers secure enforceable terms that support their long-term business objectives. 

Understanding Non-Compete Clauses

Definition of Non-Compete Clause

A non-compete clause, also known as a restraint of trade clause, is a contractual provision that restricts a party from engaging in certain competitive activities after the termination of a business relationship or sale. These clauses are designed to prevent the seller or former employee from starting a competing business or joining a competitor, thereby protecting the buyer’s investment and business interests.

Key elements of a non-compete clause typically include:

• Duration: Specifies the time period during which the restraint applies, usually ranging from 1 to 12 months.
• Geographical Scope: Defines the physical area where the restraint is enforceable, tailored to the business’s operational region.
• Scope of Activities: Outlines the specific activities that are restricted, such as opening a similar business or soliciting clients.

Purpose in Business Purchases

Buyers include non-compete clauses in business purchase agreements to safeguard their investment by preventing the seller from directly competing with the newly acquired business. This protection ensures that the buyer can fully capitalise on the business’s goodwill and market position without facing competition from the former owner, which could undermine the business’s value and growth prospects.

Additionally, non-compete clauses help in maintaining customer relationships and protecting proprietary business information, preventing the seller from exploiting these assets in a new venture. By implementing these clauses, buyers can ensure the stability and continuity of the business post-sale, fostering a secure environment for future growth and success.

Legal Framework and Enforceability

Australian Legislation on Non-Compete Clauses

Non-compete clauses in Australia are governed by a combination of Common Law Principles, the Restraints of Trade Act 1976 (NSW), and the Competition and Consumer Act 2010 (Cth). These laws collectively ensure that non-compete clauses are reasonable and necessary to protect legitimate business interests.

Under Common Law, non-compete clauses are considered prima facie unenforceable unless the employer can demonstrate that the restraint is reasonable and necessary to protect their legitimate business interests. The Restraints of Trade Act 1976 (NSW) provides a framework where such clauses are valid unless they are against public policy.

Additionally, the Competition and Consumer Act 2010 (Cth) ensures that non-compete clauses do not unduly restrict competition or harm the public interest.

Factors Affecting Enforceability

Courts in Australia assess the enforceability of non-compete clauses based on several key factors to ensure they are reasonable and not unreasonable restraints.

• Duration: The length of time the restraint applies must be reasonable. Typically, periods ranging from 1 to 12 months are considered enforceable
• Geographical Scope: The physical area covered by the clause should be limited to the region where the business operates. For example, a local coffee shop should not impose a national non-compete.
• Scope of Activities: The specific activities restricted by the non-compete must be clearly defined and directly related to the business’s operations. Overly broad restrictions can render the clause unenforceable.
• Legitimate Interests: The clause must protect legitimate business interests, such as confidential information, trade secrets, or customer relationships.

Courts also consider whether the restraint protects the legitimate interests of the business without being excessive. For instance, in AEI Insurance v Martin, the court upheld a 12-month restraint as reasonable given the nature of the business and the role of the employee.

Conversely, in 2nd Chapter Pty Ltd & Ors v Sealey & Ors, a five-year restraint was deemed unreasonable due to its broad geographical scope and lengthy duration, highlighting the importance of tailoring non-compete clauses to be specific and proportionate.

Ensuring that non-compete clauses are reasonable, specific, and necessary is crucial for their enforceability under Australian law.

Drafting an Effective Non-Compete Clause

Scope and Geographical Limits

Defining the scope of a restraint clause involves specifying the types of activities or business areas the seller is restricted from engaging in after the sale. It is essential to align these restrictions with the nature of the business to ensure reasonableness and enforceability. Overly broad scopes may be deemed unreasonable and could render the clause unenforceable.

When setting geographical limits, consider the current market presence of the business. Restricting competition to areas where the business actively operates enhances the legitimacy of the restraint clause. For example, if the business serves a specific region, the non-compete agreement should reflect that geographical area rather than imposing nationwide restrictions.

Duration of the Restraint

The duration of the restraint clause should be carefully balanced to protect the buyer’s legitimate business interests while not unduly restricting the seller’s ability to earn a livelihood. Typically, a restraint period ranging from one to twelve months is considered reasonable, depending on the industry and specific circumstances of the business sale.

Courts assess the reasonableness of the duration to ensure it is not excessive. For instance, a twelve-month restraint may be acceptable for most businesses, whereas longer periods might be scrutinised for their necessity and proportionality. Tailoring the duration to the specific needs of the business increases the likelihood of the clause being enforceable.

Consideration and Compensation

For a non-compete clause to be enforceable, it must be supported by adequate consideration within the employment contract or business sale agreement. Consideration refers to something of value that the seller receives in exchange for agreeing to the restraint. This could be a specific portion of the purchase price allocated to the non-compete agreement, ensuring that the clause is backed by tangible value.

Including clear terms of consideration not only strengthens the enforceability of the restraint clause but also ensures fairness between the buyer and seller. Without sufficient consideration, the clause may be deemed invalid by the courts, undermining its intended protective purpose. 

Common Mistakes and How to Avoid Them

Overly Broad Restrictions

Overly broad restrictions in non-compete clauses can render the agreement unenforceable. When the restraint extends beyond what is reasonable in terms of duration, geographical scope, or activities, it may violate public policy and undermine the protection of the goodwill of the business.

• Duration: Set the restraint period to a reasonable timeframe, typically between 1 to 12 months, ensuring it is necessary to protect the legitimate business interests without overextending.
• Geographical Scope: Define a specific geographic area that directly relates to the business premises and operations. For example, if buying a business in New South Wales, the non-compete should be limited to that region rather than imposing a national restriction.
• Scope of Activities: Clearly outline the restricted activities to focus on preventing direct competition and new solicitation of clients or employees without unnecessarily limiting the seller’s ability to engage in unrelated business ventures. This ensures the clause is reasonable and enforceable.

By avoiding overly broad restrictions, purchasers can draft non-compete clauses that are reasonable and enforceable, thereby protecting their business interests effectively.

Insufficient Consideration

Insufficient consideration for a non-compete clause can make the restraint of trade unenforceable. Adequate consideration must be provided within the employment agreement or business sale agreement to support the restraint.

• Proportional Value: Ensure that the consideration matches the scope and duration of the non-compete clause. For example, a longer restraint period or broader geographical scope should be supported by substantial consideration, such as a significant portion of the purchase price or additional compensation.
• Explicit Agreement: Clearly specify the consideration within the non-compete agreement to demonstrate fairness and mutual benefits. This can include details on the financial terms or other benefits provided to the seller in exchange for agreeing to the restraint.
• Alignment with Business Interests: Align the consideration with the protection of legitimate business interests, such as safeguarding intellectual property or maintaining customer relationships. This reinforces the necessity of the non-compete clause and ensures its reasonablenes.

By ensuring adequate and appropriate consideration is included in the non-compete clause, purchasers can create enforceable agreements that effectively protect their business interests and prevent the seller from engaging in new solicitation or competition. 

Case Studies on Non-Compete Clauses

AEI Insurance v Martin

AEI Insurance Group Pty Ltd is an insurance broker specializing in heavy vehicle insurance. Mr. Craig Martin was employed with AEI from July 26, 2011, to September 2, 2022, where his primary duty was to assist with new business growth opportunities. His mobile phone served as AEI’s 24/7 emergency accident assistance number, making him a key representative in the Queensland market

Mr. Martin’s employment contract included a restraint of trade or non-compete clause lasting 12 months, preventing him from soliciting or approaching AEI’s clients post-resignation. This non-compete and non-solicitation clause was integral to protecting AEI’s legitimate business interests by restricting him from engaging with a competing business within a specified radius of the business being sold.

Upon resigning on August 29, 2022, Mr. Martin joined MA Brokers, a direct competitor, and began contacting AEI clients using information from his previous role. The court upheld the enforceability of the 12-month restraint, deeming it reasonable considering the radius of the business operations and Mr. Martin’s role in handling client relationships.

Justice Thawley confirmed that Mr. Martin breached the clause by actively soliciting clients, resulting in the loss of 45 clients to MA Brokers. This case emphasizes the importance of drafting non-solicitation clauses within clauses in employment contracts to prevent former employees from undermining the business being sold. Damages were assessed at $500,000, reflecting the potential revenue loss and the breach’s impact on AEI’s business.

2nd Chapter Pty Ltd & Ors v Sealey & Ors

In contrast, the case of 2nd Chapter Pty Ltd & Ors v Sealey & Ors involved former employees Paul Sealey and Jono Vickers-Willis, who held shares in Escala Partners, and Will Allen, who did not. These employees were bound by a non-compete clause, lasting five years, restricting them from competing or soliciting Escala’s clients following their departure.

The Victorian Supreme Court, led by Justice Matthews, evaluated the enforceability of the five-year restraint. While recognizing Escala’s legitimate interest in protecting its business goodwill through non-solicitation clauses, the court found the restraint’s scope and duration unreasonable. Specifically, the five-year term and broad geographical restrictions were deemed excessive, particularly given the minimal shareholding of Sealey and Vickers-Willis.

Justice Matthews ruled the non-compete clause unenforceable for the three employees, highlighting that the restraint of trade or non-compete must be proportionate and not contrary to public policy. The cascading clause’s broad application prevented the employees from engaging with any client of Escala, not just those with direct relationships, which posed an undue restriction on their ability to be employed by a competing business within a specified radius.

This case underscores the necessity of drafting non-compete and non-solicitation clauses that are specific and proportionate to ensure enforceability under Australian law. It also illustrates the importance of tailoring restraint clauses to protect legitimate business interests without imposing excessive restrictions, thereby avoiding clauses that could be seen as unreasonable or contrary to public policy. 

Practical Tips for Buyers

Negotiating Terms Effectively

When looking to buy a business, effectively negotiating non-compete clauses is essential to protect your investment. Start by ensuring the terms align with the value in the business and the specific business activities that need protection. Utilise a cascading clause which gradually reduces restrictions over time, making the agreement more acceptable to the seller.

Key strategies include:

• Define Clear Scope: Specify the geographical area and the nature of competing activities to prevent overly broad restrictions that may be deemed unreasonable.
• Agree on Reasonable Duration: Set a restraint period that is reasonably necessary to protect your legitimate business interests, typically between one to twelve months.
• Include Non-Disclosure Clauses: Protect confidential information by ensuring non-disclosure clauses are part of the agreement, limiting the former employer from sharing sensitive data.
• Provide Adequate Consideration: Offer fair compensation or other considerations to support the non-compete clause, enhancing its enforceability.

Ensuring Comprehensive Protection

To ensure comprehensive protection of your business interests after the sale, include multiple protective measures in the agreement. Non-compete clauses may prevent the seller from starting a competing business or soliciting your clients. Additionally, incorporate non-solicitation clauses to prevent employees from being poached, safeguarding your workforce.

Essential components to consider:

• Protect Business Activities: Clearly outline which business activities are restricted to avoid ambiguity and ensure the clause is enforceable.
• Cover Suppliers of the Business: Ensure that the agreement extends protections to suppliers, preventing them from aiding businesses in competition.
• Prevent Employees from Competing: Incorporate clauses that prevent employees from joining or setting up rival businesses, maintaining stability.
• Tailor to Business Needs: Customise the clauses to reflect the specific risks and competitive dynamics of your industry, ensuring they are necessary to protect your legitimate business interests.

By integrating these elements, buyers can secure their business interests and mitigate potential risks associated with the sale.

Conclusion

Drafting a well-structured non-compete clause is crucial for buyers in small business transactions, ensuring that sellers do not engage in or support competing ventures post-sale. These clauses protect your investment by maintaining the value and integrity of the acquired business, preventing former owners from leveraging sensitive information or client relationships to establish rival enterprises.

To ensure your non-compete agreements are enforceable and tailored to your specific business needs, consult with our experienced legal team today. Contact our experts today to receive unparalleled expertise in crafting robust clauses that safeguard your legitimate business interests and support your long-term objectives. 

Frequently Asked Questions