iBy now you have probably heard of the Federal Trade Commission (FTC)’s rule to ban most post-employment non-compete agreements. Additional information about the new rule is available here. While much of the conversation has naturally focused on the rule’s significant impact on employees and how it will invalidate existing non-competes for millions of workers, the FTC’s actions will also have key ramifications for M&A and private equity transactions across all industries. Buyers and private equity sponsors in these transactions typically use a multi-faceted approach to non-competes designed to protect the value of the acquired business, which includes the use of equity-based non-competes and key employee non-competes. However, the FTC’s rule banning the majority of non-competes, assuming it withstands pending legal challenges, will require buyers and private equity sponsors to rethink many of their asset protection strategies in future transactions. In the interim, private equity sponsors and buyers should continue to operate in the ordinary course and be mindful of the potential impact of the FTC’s rule.
What is The “Sale of Business” Exemption and Will it Apply to All Transactions?
Sale-based non-competes are common in M&A and private equity transactions. Buyers typically use these provisions to prevent founders and significant equity holders from using their deal proceeds (combined with their knowledge and experience) to fund competitive ventures with the business the buyer just acquired. Most states prohibiting non-competes – even California – have historically permitted such provisions in this limited “sale of business” context. The new FTC rule also preserves these restrictive covenant arrangements in M&A and private equity transactions under its “sale of business exemption.”
Indeed, the rule carves out an exemption permitting non-competes when a “noncompete clause is entered into by a person pursuant to a bona fide sale of a business entity, of the person’s ownership interest in a business entity, or of all or substantially all of a business entity’s operating assets.” 16 C.F.R. §910.3(a). Notably, the FTC initially proposed, and ultimately rejected a requirement that the restricted party be a substantial owner, substantial member, and substantial partner and have held at least a 25% percent of the ownership interest in the business entity. It also rejected a requirement that seller must sell their entire interest in the business.
While a threshold on the ownership level was rejected by the FTC, the FTC did not clarify the nature of the ownership and who is and is not considered an owner. For example, does an equity holder who only held warrants or options in the business and receives deal proceeds in exchange thereof qualify as an owner for purposes of requiring them to execute a non-compete under the “sale of business” exemption? Moreover, neither the FTC’s rule nor its commentary discusses whether compensatory payments such as option cash-outs or transaction bonuses can support the sale of business exemption. However, it’s possible that, moving forward, buyers may require those who hold options or other derivative securities to exercise their interests prior to the closing of the transaction and receive formal shares of stock in exchange therefor (which would then be ultimately sold to the buyer) to more closely comport with the sale of business exemption. Also, note that, even without the proposed limitations about who is considered an owner and what constitutes a sale of an interest in the business, the non-compete must still pass muster under applicable antitrust and state laws, which the FTC noted “generally requires a showing that a non-compete is necessary to protect the value of the business being sold.”
Also, note that, the FTC was particularly focused on ensuring buyers do not use “sham transactions” or deploy other evasive mechanisms to circumvent its rule. Therefore, to qualify for the “sale of business” exemption, the underlying transaction must be a “bona fide sale.” Generally, the FTC defines a “bona fide sale” as “one between two independent parties at arm’s length, and in which the seller has a reasonable opportunity to negotiate the terms of the sale.” This definition should not prevent the overwhelming majority of sale transactions whereby buyers and private equity sponsors require non-competes from the selling parties.
Can Equity-Based Non-Competes Still Be Used Against Equity Holders?
In addition to non-competes entered into with owners in exchange for their deal proceeds under the “sale of business exemption”, buyers and private equity sponsors also look to apply non-competes to owners who will have continued equity in the post-transaction business. The reasoning is that buyers and private equity sponsors want to ensure that individuals who have an equity stake in their business cannot simultaneously compete with the business in a wholly separate venture. Private equity sponsors, in particular, often will require any sellers who are rolling equity into the company or key management employees who may receive equity in the post-transaction company to also be subject to non-competes. This can take multiple forms but typically include (i) non-competes in the operating agreement for the post-transaction company where such person is bound as an equity holder and/or (ii) non-competes in the grant agreement for any options or profits interests such person may receive in connection with their continued employment.
The continued enforceability of non-competes against equity holders will depend, in part, on the context of the particular agreement and whether the equity holder is also a “worker.” Operating agreements or grant agreements with non-competes may not meet the requirements of the “sale of business exemption” and, therefore, could be invalid under the new FTC rule absent another exemption. Equity-based non-competes against individual sellers who are both “workers” post-transaction and are rolling equity into (or will become an equity holder through co-investment or incentive equity awards in) the post-transaction business are at risk of being unenforceable under the FTC rule by virtue of the individual’s status as a “worker” unless another exemption applies. The rule defines a “worker” as:
“A natural person who works or who previously worked, whether paid or unpaid, without regard to the worker’s title or the worker’s status under any other State or Federal laws, including, but not limited to, whether the worker is an employee, independent contractor, extern, intern, volunteer, apprentice, or a sole proprietor who provides a service to a person.” 16 C.F.R. §910.1.
Note that it is unclear whether this broad definition in intended to encompass board members who may be considered non-traditional “workers.” But, for the avoidance of doubt, restrictive covenants with non-workers (which could include certain third-party investors) should remain enforceable.
How Does the New Rule Affect Repurchase Rights for Rolled Equity that Impose a Punitive Repurchase Price for Breach of a Non-Compete?
In addition to requiring management and other individuals who are rolling equity into the post-transaction business to be party to non-competes, buyers and private equity sponsors will often combine those non-compete restrictions with punitive rights with respect to such rolled equity in the event of a breach of any of those restrictions, including the forfeiture of equity. Alternatively, rather than a forfeiture right, buyers and private equity sponsors may include a repurchase right requiring such individuals to sell their equity to the buyer or private equity sponsor or to the company at a pre-determined price, which is often the lower of cost or the then-fair market value.
The FTC rule generally treats a forfeiture (and ostensibly any other penalty) for breach of a non-compete as an unenforceable non-compete provision. As such, forfeiture and repurchase right provisions that penalize individuals for breaching restrictive covenants are now at-risk unless covered by the “sale of business” exception.
Can Key Employees Still be Required to Sign Non-Competes?
In addition to equity holders, buyers and private equity sponsors often seek reassurances that the recently acquired employees will not leave the business and compete. Therefore, buyers and private equity sponsors often require key employees of the business to execute post-employment non-competes as a transaction closing condition. Who is considered a “key employee” varies by business and industry. As such, it can be difficult for buyers and private equity sponsors to develop a strategy for when it requires employees to sign non-competes. Further, more and more states are passing legislation banning in whole or in part non-competes entered into by employees. In any event, the new FTC rule curtails this practice of key employee non-competes.
The new FTC rule bans all new non-competes with workers, whether or not with a “senior executive.” Existing non-compete agreements may remain, but they are limited to only those who are “senior executives,” who the FTC defines very narrowly as individuals in a “policy-making position” with an annual compensation in excess of $151,164. To the extent there are senior executive employees who meet this requirement and are not already subject to a non-compete, naturally there is a heightened interest in having them sign a non-compete as soon as possible before the FTC’s rule becomes effective. If any such individuals are not already subject to a non-compete by the time the FTC’s rule becomes effective, and, unless the “sale of business exemption” applies, buyers and private equity sponsors will be unable to require key employees to sign new non-competes in connection with their transactions.
While the senior executive exemption is helpful, it is limited. That is, going forward, a buyer may only be able to assume whatever pre-negotiated non-compete exists and cannot modify its terms, including the duration thereof. Note, too, that many states limit the length of the restricted period and narrowly define what constitutes a “reasonable” non-compete in terms of substantive and geographical reach. Therefore, it’s possible that even a pre-existing non-compete with a senior executive still may not be enforceable if the applicable governing law was misapplied or ignored. Note, too, that some states – like California and Minnesota – also may award damages (including attorneys’ fees) for attempted enforcement of an unenforceable non-compete (see our article here on California’s recent statute). Therefore, even when able to assume an existing non-compete agreement with a senior executive under the FTC’s new rule, buyers and private equity sponsors must analyze the non-compete agreement they just assumed to confirm enforceability.
Looking Ahead
The FTC’s rule is already subject to legal challenge, with multiple lawsuits filed immediately after its announcement. While it remains to be determined whether the FTC’s rule will withstand these challenges, the FTC’s rule does reflect the trend of increased scrutiny of non-compete agreements across the United States. As such, buyers and private equity sponsors should begin to strategize and consider what transactions will look like going forward and how best to protect the business they will acquire. With the uncertainty of surviving legal challenges, private equity sponsors and buyer should continue to operate in the ordinary course, but plan for the future.
If the FTC’s rule survives legal challenge, potential strategies include:
- If an enforceable non-compete is entered into in connection with the “sale of business” exemption, ensure that it is reasonable and narrowly tailored to the business needs of the organization under the FTC rule, and applicable antitrust and state laws.
- Entering into non-compete agreements with “senior executives” before the FTC’s rule becomes effective.
- Providing for “garden leave” such that termination of employment is delayed (subject to any state law limitations and challenge under the FTC rule).
- Evaluating and enhancing policies and practices related to the protection of confidential and trade secret information (as the non-disclosure of this information ultimately is what non-competes are often designed to address).
- Strengthening customer/client and employee non-solicit restrictions (subject to any state law limitations) in both employment agreements and sale of business restrictive covenants to the extent permissible under applicable law (note that some states, such as California, interpret the ban on non-competes to include non-solicits).
More than ever before, it is important to consider the transaction terms by which buyers and private equity sponsors protect their businesses and ensure the “secret sauce” doesn’t walk out the door after closing.
